Sunday, November 9, 2008

Rolling the Dice on Real Estate


The weekend edition of the Financial Times reported that pension funds are turning their back on active equity managers as they reassess their strategies in the wake of the market turmoil of the past 15 months (PDF):
A survey of European and North American pension funds conducted in mid- October indicates the industry intends to continue cutting its exposure to equities to free cash to invest in alternatives such as hedge funds, private equity, commodities and property – in spite of the abject failure of many of these asset classes to provide much-vaunted “uncorrelated returns”.

Separately, research by Greenwich Associates suggests institutional investors are increasingly taking the management of their “plain vanilla” equity and bond holdings in-house and ditching their external managers.

Boston Consulting Group’s annual global asset management survey, released today, will add to the industry’s gloom by forecasting that actively managed funds will be squeezed even further by passive products such as exchange traded funds in the coming years.

“Some of the alternative absolute return strategies seem to be the main beneficiaries from the credit crisis. There will be more of a shift away from long-only strategies to more uncorrelated strategies,” said David Vafai, chief executive of BFinance, a consultancy, which has conducted the first major survey of pension funds’ intentions since the market sell-off accelerated in September.

The survey reveals that, despite getting their fingers burnt by their exposure to supposedly uncorrelated alternative assets in the past year, pension funds across continental Europe, Scandinavia, the UK and Canada are still keen for more.

A net 18 per cent of respondents said they expected to cut their equity exposure in the next 12 months, with cash being switched to fixed income and infrastructure.

Over the next three years, the transformation is likely to be starker still with a net 22 per cent of pension funds aiming to reduce equity holdings and, instead, pouring money into hedge funds, private equity, property, infrastructure, currencies, commodities and socially responsible investment.

Manager turnover could be on the rise with 77 per cent of respondents saying the market turmoil will lead them to review their fund managers – against the 25 per cent of fund managers who tend to be under review in normal circumstances, according to Mr Vafai.

Boston Consulting foresaw a similar picture, warning that asset management houses that do not have alternatives in their portfolios “may miss out on a very large and growing part of the industry’s revenue”.

It estimates that alternative and innovative products will account for 23 per cent of global assets under management by 2012, but 61 per cent of the global fee pool because of higher charges. In contrast actively managed core products such as equities and bonds will account for just 62 per cent of assets, from 74 per cent in 2007, and 36 per cent of revenues, against 49 per cent now.

Perhaps more worrying for fund managers, institutional investors appear to have been questioning their value even before this year’s sharp sell-off in financial markets.

Greenwich Associates’ survey of 419 continental European institutions found the proportion of their assets managed inhouse rose from below 60 per cent at the end of 2006 to almost 65 per cent 12 months later. Institutions have also beefed up the number of inhouse investment professionals they employ from an average of 5.6 in 2006 to 5.8 today.

“It is unclear whether the shift to internal management is a short-term phenomenon or a more fundamental change in approach tied to rising use of the core-satellite portfolio model or some wide loss of confidence in external managers,” said Rodger Smith, Greenwich consultant. “What is clear is that many institutions are taking a step back and wondering whether external managers are truly superior in assessing and managing risk. This represents a serious challenge for Europe’s asset managers.”

So the consensus is to get rid of external active equity managers, beef up your internal managers and pour more money into real estate, hedge funds, commodities, private equity and infrastructure.

I understand the shift towards bonds and infrastructure even though the deals in the latter asset class are getting priced at higher and higher multiples. But what is the obsession with real estate, private equity and hedge funds?

Real estate in particular is going to get crushed in the next downturn and nobody can convince me that it will escape the cycle unscathed.

The pension herd is doing exactly the wrong thing, selling liquid equities at their lows to move into illiquid investments coming off their highs. This is a particularly dangerous move for mature and underfunded pension plans who need liquidity to pay out benefits.

The typical knee-jerk reaction towards equity managers is shortsighted; pension funds should be investing with external equity managers that have a proven track record who got whacked in the last year - guys like Bill Miller of Legg Mason. Now is the time to invest with the 'Legg Masons' of this world.

Instead, they want more alternative investments because alternatives are immune to market downturns - at least in theory. In practice, alternative investments have turned out to be lots of hype with little or no downside protection and an additional cost of illiquidity.

But those bogus benchmarks on alternative investments allows pension fund managers to reap big fat bonuses at the end of year as they claim to add significant alpha. It is the biggest con job in the pension industry.

Could it be that this is the reason they want to shove more alternatives into their portfolios despite the latest debacle? I happen to think so because there is no other sane reason to be pouring billions into real estate at this time.

***Morning update:

Investors welcomed China's multi billion dollar stimulus package but analysts said Monday the plan will depend on Chinese companies to supply a big share of the spending:

Stock markets in Japan, Hong Kong and mainland China soared after Sunday's announcement of the 4 trillion yuan, or $586 billion, package as Beijing joined moves by governments around the world to cushion the blow of the global slowdown.

The plan calls for higher government spending on roads, airports and other infrastructure, tax deductions for exporters and bigger subsidies to the poor and farmers. Spending on health and education will be increased, as well as on environmental protection and high technology.

But it also depends on corporate investment and promises bank lending for rural projects, smaller companies and consumers.

"I don't believe a fiscal stimulus alone is enough to keep growth going. I see it as the jump-starting of a car. Corporate investment and bank lending are the fuel that will be necessary to keep it going," said UBS Securities economist Tao Wang.

Beijing might supply one-quarter of the announced spending, or 1 trillion yuan ($145 billion), with the rest coming from increased investment by Chinese state companies, bank lending or bond sales by local authorities for individual projects, said Ting Lu, a Merrill Lynch economist.

"Many state companies have a lot of cash. They just need to use it," Lu said.

The U.S. should take its cue from China and start pumping billions into their economy. What we need around the world is some classic Keynesian counter-cyclical measures to buffer the economic shocks stemming from global credit crisis.

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