Beyond 60/40: Pension plans rethink their asset mix

(October 2005) For many years during the 1990s it was conventional wisdom for plan sponsors, big and small, to follow a certain pattern for investing. Generally, plans took a traditional approach whereby 60% of investments went into stocks and 40% went into bonds. But the times are changing for pension plans and they are increasingly looking to separate skilled managers from the beta herd as they look to maximize their investment portfolios and decrease liability.

Between the Caisse de dépôt et placement du Québec’s recent purchase of a share in a Midwest pipeline, the Ontario Municipal Employee Retirement System’s (OMERS) sale of part of its real estate portfolio to the Canada Pension Plan Investment Board, and the Ontario Teachers’ Pension Plan’s high-profile investment in hedge funds, alternative investments are very much in the news.

Over the past few years, many of the largest pension funds have explicitly turned to alternative strategies and away from the 60% stock and 40% bond portfolio model popular through the 1990s. Indeed, research from a variety of consultants confirms that it is pension plans, rather than the traditional endowments or high-net-worth individuals, that are pushing hedge fund investments to record levels, and contributing to a revival in private equity, especially in leveraged buyout firms.

While pension funds have, back to the 1980s, had involvements in real estate, over the past decade it has become a tidal wave. In the interim, infrastructure investments in pipelines and toll roads, as well as commitments to timberlands, are blazing new trails in the world of inflation-protected instruments. So far, the trail points ahead with promise. Alternative investments contributed significantly to the bottom line in 2004 for some plans, with the Caisse’s real estate portfolio up 22% and its private equity holdings up 20%. OMERS’ infrastructure portfolio earned 31% in 2004.

At Teachers’, the hedge fund or absolute return portfolio contributed one-quarter of the portfolio’s $3 billion excess return and real estate accounted for one-third. Pension plans have little choice but to seek alternative sources of return, while leveraging off their relatively long liquidity horizon — that is to say, taking advantage of investments that may take a few years to mature. The key to that, says Ron Mock, vice-president of alternative strategies at Teachers’ in Toronto, is to seek out relatively uncorrelated managers who have high evidence of skill, which gives some indication of whether a manager can consistently produce an uncorrelated income stream.

No one really expects the major developed markets to generate the double-digit returns they did in the late 1990s. At best, there will be a modest risk premium over bonds, of anywhere from 0% to 3% at the outside — a far cry from the historical 4.7% premium. At the same time, long-dated bonds carry 4% yields — and some mavens think they may go lower thanks to a world awash in liquidity that has nowhere to go but bonds and real estate. (While many analysts ponder whether there is a real estate bubble, others think the same label actually applies to the bond market). In any case, a 60/40 portfolio, split among stocks and bonds, might generate enough to match the increase in liabilities, but probably will not wipe out the underfunding many plans face. Teachers’ averaged an 11.4% return over the past decade, and 14.7% last year. The benchmark returned 10.6%. However, liabilities grew 17.9%.

According to Canada’s largest institutional manager, Quebec’s Caisse de dépôt et placements, or more familiarly, CDP Capital, “the expectation of lower returns on liquid markets and more intense competition for new sources of value will make it increasingly difficult to obtain returns that meet depositors’ long-term needs. Faced with the same problems as other institutional fund managers, the Caisse will have no choice but to assume greater relative and absolute risk in seeking returns similar to those it obtained in the past, in an environment where absolute risk is especially high.”

Alpha can be a complex technical term — a way to quantify whether a traditional manager adds value, against a benchmark such as the S&P/TSX Composite Index. There are various definitions — whether it’s an information ratio or a Sharpe ratio, or simply an excess return over a benchmark. Alpha is often identified with an absolute return over cash — as opposed to matching or beating a benchmark.

“The pursuit is actually deadly — it’s very much a flawed theory,” says Tom Gunn, former chief investment officer at OMERS and now president of the University of British Columbia Investment Management Trust in Vancouver. “Whether or not one is achieving a benchmark or underachieving it, it is all about relative returns. You don’t pay pensions with relative dollars. You pay them with absolute dollars. There is a move in the whole investment business towards absolute rate of return targets rather than variable rate of return targets.” Still, the increasing availability of indexes for hedge funds is leading some pension plans to use them as their benchmark. Other plans set explicit cash targets as represented by T-bills, the London Interbank Offered Rate (LIBOR) or CPI (Consumer Price Index) plus 3% to 5%. In private equity, the benchmark is often initially set in accordance with funding requirements, rather than an index.

William Fung, a professor at the London Business School and cofounder of PI Asset Management in London, England, frames the alpha question in a different way: “Alpha is what you are willing to pay two and 20 for (2% in management fees and 20% in performance fees). It’s that part of the return you can’t replicate cheaply. Alpha is where do it yourself ends. If you can’t do it yourself, you pay for it.”

Mock concurs. As one of the largest money managers in Canada, Teachers’ can easily get beta — passive returns earned from stocks and bonds — by purchasing futures contracts based on the main stock exchanges, or by entering into total return swaps. Since futures contracts require small margins or swaps, that leaves a healthy sum, say 10%, that can be invested elsewhere. But that only works if hedge funds are uncorrelated with the market; otherwise, a plan sponsor is simply buying expensive beta. Mock concedes, “that hedge fund returns are loaded with beta; you have to really look hard in the business to find the alpha.”

There is a growing academic interest in hedge fund betas, or even investable instruments that could replicate hedge fund returns. Fung has conducted one of those studies, using factor analysis which looks at: large-cap versus small-cap performance, credit spreads and market trends that can help to plot hedge fund returns, even though managers may not be directly making these investments. The factors seem to account for about 90% of hedge performance. But he says, “You still need to pay for that extra bit of skill. The big question is: What is the right balance? Am I paying too much?”

Finding alpha is difficult work. Different skills are needed for different alternative strategies, says Gunn. “In real estate, it has to do with people’s demonstrated ability to make transactions in the past. It’s the same thing, ideally, in the private equity space,” he says. “Unlike public investing, the record of the manager is usually repeatable. That’s because what you’re investing in is a management skill rather than just a securities selection skill. “The corporate skill, he says, “is buying an asset and figuring out how actually to improve the underlying value of that asset.”

By contrast, hedge fund managers, most of whom were trained on the proprietary trading desks of the banks, seek out short-term mispricings, in very narrowly defined strategies. The skill was really in the execution. “Hedge fund managers should have a recognizable skill and should have a definable skill and be able to explain it,” Gunn says. “If they can’t explain it, then chances are you may just be investing in luck and that’s where you get the confusion between someone who is just hot at picking markets or if you’ve got someone who actually knows how to make money.”

The distinction is important. Researchers have identified market cycles in particular strategies. Some managers simply earn the beta for that strategy — they are paid for showing up for work. Others exhibit skill. “This gets into the argument of how much capacity there is in the market,” says Gunn. “They only have so much capacity and eventually, the more players there are, the value that can otherwise be found from market inefficiencies gets arbitraged out.”

Capacity has another side to it. If strategies falter because too much money is chasing too few opportunities, hedge fund firms starve. “A lot of hedge funds come in with 1.5% management fees,” according to Jim McGovern, chairman of the Canadian chapter of the Alternative Investment Management Association in Toronto. “So take $750,000 on a $50 million pool, let’s say you need yourself, probably another portfolio manager, another trader, somebody in the back office — so you’re talking four people, four salaries to pay, plus overheads, and nobody’s making a good living on that, relative to what you could be offered in the long-only world.

Then it’s a really an issue of what you can make that $50 million pool do. Can you consistently make it go up 10% to 12%, then you’re looking at $5 million in gains, times 20%, that’s a million dollars. That starts to look attractive.”

Still, he says, most managers aim to reach at least $100 million in assets. That allows for a bigger organization and creates the potential for institutional investments. No institutional investor wants to be a quarter or a third of a single manager’s capital. But many funds never reach that $50 million level, and so may go out of business simply because they’re unprofitable for the manager.

In addition, even for successful funds, according to Fung’s estimates, alpha, defined as returns in excess of LIBOR, has been compressed to 29 basis points a month now from 63 basis points a month to 1998. Some observers suggest this means too much money is piling into the hedge fund market. Others, like Fung, point out that different hedge fund strategies fall into and out of favour. For instance, convertible arbitrage — where managers buy convertible debt and short the stock that the debt will convert into — was in the doldrums even before the major ratings agencies downgraded the debt of two of the major issuers, Ford and GM, to junk status this past spring.

Interestingly, investors seem to know who has alpha and who hasn’t. In another study, Fung tracked the performance of funds of funds. Only 15% demonstrated alpha, but at the end of the study, 90% of those were still in existence. Of the funds that didn’t demonstrate alpha, half were closed. What’s more, investors keep adding to money flowing into the funds with alpha. Asset growth was flat for funds without alpha. “Investors are anything but ignorant,” Fung concludes.

That is confirmed by a July 2005 KPMG survey, “Hedge Funds: A Catalyst Reshaping Global Investment.” Institutional investors expect hedge funds to grow — but they don’t expect the same returns as the past.

But there’s a paradox here. Most f und managers are not operating at full capacity: “much of the reported surplus capacity is not capable of generating risk-return characteristics in-line with client expectations,” the survey finds. Instead, the most successful funds will probably close to new investors; they are at capacity, and KPMG estimates them to be 115% of the universe. Investors will be looking at aspiring managers who do have capacity. But if they don’t have alpha, they probably won’t last.

This article originally appeared in the August issue of Benefits Canada

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