Thursday

Fund alpha

Pension fund absolute liabilities require absolute performance. Many pensions take too much market risk. Why let funded status and income streams be affected by volatile stocks and interest rates? f you invest prudently with the world's BEST managers there is no need to reduce benefits or increase capital contributions.

Great absolute return managers deliver what we need. +8% each and every year to meet actuarial assumptions. Expected asset class returns have little to do with funding liabilities. What the economy does should NOT effect portfolio growth. Manager selection is crucial. 90% of products purporting to be hedge funds are bad but 10% are good.

The lower expected returns the MORE capital needed today. For each $1 million owed in 2030 to beneficiaries, should you

1) Invest $500,000 in bonds. "Investment grade" yields are the "correct" discount rates assumed by corporate plans

2) Invest $300,000 in betas. Hope for 6-8% CAGR in "assumed" risk premiums and bonds, used by most public plans

3) Invest $150,000 in alphas. Receive +10% net from the best absolute return funds, used by the smartest, most prudent institutions in the world

Pension funds have a fiduciary duty to hire quality managers. Benefits consultants don't have the ability or inclination to identify them. Box-tickers create "asset allocation buckets" that get filled with risky long only stuff they recommend! The result is the retirement funding crisis caused entirely by their advice.

With limited risk management skill, constructing robust portfolios or how to select good traditional managers, such "help" is even worse when it comes to alternatives. It's time for true fiduciary duty. Why are most pensions investing retiree and taxpayer cash on inferior managers not smart or experienced enough to run a hedge fund? Such B-teams have no place in prudently managed portfolios. Skill is the way to meet promised liabilities at minimized cost to sponsors and paid-in beneficiaries.

Replace market risk with manager risk. There is no "expected return" from asset classes but there's plenty of "unexpected risk".  It's the LIABILITIES that matter not the asset allocation. Great managers don't run long only funds. Therefore long only has no place in a quality portfolio. Why avoid the alpha all stars and speculate on beta-based farm teams? Pensions should de-risk by transitioning to 100% quality and get rid of minor league mediocrities.

There's no pension crisis. Only a need for better capital usage. It is a return assumption versus interest rate crisis. Liabilities can be met without severe benefit cuts, major capital contributions or excessive risk taking. The problem stems from bad theories, weak diversification, overoptimistic scenario planning and poor manager selection. Asset allocation isn't risk management. Hope for the best but hedge for the worst. Risk free bonds are not risk free. Miracle of compounding is only miraculous at HIGH returns. The gap from 3% to 5% is much lower than 8% to 10% over long periods. Too much in bonds guarantees required returns won't be met.

Forget about asset allocation. Capital market assumptions are irrelevant. 100% in skill is the way forward. Avoid unhedged stock and bond funds. Why put fiduciary capital in beta benchmarks when you can invest in top alpha funds as REPLACEMENTS? Take lower risk than the market for higher returns. Use 10% as the discount rate and hire the best. Many are reducing "expected" returns and increasing the burden on capital contributors. Nothing wrong with de-risking as long as it's not de-returning. The solution is investing sensibly with competent managers. The prudent man invests in skill strategies (alpha) not asset classes (beta).

Invest in skills not assets. The pension underfunding crisis disappears by investing carefully and intelligently. The trustees and CIO are glad that plan will outperform peers and match long term liabilities. Retirees won't need to pay in more or worry about income after working and sponsors will avoid devastating drawdowns like 2008. Someday 100% in skill will be standard for all investors. Why ignore safer strategies and financial innovations? Why take headline risk of unskilled "passive" beta? Minimize tracking error to liabilities not assets. Hedge liabilities with proper hedge funds. There is no inherent return from any asset class including bonds.

Increase expected returns, lower age eligibility and invest smartly. As the most sophisticated investors have realized, good hedge funds are the cheapest and safest solution. Bonds are expensive and default prone. 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 market beta or suffer its vicious clawbacks. Skill is the friend, time is the enemy. Some sovereign wealth funds are already 100% allocated to external and internal alpha strategies. Long term success needs short term focus. Some say assumed returns are too high. NONSENSE. Raise them and invest in skill.

Alternative investments are 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 provides 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 2030? Or 2050? The Japanese Nikkei is lower today than in 1983. 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 decide. Some investors 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 conservative so no investment opportunity gets my attention unless there's a high chance of +10% total return each year. My VALUE philosophy requires managers with skills priced much lower than their worth. 2 and 20 for alpha is cheap, 0.20 for beta is expensive. Why not ask top asset managers to make money to fund long term income streams? A few institutions 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. Only the ignorant treat "hedge funds" as an asset class.

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?

Prudent portfolio construction for the long term. 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!

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.

A pension with 100% in "average" hedge funds in 2000 would be fully funded. 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.

How little was learnt and how much forgotten from 2008? Would a doctor that destroyed the health of all her patients be allowed to continue in practice? Lawyers that lose every case don't get clients so why are ideas that wrecked the finances of so many states and corporations still getting advisory mandates? Worse they are now trying to do discretionary portfolio management despite being unqualified for the role. Asking conflicted pension consultants how best to meet liabilities is like asking arsonists to be firemen. OCIO is handing them matches and gasoline.

By Veryan Allen Creative Commons License

This work is licensed under the Creative Commons Full Attribution, Non-Commercial, No Derivative Works 3.0 License

Hedge Fund Hedge fund

ヘッジファンド

F u n d §©®±¼½¾µßαβγδσ€∂√∞≠♠♣♥♦ΣΦΨΩ Follow Me on Pinterest