Tuesday, January 25, 2011
Pension fund? Just met with another large pension de-risking its entire portfolio by moving to 100% alpha strategies. Why let retirement benefits, income streams and funded status be affected by interest rates and volatile stock markets? The trustees and CIO are pleased the plan will outperform its peers and match liabilities. Retirees won't have to worry about a proper income after working and sponsors will avoid a deep drawdown like 2008 or 2002. Someday 100% in alternatives will be standard. Why ignore top managers? Why endure the headline risk of unskilled funds? Minimize tracking error to liabilities not assets.
Absolute liabilities need absolute returns. It's now rare for institutions to not invest in alternatives but allocations are often too low or made to mediocre managers. Promises must be paid regardless of the economy or discount rates but how to optimally fund future needs today? Most investors don't have time to rely on stock markets to deliver. Skill is the friend, time is the enemy. Increase expected returns, reduce age eligibility and invest smartly. Some sovereign wealth funds are already 100% allocated to external and internal skill-based strategies. What do you know that they don't? Long term success requires short term focus.
There's no global pension crisis. Only a need for better capital use. It's a return assumption versus interest rate crisis. Liabilities can still be met without severe austerity measures, major capital contributions or excessive risk taking. The problem stems from bad theories, weak diversification, overoptimistic scenario analysis and poor manager selection. Asset allocation isn't risk management. Hope for the best but prepare for anything. Risk free bonds are not risk free. How many actuaries model for most members reaching 100? The miracle of compounding is only miraculous at HIGH returns. The gap from 4% to 5% is much lower than 9% to 10% over the long term. Too much in bonds almost guarantees a high enough return won't be achieved.
Alternative investments can be the cheapest liability solution. Increase performance and reduce shortfall risk with the best risk/return strategies. Expect and require +10% after fees. I do. Global markets are complicated and codependent so invest in unskilled managers or those with the ability to capture alpha? Social security and portfolio optimization from assets or strategies? Fiduciary duty requires putting capital to work in the most cost-effective ways to maximize growth and minimize risk of not being able to deliver. Whether you have $1,000 or $1 trillion to invest the issue is the same. A $1 million portfolio should provide annual income of $100,000 with principal protection. Age in bonds at these yields?
Portfolio stress tested for negative asset returns over the NEXT decade? Why fixate on the stock/bond split when you can hire top talent to exploit market inefficiencies? Hope for the unrequited love affair with stock indices to finally deliver? Even when they do go up it's at unacceptable risk. The total return S&P 500 has underperformed cash since 1997 and the Dow was higher in 1905 than 1942. What if US markets are lower in 2025? Or 2040? The Japanese Nikkei is lower today than in 1984. I'd rather find brilliant managers than bet on asset classes. Obeying "World" stock and bond weightings, missing emerging opportunities and new investment strategies has cost too many retirement plans too much money.
It's not WHAT or WHERE to invest but WHO can best put cash to work. Some still pick managers to simply deliver asset class performance but I prefer teams that generate higher absolute returns than the risks they take on. I'm very risk averse so no investment opportunity gets my attention unless there's a high chance of +10% total return each year. My deep VALUE philosophy requires managers with skills priced far lower than their worth. 2 and 20 for alpha is cheap, 0.20 for beta is expensive. Why not ask top fund managers to make money to fund long term income streams? Some even have a "maximum" percentage in hedge funds! As if managed futures and global macro are affected in the same way as equity long/short and distressed debt managers. Only the ignorant treat "hedge funds" as an asset class. They are not.
How to fund CERTAIN cash flows in an UNCERTAIN future? Stay the course with long only or replace with short/long? Retirement "fixed-income" needs higher yields than most "investment grade" bonds and stock dividends are paying. Over the long term passive can't win in an active world. Risk assets fluctuate together more so how to diversify properly? 2010 and 2009 were "up" years so equities are back on track to compensate for risk? Those gains were lost in 2000-2002 and 2007-2008 but this time is different? Bet on the commodities bubble or hire the best commodities traders? Focus on alternative alpha, upgrade the manager mix and reduce risk OR cut benefits, raise retirement ages, increase capital contributions and remove economies of scale?
The $64 trillion question: prudent portfolio construction for fiduciaries. Who is best equipped to navigate markets and perform no matter what happens? We live in a high frequency economy. Beta bets are being replaced by alpha capture opportunity sets. Long only relative return is being substituted by long/short absolute return. Pensions affect all people of every age, everywhere whether they are called superannuation schemes, mandatory provident funds or retirement systems. Many employees and plan sponsors pay in more than necessary because of lower expected returns. Static 60/40 stocks and bonds fails to take advantage of dynamically changing environments or the wide dispersion of security returns. Pension funds themselves are short/long. No point in "long term" if beneficiaries need their checks in the short term.
Fixed-income arbitrage? Return assumptions matter. Some people just won the $380 million Megamillions lottery. Or was it $2 BILLION? Simple NPV arithmetic favors the one time net payment of $180 million rather than the 26 year option of $14.6 million annually. The publicized future value is discounted by interest rates not by the return that conservatively can be achieved by sensible portfolio construction and manager selection. Good strategies deliver +10% a year over time. The very best funds +20% CAGR. Getting $180 million today is equivalent to $2 billion then, given the jackpot is the amount received after 26 years. Lump sum or annuity? Always the lump sum if you can invest the proceeds at better than discount rates. Provided they are advised competently!
The cheapest way to long term income and capital gains? The LOWER future returns the MORE capital needed. If you owe $1 million in 2030 to yourself or employees?
1) Invest $500,000 in bonds. "Investment grade" yields are "correct" discount rates.
2) Invest $300,000 in betas. Hope for 6-8% CAGR in "assumed" risk premiums and bonds.
3) Invest $150,000 in alphas. Receive +10% net from the best absolute return funds.
Interest rates should not impact "expected returns" used to calculate liabilities. Despite conventional "wisdom" there is nothing wrong with assuming 10%. What is wrong is thinking buying and holding stocks and bonds will deliver it. Invest in strategies applied to assets not asset classes themselves. Despite an "up" 2010, equity beta is too volatile over any time horizon to be relied on to help meet liabilities. Long term bonds don't yield enough and have too much duration and default risk. Decades count more than years. The percentage required in alternatives rises inversely with bond yields.
Hedge fund capacity is not a problem. Some say there isn't sufficient room in alternatives to rapidly increase allocations. That's nonsense. The passive index and ETF mania creates MORE mispricings and arbitrages than ever before. Securities bought because they are in a benchmark not because they are good investments! 80% of hedge funds are bad so the more that appear the more money to be made out of them by the 20% genuinely skilled managers. Depending on strategy, size does not damage performance though obviously hedge funds do hard close if necessary. 2008-2010 was a great 36 month period of varied market conditions to assess who knows what they are doing. Most don't.
The best deliver. 3,000 hedge funds made money in 2008. 2010 was fine. The third largest, Paulson & Co., +15%. The biggest hedge fund, Berkshire Hathaway, did +20%. The second largest hedge fund Bridgewater Associates returned +30%. Most good managers returned +10% in 2010 and those that didn't, performed very well in 2008. Smaller, newer hedge funds as a group have higher returns than larger, older hedge funds. Never have more than 5% in any fund NO MATTER HOW SUCCESSFUL. Everyone has losing years sometimes. It's losing decades that are unacceptable. Stock AND bond indices have had losing decades and will again.
Suppose you need to put $200 billion into hedge funds. I already know who the best 200 managers are so it would be straightforward to allocate each $1 billion. Then remove and add new managers when even better strategies appear. The hedge fund industry AUM is tiny compared to its ultimate size. I've seen strategies like high frequency trading go from very limited capacity to running decabillions today. Emerging markets emerge continually. There is no lack of room for alpha capture. Innovative strategies and financial products are being developed all the time. When hedge fund capacity actually is an issue there will be interplanetary markets to arbitrage. Then that speed of light issue really will matter. Low latency helps every strategy. The quicker you make and execute an investment decision the higher the return.
Treat "hedge funds" as an asset class and you will be disappointed. There is huge dispersion in ability. The strategy universe is too diverse to be pigeon-holed into one neat asset allocation box. Security analysis and manager due diligence require similar expertise and experience. If an investor hasn't spent 10,000 hours analyzing and trading a wide range of securities, and ANOTHER 10,000 hours researching managers and strategies it is unlikely they have what it takes. I can't think of any consistently successful investor anywhere that hasn't served those 20,000 hours. Lucky investors don't need them but skilled ones do. There is no short cut to acquiring the acumen required to get good enough to make that +10% CAGR. What can be done is to begin as early as possible. I did my first frontier markets arbitrage trades aged 11 but still have much to learn.
Any pension with 100% in "average" hedge funds in 2000 is now in surplus. With proper analysis and due diligence you can do much better than the mere "average". The "typical" hedge fund is no use and zero-sum alpha means "aggregate" performance converges to the risk free rate. The best way to fund retirement is to have the best managers in the portfolio. Those with their own wealth at risk and who have demonstrated the ability to deliver absolute returns in all market conditions. Benefit promises to yourself or others are mandatory payments no matter what the markets do.
Absolute liabilities need absolute returns. It's now rare for institutions to not invest in alternatives but allocations are often too low or made to mediocre managers. Promises must be paid regardless of the economy or discount rates but how to optimally fund future needs today? Most investors don't have time to rely on stock markets to deliver. Skill is the friend, time is the enemy. Increase expected returns, reduce age eligibility and invest smartly. Some sovereign wealth funds are already 100% allocated to external and internal skill-based strategies. What do you know that they don't? Long term success requires short term focus.
There's no global pension crisis. Only a need for better capital use. It's a return assumption versus interest rate crisis. Liabilities can still be met without severe austerity measures, major capital contributions or excessive risk taking. The problem stems from bad theories, weak diversification, overoptimistic scenario analysis and poor manager selection. Asset allocation isn't risk management. Hope for the best but prepare for anything. Risk free bonds are not risk free. How many actuaries model for most members reaching 100? The miracle of compounding is only miraculous at HIGH returns. The gap from 4% to 5% is much lower than 9% to 10% over the long term. Too much in bonds almost guarantees a high enough return won't be achieved.
Alternative investments can be the cheapest liability solution. Increase performance and reduce shortfall risk with the best risk/return strategies. Expect and require +10% after fees. I do. Global markets are complicated and codependent so invest in unskilled managers or those with the ability to capture alpha? Social security and portfolio optimization from assets or strategies? Fiduciary duty requires putting capital to work in the most cost-effective ways to maximize growth and minimize risk of not being able to deliver. Whether you have $1,000 or $1 trillion to invest the issue is the same. A $1 million portfolio should provide annual income of $100,000 with principal protection. Age in bonds at these yields?
Portfolio stress tested for negative asset returns over the NEXT decade? Why fixate on the stock/bond split when you can hire top talent to exploit market inefficiencies? Hope for the unrequited love affair with stock indices to finally deliver? Even when they do go up it's at unacceptable risk. The total return S&P 500 has underperformed cash since 1997 and the Dow was higher in 1905 than 1942. What if US markets are lower in 2025? Or 2040? The Japanese Nikkei is lower today than in 1984. I'd rather find brilliant managers than bet on asset classes. Obeying "World" stock and bond weightings, missing emerging opportunities and new investment strategies has cost too many retirement plans too much money.
It's not WHAT or WHERE to invest but WHO can best put cash to work. Some still pick managers to simply deliver asset class performance but I prefer teams that generate higher absolute returns than the risks they take on. I'm very risk averse so no investment opportunity gets my attention unless there's a high chance of +10% total return each year. My deep VALUE philosophy requires managers with skills priced far lower than their worth. 2 and 20 for alpha is cheap, 0.20 for beta is expensive. Why not ask top fund managers to make money to fund long term income streams? Some even have a "maximum" percentage in hedge funds! As if managed futures and global macro are affected in the same way as equity long/short and distressed debt managers. Only the ignorant treat "hedge funds" as an asset class. They are not.
How to fund CERTAIN cash flows in an UNCERTAIN future? Stay the course with long only or replace with short/long? Retirement "fixed-income" needs higher yields than most "investment grade" bonds and stock dividends are paying. Over the long term passive can't win in an active world. Risk assets fluctuate together more so how to diversify properly? 2010 and 2009 were "up" years so equities are back on track to compensate for risk? Those gains were lost in 2000-2002 and 2007-2008 but this time is different? Bet on the commodities bubble or hire the best commodities traders? Focus on alternative alpha, upgrade the manager mix and reduce risk OR cut benefits, raise retirement ages, increase capital contributions and remove economies of scale?
The $64 trillion question: prudent portfolio construction for fiduciaries. Who is best equipped to navigate markets and perform no matter what happens? We live in a high frequency economy. Beta bets are being replaced by alpha capture opportunity sets. Long only relative return is being substituted by long/short absolute return. Pensions affect all people of every age, everywhere whether they are called superannuation schemes, mandatory provident funds or retirement systems. Many employees and plan sponsors pay in more than necessary because of lower expected returns. Static 60/40 stocks and bonds fails to take advantage of dynamically changing environments or the wide dispersion of security returns. Pension funds themselves are short/long. No point in "long term" if beneficiaries need their checks in the short term.
Fixed-income arbitrage? Return assumptions matter. Some people just won the $380 million Megamillions lottery. Or was it $2 BILLION? Simple NPV arithmetic favors the one time net payment of $180 million rather than the 26 year option of $14.6 million annually. The publicized future value is discounted by interest rates not by the return that conservatively can be achieved by sensible portfolio construction and manager selection. Good strategies deliver +10% a year over time. The very best funds +20% CAGR. Getting $180 million today is equivalent to $2 billion then, given the jackpot is the amount received after 26 years. Lump sum or annuity? Always the lump sum if you can invest the proceeds at better than discount rates. Provided they are advised competently!
The cheapest way to long term income and capital gains? The LOWER future returns the MORE capital needed. If you owe $1 million in 2030 to yourself or employees?
1) Invest $500,000 in bonds. "Investment grade" yields are "correct" discount rates.
2) Invest $300,000 in betas. Hope for 6-8% CAGR in "assumed" risk premiums and bonds.
3) Invest $150,000 in alphas. Receive +10% net from the best absolute return funds.
Interest rates should not impact "expected returns" used to calculate liabilities. Despite conventional "wisdom" there is nothing wrong with assuming 10%. What is wrong is thinking buying and holding stocks and bonds will deliver it. Invest in strategies applied to assets not asset classes themselves. Despite an "up" 2010, equity beta is too volatile over any time horizon to be relied on to help meet liabilities. Long term bonds don't yield enough and have too much duration and default risk. Decades count more than years. The percentage required in alternatives rises inversely with bond yields.
Hedge fund capacity is not a problem. Some say there isn't sufficient room in alternatives to rapidly increase allocations. That's nonsense. The passive index and ETF mania creates MORE mispricings and arbitrages than ever before. Securities bought because they are in a benchmark not because they are good investments! 80% of hedge funds are bad so the more that appear the more money to be made out of them by the 20% genuinely skilled managers. Depending on strategy, size does not damage performance though obviously hedge funds do hard close if necessary. 2008-2010 was a great 36 month period of varied market conditions to assess who knows what they are doing. Most don't.
The best deliver. 3,000 hedge funds made money in 2008. 2010 was fine. The third largest, Paulson & Co., +15%. The biggest hedge fund, Berkshire Hathaway, did +20%. The second largest hedge fund Bridgewater Associates returned +30%. Most good managers returned +10% in 2010 and those that didn't, performed very well in 2008. Smaller, newer hedge funds as a group have higher returns than larger, older hedge funds. Never have more than 5% in any fund NO MATTER HOW SUCCESSFUL. Everyone has losing years sometimes. It's losing decades that are unacceptable. Stock AND bond indices have had losing decades and will again.
Suppose you need to put $200 billion into hedge funds. I already know who the best 200 managers are so it would be straightforward to allocate each $1 billion. Then remove and add new managers when even better strategies appear. The hedge fund industry AUM is tiny compared to its ultimate size. I've seen strategies like high frequency trading go from very limited capacity to running decabillions today. Emerging markets emerge continually. There is no lack of room for alpha capture. Innovative strategies and financial products are being developed all the time. When hedge fund capacity actually is an issue there will be interplanetary markets to arbitrage. Then that speed of light issue really will matter. Low latency helps every strategy. The quicker you make and execute an investment decision the higher the return.
Treat "hedge funds" as an asset class and you will be disappointed. There is huge dispersion in ability. The strategy universe is too diverse to be pigeon-holed into one neat asset allocation box. Security analysis and manager due diligence require similar expertise and experience. If an investor hasn't spent 10,000 hours analyzing and trading a wide range of securities, and ANOTHER 10,000 hours researching managers and strategies it is unlikely they have what it takes. I can't think of any consistently successful investor anywhere that hasn't served those 20,000 hours. Lucky investors don't need them but skilled ones do. There is no short cut to acquiring the acumen required to get good enough to make that +10% CAGR. What can be done is to begin as early as possible. I did my first frontier markets arbitrage trades aged 11 but still have much to learn.
Any pension with 100% in "average" hedge funds in 2000 is now in surplus. With proper analysis and due diligence you can do much better than the mere "average". The "typical" hedge fund is no use and zero-sum alpha means "aggregate" performance converges to the risk free rate. The best way to fund retirement is to have the best managers in the portfolio. Those with their own wealth at risk and who have demonstrated the ability to deliver absolute returns in all market conditions. Benefit promises to yourself or others are mandatory payments no matter what the markets do.
