Total Fund Management Part 3: When All Roads Lead to Rome

This is Part 3 of a seven part series on integrated Total Fund Management brought to you by Mihail Garchev, the former head of Total Fund Management at BCI and I. Please take the time to read Mihail's synopsis below followed by my comments and a clip where delves deeply into today's comment (added emphasis is mine, also slightly edited this version):

Before we continue with Episode 3 today, let us take a minute and quickly look at the summary takeaways from Episode 2 last week or "what nobody told you about long term investing." We started Episode 2, challenging the notion that long-term investing is about the horizon. And what we concluded was that long-term investing is not only about the horizon but about wealth maximization. Then the natural question was, "how one maximizes wealth." And we looked at how prices, cash flows and reinvestment drive wealth maximization.

Although it is commonly accepted that a long horizon's final wealth is driven mostly by cash flows, it was surprising to find that prices, cash flows and reinvestment contribute equally at the 15 to 20-year time horizon. Price alone contributes 70 percent of the terminal wealth and a five-year horizon. And then we ask the question, how long is the long term?

This means that if we consider horizons of 5, 10, 15, or even 20 years, we cannot disregard managing the price risk. We cannot just ignore prices and hope cash flows will do all the heavy lifting for us.

We also looked at an example that illustrated that achieving the long-term return alone is not sufficient because cash flows or liabilities appear within the horizon. In this case, in the presence of liabilities, the long term becomes a series of short terms.

As such, the end-horizon (terminal) wealth now depends on how the returns appear throughout this period. This simply means that the short terms' path or the price risk needs to be managed. We also illustrated that what needs to be managed is not just the returns themselves but also the gap between the long-term required return and the current achievable short- and medium-term returns at different horizons.

We briefly illustrated this with a stylized example of a portfolio over a 40-year horizon. We demonstrated that a 2 percent gap of the achievable versus required returns for a typical pension fund portfolio results in a 40 percent probability of zero assets over a 40-year horizon. It is an inevitable 100 percent loss for a 4 percent gap over the same horizon. We then referred to a real-life example from the recent experience of CalPERS in the United States, where a gap of more than 3% has led to a ruinous funding ratio of 68 percent. Finally, we also demonstrated how avoiding adverse outcomes is critical to maximizing wealth.

The roadmap of the series so far

The avid readers of the series would have observed already that the topic of TFM spans across most of the organizational, investment, and client aspects. So far, we have presented over 2 hours of content and over 200 slides. It is a good point to pause and outline the progress of the series thus far.

A typical design of an investment strategy is based on several essential phases.

First, one needs to formulate a set of beliefs, or the fundamental question of "why." In the series, we have outlined a number of both organizational and investment beliefs related to TFM. The beliefs then lead to formulating the strategy, or the question of "what" is the strategy to implement the beliefs. Again, in the series, we have been talking about organizational and investment strategy conclusions and defining the investment objectives, which is part of the strategy itself. The optimal objective of TFM is, in fact, the focus of Episode 3's discussion.

Once the strategy is defined, then comes the question of "how" one implements the strategy. It is about the framework, process and how to build the capability. The final aspect is the governance and the evolution of the organizational structure. This is the endpoint of our journey and our series. We will be talking about the Canadian pension model 2.0 and the critical role of TFM to enable its implementation and functioning.

The next slide summarizes everything we concluded regarding the organizational and investment beliefs, organized following our roadmap. First, we started with the organizational beliefs and why there is an increased focus on TFM today. We spent most of Episode 1 discussing this topic. Then, in Episode 2, we formulated several investment beliefs that stemmed from discussing what nobody told you about long-term investing. 

The discussion on the organizational and investment beliefs led us to the conclusions of the strategy to implement the beliefs. We discussed these throughout Episodes 1 and 2. The next slide incorporates all the key points.

Now that we have outlined the progress so far, it would help visualize the journey once more on our series roadmap.

The purpose of Episode 3 today

Episode 3 today is the final stop in discussing one last important point on the TFM strategy topic.

Let us illustrate the purpose of Episode 3 using our roadmap and a simplified example. An investor concludes that stocks and bonds would be the best asset classes to hold (for whatever reasons). The investor has just formulated an investment belief.

The investor then creates a portfolio of stocks and bonds. By doing this, the investor hires a multi-asset portfolio manager and creates portfolio stocks and bonds. By doing this, the investor transforms the investment belief into an organizational (hiring a multi-asset manager) and investment strategy (creating a stock/bond portfolio).

The question then is, what would be the investment objective of this portfolio of stocks and bonds, and how the multi-asset manager will be judged for its success. The investor defines the investment objective as minimizing the stock-bond portfolio's risk to achieve a 6% return. This happens to be Harry Markovitz's portfolio optimization objective.

We just described the link between investment beliefs and the organizational and investment strategy with the example above. The investment strategy cannot exist in a vacuum without having an investment objective.

Then, what is the investment objective of TFM and how different it is from the optimal objectives based on the Markovitz efficient frontier, or any of its extensions, or an asset-liability objective (surplus optimization, stochastic optimization, liability-driven investing)?

We talked at length about the need to manage the short- and medium-term returns to maximize wealth. Before even venturing into the topic of what framework, process and capability one needs to manage such a process, we still have not yet discussed how to define what is optimal when we are talking about a path-dependent multi-horizon asset allocation problem.

We just described the equivalent of Harry Markovitz's portfolio optimization and efficient frontier, and hence, the title in the introductory slide to this episode. You are certainly curious about what Rome has to do with it. You have to watch the series, and it will all become clear once you understand the logic and see the physical experiments.

We intentionally avoided any mathematical interpretation but instead opted to help practitioners and executives interpret the optimal objective intuitively via visualization of the critical concept and real-life experiments inspired by physics phenomena. Again, it is best if you watch the video presentation.

For completeness, the investor in the simple example above might also add private asset classes as a strategy. A similar question then arises: What would be the optimal investment strategy objective for these private assets, and how does it fit within the overall portfolio one? This should already sound familiar to the discussion we had in Episode 1 about the four pillars of the total portfolio, and what matters for private assets (and wealth maximization and the importance of cash flows).

Managing the long and winding road

To better understand why we are talking about some of the things today, it would be helpful to turn back time and revisit some of the points we made in Episode 1 and 2. If you recall, in Episode 1, we discussed the difference between asset allocation ("AA") and TFM, and we said that AA is primarily about what assets to own, while TFM is primarily about when to own the assets and how to own the assets.

And in this context, we introduced another way to view the same problem as AA, and we used this analogy of turning AA upside down. We meant by the notion of turning AA upside down because instead of constructing portfolios based on asset classes to achieve future outcomes, we could construct a policy portfolio that contains outcomes instead of asset classes — an outcome-oriented policy portfolio. Then, at any point in time, one can hold any asset mix, which leads to achieving these outcomes within an acceptable variation of these outcomes. This analogy is akin to managing the "long and winding road" around the long-term return objective, which in a time-dimension representation is an upward sloping line (e.g. the 6 percent constant return objective).

As such, TFM is about managing the long and winding road to achieve long-term outcomes. It includes all the investment strategies we discussed in the "roadmap" section earlier in this post: the efficient flow of capital, managing beta given short and medium-term returns, and also managing the beta of the private asset classes to allow them to maximize cash flows, managing cross-asset beta in public markets, avoiding adverse outcomes and ensuring liquidity and efficient implementation.

Now, we mentioned that TFM manages the long and winding road... ...there is this saying that all roads lead to Rome. Researchers analyzed more than three million road journeys to check if that was really true. And it turns out it is true; the longest road network is to Rome.

And although all roads lead to Rome, which road we take matters. Suppose we know with a certain probability the expected returns of the various asset classes over different time horizons, and we know our end goal objective. The question then becomes, what is the optimal portfolio to hold TODAY, given that we know with a certain probability the future path of returns over time.

Think about it as the daily commute dilemma similar to finding the shortest drive to a final destination in the presence of congested traffic (and congested traffic, in this case, it is low or high expected returns).

We have been mentioning throughout the series this notion of "short- and medium-term expected returns," or "expected returns over different horizons." At this point, it would be useful to finally introduce the actual term, which is the "term structure of expected returns," similar to the concept of the term structure of interest rates. It is central to managing a path-dependent process, and we will talk about it in detail in Episode 4.

Given that expected returns evolve through time (the term structure of expected returns changes), TOMORROW, we will need to make a new decision and hold the portfolio that now has the highest probability of achieving the end outcome. And the next day again. This is the path-dependent nature of the portfolio decision.

By evaluating the portfolio today through the prism of the term structure of expected returns, we can now also manage the gap between achievable expected returns (the ones that come from the term structure) and the long-term required return (the end outcome). We can evaluate whether the achievable returns would be higher, equal or lower than the required returns.

And choices need to be made. For example, if the current achievable returns are lower than the required return, asset classes will need to be overweighted/underweighted, or leverage might be necessary to achieve the required return. Depending on how future returns are expected to unfold, increasing or decreasing the level of liquidity might be necessary. This is all about today's decision, given what we know with a certain probability about the future.

Now, we have all the possible paths between these asset classes at different horizons. And of all the possible paths, there is always the possibility to do nothing, which effectively means to hold the same combination of assets throughout the time horizon and to hope and pray to achieve the required return outcome at the end.

And this should sound already familiar to you because this is the proposition of AA (asset allocation), where we define an initial set of assets, and we define long-term expected returns. And we hope and pray that these long term expected returns would materialize, which means that our outcome would be materialized as well. As long as we are right about the long-term expected returns, "do nothing" is an optimal proposition.

There are also two requirements for the do-nothing case to be the optimal one. First, we have to have constant long-term expected returns through each one of these horizons. Second, remember that long-term expected returns are a sufficient objective as long as we do not have any cash flows or liabilities between time horizons. Both these propositions are highly unlikely; returns would never be the same throughout the period. And of course, there are always cash flows and liabilities, even more so for mature pension plans.

Thus far, the discussion brings the question of which is the optimal path of the portfolio to arrive safely and on time in our proverbial Rome, which minimizes time and maximizes wealth, given expected returns at different horizons and transaction costs.

To illustrate this, the presentation borrows some ideas from physics.

Now, let us say we want to determine the fastest way for an object to travel between points A and point B, point B being our proverbial Rome. And for this object, there is also the influence of gravity and friction, which you can think of as the returns and transaction cost. We know that time equals distance divided by speed. Then, we can minimize time by minimizing distance, or we can minimize time by maximizing speed. Unfortunately, neither the shortest path nor the highest speed is the optimal solution. It turns out, there is a third optimal path.

Now, this challenges the pension "Nirvana" because the shortest distance, which one could think of as having steady returns, does not lead to the fastest arrival at the final destination. The optimal path is not only the fastest, but it also has another property as well. Let us say we have three portfolios that start at the same time on the optimal path. And the only difference is that they are at a different point on the optimal path curve. But in the end, they all arrive at the same time. In other words, as long as the portfolio always gets back to the optimal path, it will arrive "on time."

Yet again, the inconvenient thought that "distance," similar to the "horizon," are suboptimal (to say the least) objectives. The "daily commute" dilemma describes it very well.

Now that we illustrated that the notion of distance does not matter and that what matters is how quickly and safely one arrives at the destination, let us revisit the notion of safety.

If you recall, in Episode 2, we discussed how one maximizes wealth. So, it was about producing inflation-adjusted cash flows or having growth; reinvesting at the best current returns; avoiding negative returns, eliminating hidden or unwarranted exposures and costs, having unencumbered liquidity when needed, and not selling assets at the worst time.

Why liquidity is paramount to "safety," avoiding negative returns is second best. If you recall, in Episode 2, we demonstrated how avoiding negative returns leads to maximizing wealth.

Earlier, in Episode 1, we discussed the three critical reasons for the increased focus on TFM. And these three reasons were organizational development, client evolution, and the external environment. Importantly, in the client evolution discussion, we briefly mentioned that the client maturity profile leads to an increased sensitivity to adverse outcomes. Let us now see why client maturity and avoiding adverse outcomes are increasingly important today as part of the TFM objective.

We already mentioned the pension clients' increased sensitivity to adverse outcomes. But how much precisely has this sensitivity increased?

The presentation shows that the annual increase in contributions required to offset a one-time negative portfolio since the late 90s valuation cycle has virtually doubled in the most recent valuation cycle. The main reason pension clients today are twice as vulnerable to adverse outcomes as they were before is the confluence of many of them having net cash outflows and the market environment. Market environment determines how market returns happen, and as we saw earlier, how market returns happen matters for the final wealth.

When markets are strong, the net outflow risk is not apparent. However, market downturns are more likely to require contribution rate increases, and even worse, prolonged downturns may require further structural adjustments.

To manage this market and cash flow risk, one needs a path-dependent allocation, which considers the current market environment and medium- and short-term expected returns and manages adverse market outcomes.

This all brings back the discussion about portfolio outcomes. Pension client needs are evolving, as many plans are maturing. This means that they are more sensitive to investment risk, income, liquidity, the path of returns and end wealth. This means that indiscriminate growth will not be the easy solution. Clients need more outcome-oriented portfolio management. Pension managers would have to adapt and manage and provide outcomes. These outcomes could become the primary measure of success while empowering more efficiency and effectiveness in managing client portfolios. 

This concludes our Episode 3, so let us look at the summary takeaways. In today's episode, we illustrated how to think about the optimal objective of TFM:

  •  It is not about "long" or "short," but about "fast" or "slow" and "safe." 
  • The optimal objective is also about what decisions about the portfolio we need to make today, given what we know with a certain probability about the future and the required outcome. 
  • A path-dependent, multi-horizon objective allows us to evaluate the gap between achievable and required returns and make decisions about the asset class weights, leverage, and liquidity. 
  • Finally, pension clients today are more sensitive to adverse outcomes than ever. The main reason pension clients today are twice as vulnerable to adverse outcomes as they were before is the confluence of many of them having net cash outflows and the market environment.

We keep returning to the conclusion that Total Fund Management requires a path-dependent allocation, minimizing adverse outcomes, efficient portfolio maintenance. In Episode 4 next Thursday, we will discuss what one needs to do all this work.

Episode 3 concludes our discussion on the organizational and investment beliefs and the strategies and objectives to reflect these beliefs. In Episode 4, we will embark on the topic of implementation: framework, process and capability.

Let me begin by thanking Mihail Garchev for another great comment on integrated Total Fund Management.

If you have not seen Part 1 and 2, you can do so by clicking here and here.

I highly recommend you take the time to read our previous comments and watch the previous episodes in order to get the right foundations.

Once again, the material covered here isn't available in textbooks, consultants don't cover it properly or at all, it can only be produced by someone like Mihail who not only has extensive experience and knowledge, he's also an excellent teacher and it comes across in the clip below.

In fact, Mihail was really proud of Part 2 last week because it outlined the critical investment beliefs behind TFM, but I actually prefer Part 3.

Why? It's not too long, goes over the required material from previous parts very well and it packs a lot of critical issues which capture the essence of what TFM is all about.

Let me explain. Say we had the "model Canadian pension portfolio":

  • 35% in Public Equities
  • 20% in Fixed Income
  • 12% in Private Equities
  • 15% in Real Estate
  • 10% in Infrastructure
  • 5% in Credit (includes Private Debt)
  • 3% in Hedge Funds
  • Leverage up to 30%

Now, this is just an example, don't go repeating this is THE Canadian model portfolio, it's not because all pensions are different, they have different maturities, some use more leverage than others, some are more exposed to private markets than others, etc.

I'm just using this as an example. Say our actuaries and quants at our model Canadian pension used the profile of our liabilities, set expected returns for each asset class, plugged it into some optimizer, and voila, these are the recommended weights to achieve the long-term expected return.

And then what? Then, we trust the model, set these weights on cruise control and let the individual teams go to work doing what they're suppose to be doing, adding value over their benchmark. 

The strategic asset mix is basically set on cruise control, with tight ranges. Then, we can use tactical asset mix to overweight or underweight any asset in any year and use leverage to take advantage of opportunities as they arise, but it's this strategic asset mix which drives long-term returns and it's basically static.

There's a common belief out there that all that matters is getting the strategic asset mix right and the rest is irrelevant.

To be sure, it's critically important to get the strategic asset allocation right but nothing can be further from the truth when people say "that's all that matters". Mihail demonstrates this very well.

CalPERS and many US public pensions got their strategic asset mix right but the outcome (most of them are underfunded and some are chronically underfunded) is very different from Canadian pensions which are fully funded.

Why? One big reason is plan design, Canadian pensions got it right, sharing the risk equally among active and retired members.

But another critical reason is governance and their ability to operate independently from government,  like a business, which helps them attract top talent to manage the bulk of assets in-house. 

Importantly, in a record low rate environment, there are three things that can impact your investments in material ways even if you get the strategic asset mix right:

  1. Execution risk: This is basically the risk of not realizing on your value creation plan. This impacts private markets mostly and it's critically important because that's where you get your cash flows to reinvest in asset classes. OTPP's CEO Jo Taylor talked about this in yesterday's panel discussion which I covered here).
  2. Costs: In a record low rate environment, fees and costs matter more than ever and can significantly detract from long-term performance.
  3. Margin of error is lower: In fact, in a low rate environment, not only do you need to get your strategic asset mix right, you need to get all your investment activities right, there's simply no room to make errors because one bad year can set you back years.

Now, I'm going to let you in on a little secret. I love actuaries, some are better than others, but they're all super smart people and they yield enormous power at pensions

Actuaries don't like tinkering with strategic asset mixes, it creates volatility for the contribution rates and that gets governments and unions on their case, so they typically set it and forget it and only tinker with it when there's a really good case to be made to add an asset class.

But strategic asset mixes are based on long-term expected returns and even the best industry minds get those wrong (Jeremy Grantham, Clifford Asness and others are often completely wrong on their long-term forecasts).

In general, setting probabilities on financial outcomes is very difficult for a lot of reasons:

  • Disruptions happen all the time. It could be technological, a pandemic, climate change, political, social or whatever.
  • It might be a secular shift. I just finished writing a comment on whether there's a secular shift in real estate happening right now.
  • More policy intervention: How do central banks adopting QE Infinity impact future returns?
  • Tsunami of capital: Yesterday, OMERS' CEO Blake Hutcheson mentioned the tsunami of capital chasing private market deals, impacting future returns. This is something I've alluded to many times which is why execution risk matters now more than ever.

The point I'm making is it's hard to ascribe long-term expected returns to many asset classes because the world is constantly evolving.

I mentioned to Mihail who shared this:

Correlations are not a given, they are an artifact of evolving economic conditions and the headwinds and tailwinds of other technological, environmental and socio-economic drivers (this is why themes are very important in the portfolio construction context, not only in an investment context). Given the extraordinary world of disruption, both technological, societal, environmental, regulatory, you name it, it would be even harder to know what these correlations would be. So it would be much harder to assume any stable asset relationships.

The same goes for the magnitude – a disruption could swing fortunes of businesses, sectors, and economies overnight with significant magnitude.

As for the mean reversion, in a disruptive future, mean reversion might be less likely – structural changes might took place, even if temporary, but who knows how long temporary is.

Look at globalization, travel, office, and many others. Things might get back to the mean, but who knows how long this would take. Or simply, the equilibrium mean might change at a different level. Also, the very definition of what the mean is might change as well. For example, many are observing the multi-year underperformance of value, and the 60% down from the latest peak? And the conclusion is that a reversal to the mean might be just around the corner. But it might be that the very way the value factor is defined might not be appropriate given the move to a content economy? Perhaps what was an accounting metric proxy for value has changed and does no longer express the underlying financial reality.

I also mentioned that I took Honors Econometrics and History of Economic Thought at McGill during my undergrad years and our professor, Robin Rowley, really got into the Keynes-Tinbergen debate and what other great economists (like Hicks, Hayek, Knight and others) thought of probability in economics.

In fact, Robin Rowley and Omar Hamouda wrote a book, Probability in Economics, which brilliantly captures the nuances of how different economists thought on the subject (not an easy read but economists will love it).

The point of all this is you can have the best strategic asset allocation ever and still fall short of your goal, and Mihail shows this with his CalPERS example.

The other point worth making is tactical asset allocation and Total Fund Management are two very different things.

Most pensions lose money on TAA but TFM is much deeper, much more important to realize on your final wealth outcome.

It involves managing the path to the final outcome, the long winding road:

  • How do you execute your investment strategies, especially in privates?
  • How do you reinvest dispositions in private equity?
  • How do you manage downside risk at any given time?
  • What is the approach you're using in Private Equity and Private Debt?

Go back to read my comment on OTPP getting into wealth management where I discuss the importance of jointly sponsored co-investments and how they're the most profitable PE investment, more than purely direct, syndications (a lesser form of co-investments), and fund investments where fees take a big chunk of long-term returns.

And while Private Debt is a hot asset class, I wouldn't put guys like PSP's Scuderalli or CPP Investments' John Graham in the same boat as others who have the wrong approach.

Anyway, I've rambled on far enough, hope Mihail and I gave you a lot of food for thought here.

Below, Episode 3 of the seven-episode series "Introduction to Integrated Total Fund Management" presented to you by Mihail Garchev, former VP and Head of Total Fund Management of BCI. I really like this episode, not too long and packed with great insights.Thank you, Mihail.