Monday, October 12, 2009

More Risk? More Complexity?


Following up on my last comment on the squeeze on pensions, David Budworth of the London Times writes that final-salary pension plans urged to take more risks:

Trustees of struggling final-salary pension plans are being urged to adopt racier investment strategies or risk losing up to £150 million of benefits for thousands of scheme members.

About 75 final-salary pension plans have such large funding shortfalls that they will wind up in the next two years — forcing 15,000 members into the Pension Protection Fund — unless they take radical action, according to Hewitt Associates, a human resources consultancy, but the schemes could be saved if the trustees overhauled their investment strategies, turning to alternative assets, such as derivatives and infrastructure.

Traditionally, final-salary schemes have invested in conventional shares and fixed income, including government bonds. But John Belgrove, the principal consultant in Hewitt’s global investment practice, said that sticking with conventional strategies would fail to save those schemes most at threat of winding up. This, in turn, could trigger company insolvencies as the companies are presented with unaffordable pension debts for payment.

He said: “Many defined-benefit schemes in this situation are running significant risks resulting from their traditional equity-heavy narrow strategies. Sponsors cannot stomach the financial rollercoaster ride that is the consequence of static long-term investment thinking, yet closing a pension scheme should only be an action of last resort.

“Reviewing the scheme’s investment strategy, its current asset allocation and risk exposures is absolutely critical. In today’s complex investment environment, there are options available to trustees that can genuinely improve scheme efficiency and ultimately reduce further potential strain on the Pension Protection Fund.”

Mention of derivatives, swaps and hedge-fund type strategies is bound to raise protests from some trustees, who regard these instruments as complex and, therefore, inherently riskier. However, Hewitt’s approach has some high-profile supporters.

Ros Altmann, a governor of the London School of Economics and a former adviser to the Treasury and No 10 on pensions policy, said: “I wouldn’t say that it is a higher-risk strategy — it is lower risk. What trustees have done so far is take a great bet on the stock market based on the notion that equities will outperform over the longer term.”

Aon Consulting said this month that the stock market revival had helped to narrow the gap between the value of assets and liabilities for the 200 biggest final-salary schemes. But these still stood at £62 billion, down from £78 billion in August.

Larger final-salary schemes have begun adopting alternative techniques in an attempt to control liabilities. However, experts question how easy it would be for smaller schemes to move into the likes of swaps and derivatives. Many pension trustees are amateurs, work part-time and have non-financial backgrounds.

However, Hewitt argues that failure to act will leave scheme members out of pocket. The Pension Protection Fund guarantees all pensions that are already being paid, but only 90 per cent of those yet to be paid, up to a maximum of £28,742 a year for 2009-10. Hewitt calculates that about 15,000 final-salary scheme members could lose an estimated fifth of their benefits — about £10,000 each — if their scheme enters the Pension Protection Fund.

With all due respect to Dr. Ros Altmann, smaller pension plans have no business investing in hedge funds, or other alternative investments like private equity. They should, for the most part, stick to a 60/40 stock/bond portfolio and look to allocate to quality managers.

If they are hell bent on hedge funds, then they should go to reputable funds of funds that will not rape them on fees and that offer managed accounts. But I am skeptical of most funds of funds and the reality is that smaller plans shouldn't be investing in strategies they do not understand.

Speaking of keeping it simple, Maik Rodewald of the FT writes, The future of investing: academics predict more complexity (hat tip to Fred):

“A theory should be as simple as possible, but no simpler.” If one applies Albert Einstein’s words to a colourful basket of theses from leading US academics about the future of investing, it could look like this:

Andrew Lo of MIT’s Sloan School of Management provides the foundation of the theory. For one of America’s current academic superstars, it is pretty clear how the future must look: “We need to solve investors’ biggest problem – uncertain outcomes of risks and returns.”

Mary Schapiro, the new chairman of the Securities and Exchange Commission, works along similar lines. Her mantra: “How does this help investors?” is a simple and threatening statement set to challenge many in the asset management industry.

So far, so simple. However, beyond this basic plot, it gets complicated.

The consequence of Mr Lo’s intuitive statement could prove vexing for those, like Ms Schapiro or academics such as Harvard’s Robert Pozen, who advocate the need for simplicity and a so-called “back-to-basics” approach. Ironically, they could soon find themselves in a complex world where financial engineering celebrates a massive comeback, rather than in a simplistic universe of current accounts, plain vanilla products and massive regulation.

We can explore some details of this world by asking some simple questions.

Will we be fully certain about our risks and rewards?

No, but we are getting closer as financial engineering is set to shift its focus from delivering more return to providing more stability. For example, according to Mr Lo, in less than five years an investor will be able to buy an equity linked product, guaranteeing him a volatility of, say 15 per cent. However, financial engineers are still far away from understanding why markets change so quickly without necessarily being efficient – solving this big puzzle will take another 50 years.

Will we still think in asset classes?

Yes, but there will be many more, as more investors pick up hedge fund type strategies and as technology allows them to move away from market cap-weighted, long-only indices to employ more sophisticated, yet investable benchmarks.

Harvard professor Luis Viceira goes further, suggesting investors would benefit from allocating money to products that directly expose them to performance drivers like equity risk, real interest rate risk and inflation risk, instead of investing in pools of risks like asset classes, where risks are not clearly separated.

Will we still use indices?

Yes. Since there are many more asset classes, there are as many new indices and betas (market or asset class returns) to choose from. Prominent examples are carry trade betas (the strategy of borrowing in low interest currencies to invest in high interest ones), credit trade betas, volatility betas, liquidity betas and alternative betas, which replicate the performance of hedge fund strategies.

Will we still strive for more than just average?

Yes. Mr Lo, along with academics at Harvard Business School such as Robert Pozen, Kenneth Froot, Malcolm Baker and Luis Viceira, still regards alpha, outperformance based on unique insights, as the ultimate goal of intelligent investing.

This judgment comes as a surprise at a time when passive investments are seriously challenging the business models of traditional long-only managers and trustees are asking whether a pension fund needs alpha at all.

Will we perceive risk differently?

Yes, mainly because of two risks no one cared about much: illiquidity and inflation. According to Mr Froot, “investors will demand higher risk premiums as a consequence of the illiquidity and intransparency of the bond market”.

US investors such as university endowments should have learned their lesson with illiquidity, adds behavioural finance expert Malcolm Baker: “They had to realise their investment horizon is much shorter than they thought.”

Inflation, on the other side, catches Mr Viceira’s attention. That is why he advocates inflation-linked investments as the most likely new risk-free asset class, not cash or money market deposits.

Endowments have taken up Mr Viceira’s idea, as has APG investments, the asset management arm of Dutch pension fund ABP, where Mr Viceira sits on the board.

Will we still benefit from diversification?


Yes, but it could disillusion investors even more than before. The excessive liquidity provided by the central banks is a big concern for the academics. They expect asset price bubbles, primarily in bonds, but also in emerging markets.

Will hedge funds disappear?

No. For Mr Lo, hedge funds are “the Galapagos islands of the financial services industry”, as they will adapt fastest to new opportunities, giving them a competitive advantage.

However, hedge funds are likely to come under fee pressure.

Will the US capital markets become less attractive?

No, says Andrei Shleifer of Harvard’s economic department. The Russian-born academic expects the US to remain the financial superpower. Hence, with the largest and most liquid capital markets in the world, it will still attract the bulk of investors’ assets.

More risk? More complexity? What are investors and trustees to do? Let me share some comments with you. The financial engineers are working hard to "tame risk" but in my experience when everyone is rushing to play the same game, they all knowingly (or inadvertently) add to systemic risk.

A few years ago, everyone was peddling capital guaranteed structured notes in Canada and elsewhere. Go to any major investment bank and see how the sales of their structured products dropped off a cliff. It was the biggest scam I ever saw and yet so many retail (and few institutional investors) bought into these "capital guaranteed" notes, much to their demise.

I can tell you how it worked. Investors buy the product, the investment bank then buys a zero-coupon bond on margin and invests the cash proceeds into a fund of hedge funds. When the hedge funds were making money, this strategy worked well. But in 2008, the liquidity risk and leverage of these strategies were exposed as hedge funds suffered material losses and the structured products made nothing for investors. After fees, they ended up losing money.

[Note: The OECD has an overview of hedge funds and structured products: issues of leverage and risk.]

I like to keep things simple. For example, if you know most long/short hedge funds are long small cap stocks and short large cap stocks, why should you pay 2 & 20 for this "alpha"? Play their game and you'll beat most of them (Hint: Go back to review my post on why small is beautiful).

In the future, most betas, including 'alternative betas', will be replicable so to make money you'll need to think about how betas are correlated in a financial crisis and how to take proper risks on the betas that are being arbitraged to death. As for alpha, it doesn't have to be complicated, and you don't need to hire an army of quants to figure out how to make money. All you need is common sense, some conviction on where we're heading and some good old fashion investment savvy. And remember not to follow the herd, but follow the leaders.

***Comment from a senior pension fund manager***

A senior pension fund manager sent me this comment:

This is sadly, bang on in terms of where things are going. Whenever a consultant ends their pitch and says “if you don’t do xyz (usually a derivatives or illiquid strategy), you may be breaching your fiduciary duty as a Board”, I cringe. The consultants have a massive vested interest in complexity, and are hugely underestimated actors in creating the conditions for the herd mentality in institutions, by outright intimidating the many lay Boards. And the “sophisticated” Boards are usually populated with investment dealer types, who see the merits of pushing fees to their old friends and colleagues, and certainly don’t resist pro-trading type operations within institutions. Even I am clever enough to swim with the riptide, but I intend to keep my swim trunks on…

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