Total Return Portfolios Raise Allocations to Alternatives
Alternative Investments Are Shown To Enhance Portfolio Risk/Reward Profiles
Copyright 2000 Barclay Trading Group, LTD.
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According to Pensions & Investments 1997 survey of U.S. Erisa and public pension plans, approximately 80% of pension assets are invested in U.S. stock and bond markets and investment results are measured against a benchmark portfolio of 60% stocks and 40% bonds. However, there are some notable exceptions to this rule.
Harvard, MIT, Stanford, Yale and others have been implementing portfolios based on a total return performance objective. This strategy includes substantial investments in less "efficient" markets such as private equity, real estate and "absolute return" areas. Allocations to the more traditional markets, stocks and bonds, have been reduced accordingly.
Yale's program has been operative for more than a decade and the results are impressive. Over the ten-year period ending June 1997, Yale's portfolio return of 13.5% placed it in the top one percent of SEI's rankings of large institutional investors.
According to the December 1997 Harvard Business School Case Study, "The primary reason for Yale's superior long term performance record had been the excess returns generated by the portfolio's active managers." This argument seems to fly in the face of stock market research that demonstrates that most active managers under-perform a passive, benchmark such as the S&P.
In order to gain a better understanding of these and other issues surrounding the efficacy of a traditionally benchmarked portfolio versus a total return portfolio, we've invited a distinguished panel of experts to answer some questions for us. Our panel includes:
Karl V. Chalupa, Gamma Capital Management, LLC. Mr. Chalupa is President of Gamma Capital Management, an alternative asset manager specializing in fundamentally based quantitative investment strategies. Prior to founding Gamma Capital, Mr. Chalupa was Vice President and Manager of the Currency and Alternative Investment Strategies Groups at State Street Global Advisors. Mr. Chalupa graduated cum laude from Northern Illinois University with BAs in Economics and International Relations and received an MA in Economics from Brown University.
James F. Tomeo, RXR Capital Management, Inc. Mr. Tomeo has been with RXR since 1986. He is an Executive Vice President and Director, and is responsible for the firm's alternative investment product development. He is an advisor to Institutional Investor on matters related to Japanese pension fund reform, is the former Chairman of the International Committee of the Managed Funds Association, and is the U.S. representative to the Education and Research Committee of the Alternative Investment Management Association based in Europe.
Takanori Yokose, Mitsui & Company Commodities Corporation. Mr. Yokose is the President of Mitsui & Co. Commodities Corporation in New York, which is a manager of managers and the FCM of Mitsui & Co., Ltd. in Japan. He is responsible for structuring investment products, selecting investment managers for their portfolios and managing their risk.
Q: According to Pensions & Investments' 1997 survey of U.S. Erisa and public pension plans, approximately 80% of pension assets are invested in U.S. stock and bond markets and are benchmarked against a 60% stock/40% bond portfolio. However, some institutions have shied away from this traditional benchmarked approach and are using a total return approach. What do you believe is meant by a total return approach to asset allocation?
Chalupa: A total return approach to asset allocation is one in which each asset's risk-adjusted performance is evaluated relative to the risk-adjusted performance of all assets in the investment universe. For example, a large cap equity fund should be evaluated based on how its risk-adjusted returns compare to the risk-adjusted returns of bonds, real estate, and alternative investments, not a comparable passive equity benchmark such as the S&P 500.
Tomeo: A total return portfolio is capable of performing well in any economic environment, whereas a benchmarked portfolio typically depends on the performance of one major market, like the S&P 500.
The concept of benchmarking grew out of the postwar era, a time when investments were mainly in short-term deposits, U.S. Treasury securities, and some blue chip stocks. As the capital markets strengthened, portfolios linked to such a benchmark also posted higher returns. By 1970, with optimizing in full swing, managers were justified allocating larger and larger percentages of the portfolio to stocks. And then there was October 1987, the first wake up call.
Today, investors think globally, not only in a geographic context but also in a product or asset class context as well. Investments in real estate, international securities, currencies and derivative instruments have been accepted by the institutional world as an essential source of diversification. It's just a matter of time before the total return approach fully matures into a classic investment philosophy.
Yokose: I use total return and absolute return to mean the same thing. A total return approach has the potential to perform well under any kind of environment such as a bull/bear market, trending/choppy price pattern, etc. Japanese institutional investors have eagerly awaited a total return approach for a long time, especially after the Nikkei Crash in the early 90's. Such an approach would be particularly useful for Japanese pension funds, most of which have been structured based upon the assumption of a 5.5% annual return in Yen.
Q: What role can alternative asset managers (CTAs and Hedge Funds) play in the development of the total return portfolio?
Chalupa: The role of alternative investment managers depends entirely on their ability to produce risk-adjusted returns superior to more traditional investment strategies, and to produce return streams that are uncorrelated or negatively correlated with more traditional assets.
Since a total return approach is only concerned with an asset's effect on the risk and return of the total portfolio, an alternative manager has to satisfy one or both of these constraints in order to add value.
Tomeo: First, develop products with ample capacity that are transparent, marked to the market, and priced competitively. These are the standards that institutional investors will insist upon, especially after the difficulties of 1998. In order to be successful penetrating the institutional marketplace, the hedge fund manager and CTA will have to be superior in all areas of the business, not only performance.
Secondly, survive. Pursuing alternative investments today is still the road less traveled, particularly in the institutional world. Survivor bias is an issue for most professional investors. They contend that the alternative investment industry's performance is difficult to quantify due to the survival of only the most successful managers (since it's assumed that the poorest performing managers are out of business and no longer included in the industry statistics). The longer the alternative asset industry persists in providing value added, the easier the job of penetrating the institutional marketplace becomes.
Yokose: Alternative asset managers can be of great assistance especially to Japanese institutional investors. Those managers who have investment programs that are able to consistently meet moderate return expectations with low volatility, reasonable fees, high liquidity and reasonable transparency would be the most desirable. In particular, the transparency issue seems to be a key requirement for managers who want to be successful in attracting Japanese institutional investors.
Q: Has the enthusiasm towards alternative asset managers been dampened by the Long Term Capital Management debacle of 1998?
Chalupa: The LTCM debacle has clearly dampened demand for alternative investments. In the long term, however, investors will return since alternative investments overall did provide good diversification in the August sell-off in equities. It just happens that media attention was focused on the big name disasters and ignored the positive diversifying benefits of many other alternative funds. Moreover, the LTCM episode illustrated the risks of excessive leverage, loose risk controls, and too much reliance on statistical distributions without an understanding of the economics behind them.
Tomeo: In general, the evidence suggests it has. However, when you analyze the market more closely, the institutions that have mobilized an alternative investment capability remain committed, and in some cases, even more so.
Although the U.S. equity market performed well again in 1998, the cracks in this economy are becoming more apparent. Professionals can't ignore investing in alternatives given the Japanese financial dilemma, the Asian crisis, emerging market meltdown, and now the real potential for a slowdown in Europe and Latin America. If the U.S. stock market suffers a major, prolonged correction, those institutions that have programs in place will more quickly and effectively diversify away their risk. That is not to say that LTCM was not a significant event in the evolution of the alternative asset industry.
LTCM was a wake up call for more stringent due diligence. Evidence suggests that investors in LTCM were not given the information most institutions require from their investment managers. Without transparency and adequate reporting, there was no way to determine the extreme leverage taken in the portfolio (as much as 200 times invested capital) and the degree to which the underlying investments had become increasingly illiquid. I don't expect these issues to be overlooked in the future.
Yokose: Both the Russian crisis and the LTCM incident greatly influenced Japanese investors' interest in hedge funds in 1998. As a result of the losses associated with these events, many investors suspended their new investments to hedge funds and many brokers postponed new fund of fund sales. Some of the investors who had hedge fund exposure redeemed their units.
However, we should not overlook the fact that some of the investors who redeemed were Japanese large financial institutions that have been suffering from severe balance sheet problems as well. Japanese demand for such products still remains larger than we expected. The continuing bullish activity of the US equity market in the 4th quarter of 1998 and the recovering performance of hedge funds have encouraged Japanese investors to resume making hedge fund investments. Japanese investors have gradually been changing their shy attitude.
Q: Which alternative investment strategies are most popular to institutional investors? What trade-offs will these investors accept in terms of return versus liquidity?
Chalupa: The most popular investments are private equity, market neutral and long-short equity funds, and event-driven funds. The reason for this is familiarity. These vehicles are closely related to the traditional stock and bond investments that make up the bulk of institutional investment portfolios. Moreover, the analysis required for evaluating these strategies is not much different from the analysis needed to analyze traditional stocks and bonds. The source of returns is also much more closely related to the "productivity of capital" argument that justifies long-only investment in traditional stocks and bonds. It is much easier for a pension plan sponsor to entertain hiring a long-short equity manager than a commodities trading CTA who can't explain the economics of why he/she (hopefully) makes money.
In terms of trade-offs, the big lesson coming from the LTCM disaster is that liquidity is good and transparency is good. Long lock-ups are likely to be a thing of the past along with extreme secrecy about the makeup of portfolios. It is quite likely that only managers with extraordinary risk adjusted returns will be able to justify lockups (for anything other than private equity) longer than one year. Also, liquidity for funds is likely to become quarterly or even monthly over time.
Tomeo: Those strategies that make the most intuitive sense are popular with institutional investors. Real estate, private equity and international securities investing has become increasingly popular over the past five to ten years. On the other hand, hedge fund investing has only become popular within the past three to five years.
In the hedge fund area, institutions favor those strategies that use little or no leverage and whose investment philosophies are easily understood. For example, several endowments and pensions have made initial allocations to market neutral equity investing. This was a comfortable transition, from a long biased value and growth orientation, to simultaneously selling short over-valued shares on a beta neutral basis. This doesn't require new skills, merely the ability to quantify market, industry, style and sector risks from both the long and short side of the trade.
The institutional community has also accepted global top down strategies that use quantitative analysis. These strategies use TAA and econometrics on G-7 economies to create exposures, both long and short (fully hedged) in order to produce absolute, non-correlated return performance.
Managed futures, although similar in style, must overcome the confusion over the role price series analysis plays in active portfolio management.
Yokose: Market neutral type strategies seem to be the best fit for Japanese institutional investors seeking consistent returns. Japanese institutional investors require monthly liquidity and reasonable transparency as well. In the case of managed futures, CTAs very often provide 100% transparency. Hedge fund managers should follow within certain limitations. This should help them break through to the huge Japanese institutional market.
Japanese institutional investors are basically conservative. Pension funds, most of which are structured based on a 5.5% annualized return (in Yen) assumption, desire consistent performance. They have about a fourth of 1.2 quadrillion Japanese Yen in total that is looking for the right investment direction. The boards of directors of institutional investors and the investment committees of pension funds are quite hesitant to sign contracts committing them to black box types of investments, even though the past performance of some of these black box approaches looks good.
Q: Much has been made about the success of Yale University's total return portfolio. Over the ten-year period ending June 1997, Yale's annualized return was 13.5%, more than 2% higher than the average of all endowments. Can others following in their footsteps reasonably expect to outperform industry averages by such a wide margin? What would be a reasonable expectation?
Chalupa: Clearly not everyone can outperform the average. Doing so for extended periods requires the ability to recognize managers that are true alpha generators. This is not an easy task for experienced professionals let alone individuals for which asset management is a part-time job. This can be seen in the performance of professionally constructed funds of funds last year. Many such funds suffered crippling losses in August and September despite including such "blue chip" alternative investment names as LTCM, Everest, and III.
Picking good alternative managers is as much an art as science and is even more difficult than picking traditional managers. The reason is that most alternative managers have short track records that have been generated trading within larger institutions. Even those with long histories have often used different methodologies which significantly weakens the usefulness of the track record for predicting future performance. Picking good managers depends as much on in-depth knowledge of their styles and special attention to their ability to manage risk and run a viable business as it does on quantitative analysis of their performance.
Clearly it is possible for a pension plan or endowment to outperform its peer group for the long term. The ones that do so are likely to have consultants that have the ability to pick good up-and-coming managers. All too often, by the time a manager becomes a "blue chip" name, he's no longer generating consistent excess returns.
Tomeo: Is past performance any indication of future results? If you believe that skillful trading is sustainable over time, that diversification is the only "free lunch," and that it is prudent to invest in assets that have the potential to do well when global stock and bond prices are falling, then it is reasonable to assume that a total return approach can outperform a benchmarked portfolio over time. The margin of over-performance is difficult to project. It will primarily depend on the performance cycle of the benchmark, since a total return portfolio by definition should be more stable.
Although it's true that the Yale portfolio did have the added advantage of superior hedge fund returns in the reporting period ending December 1997, it is also true that the "average endowment" had the support of the US stock market. The lesson to be learned here is not one of outperformance, but efficiency. While Yale's endowment has achieved very competitive returns, the risk it assumed was substantially less than the benchmarked portfolio due to equivalent allocations among hedge fund, private equity, US equity, real estate, international equity, and fixed income components. It's MPT taken a step further.
When we look back on this time in the history of portfolio management, the US fiduciary will be described as having assumed an excessive amount of exposure in the stock area. The average investor will appear to have been bordering on imprudence, given the array of alternative investments available in the marketplace. However, it's never been easy to break a paradigm, and this one is no exception. With careers at risk, the formation of the new paradigm will have to be driven by necessity rather than prudence.
Yokose: Why not? However, investors have to be sophisticated enough to understand not only the concept of the total return approach but also the risks involved. It is worthwhile for investors to consider working with third party consultants or a manager of managers to enhance their efforts. I would suggest that investors consult with many experts prior to their investment decision. Keep your eyes on their performance and fees. An annualized return target in the range of the risk free rate plus 5% to 10% would be a reasonable expectation.
Copyright 2000 Barclay Trading Group, LTD.