Rational Advisor

Asset Allocaton Summit, Toronto Feb 4 2009

Here are my notes from the Asset Allocation Summit in Toronto. attended by large pension funds.

Over all a great summit, to discuss the problems and issues facing pension funds.

Some disappointments were in that I was not impressed with most of their structures.

For example, one Crown Corporation Pension fund for Canadian equities has its own group of managers internally - employees. Their rational was it kept costs down. When quizzed later about pension short falls, they’re comment was “we are a Crown corporation, we never have short falls, tax payers help us”

I was also not impressed with the consultants, and their justifications for their modelling, prodcuts and risk reductions. The big product push was around Infrastructure investing - wonder if Obama had anything to do with that! The infrastructure players there - second largest in the world Maquarie, did admit that there is no history on this asset class!

The greatest surprise was the amount of pension short falls. The fac that they did not have as much money to pay the employees.

Anyways here are some of the more important notes.

- No one saw the tail risk as a reality. Tail risks are a definite reality. A tail risk is the part of the bell curve of investment returns at the very edge - the lowest and the highest. Mostly financial engineers talk about 2 standard deviations, the most common returns (66%) etc. Now Pension Funds are including the whole returns - NOT just the most common, to get a perspective of the worst possible one time event, even if it only happens once every a hundred years.

- What will it take to go back to being offensive investors, instead of the current defensive mindset? - A couple of years of low returns and time to forget the current panic.

- How do determine what asset class to incorporate in to your asset mix? The excitement and newness of adding alternative asset classes and new asset classes is dangerous. We forgot the Tickle-Me-Elmo lesson. Grandmas used to line up for ages to pick that doll for Christmas, only six months later it was in the bargain bin section. We always have to remember Risk and NOT theory, keep an eye on cash flow requirements, and determine asset classes by them. It’s the theories of portfolio management with their backward bias of correlation, standard deviation, efficient frontier, modern portfolio theory that has got us into the current problem. Pension funds are now realizing that the science and mathematics does not measure up to reality - this has been a rude awakening.

- Are alternative asset classes appropriate? Defined contribution plans have higher fees, and to justify these fees, pension companies have jumped on alternatives, such as, hedge funds, real estate and infrastructure and this has really hurt them. Not just companies but investment advisers and consultants have got fee hungry and to justify
these fees and to add to the complexity have jumped on these derivative based products. Many alternatives are less liquid and hard to monitor. Real Estate is not priced daily, and neither is infrastructure or hedge funds. If everyone wants their money out at the same time, this illiquidity could lead to drastic results, as we are witnessing. Long/short hedge funds are highly correlated to small cap growth. And small cap growth is much cheaper.

- What mistakes have you made in benchmarking? The mistake has been to ask managers to beat a benchmark over short periods of time such as a year. This has forced good managers to become index huggers, and this has led to greater volatility, as more and more managers copy the index securities. Afraid of underperforming it for a year. The best thing is to not measure over a year, but measure over 3 and 6 years. This will allow the managers to take their focus on the index over a year.

- Statistics in pension plans that use overlay managers to reduce risk, shows that they did not add much value. Risk management was not improved. Theoretically they should have, but practically they did not. There was no overlay manager that showed a benefit over a simple balanced portfolio - Not one.

- What has current markets done to emerging markets and hedge funds? Hedge funds and emerging markets have been decimated, and are a difficult class to justify. Now we are seeing real value in public markets over private markets. Public markets (public stocks) also have lower fees than private companies. Last year we saw a plot of deals of private equity fall apart. Because of the drops in these deals, and the less frequent valuation dates on these, the weights ran up of poor private equity positions. And this was dangerous. A lot of the private equity deals were created by the financial engineers and investment bankers. We’ve now realized that financial engineering is NOT the way to go. Thankfully the investment bankers have now been thinned because of their own mis-handling.

- Pension funds are now eating into their liquidity due to their love affair with emerging markets, hedge funds and private equity deals.

- The most appropriate way forward because of the dramatic shift in demographics is to focus on the basics of income generation requirements. The more we have gone away from this, the more we have put the risk of capital at risk.

- LDI (Liability Driven Investing) How will it impact asset allocation? This will drive future asset allocation strategies. This is really key. You cannot consider an Asset allocation without understanding LDI. You need to monitor it year over year and
understand the mismatch risk. For retail fund companies, they need to identify the typical client for their portfolios and watch year to year that clients liabilities. Create liability benchmarks.

- How can Asset allocation aid pension plans facing shortfalls? Increasing risk can increase the shortfalls. CP rail recently issued stock to fund the pension short fall of their pension plan - incredibly, the markets took this negative as a positive. They didn’t raise capital to increase profitability or increase machinery etc!

- Remember you don’t need to shoot the lights out, it’s this shooting that’s led to the pension short fall.

- Are there any asset class strategies that have emerged due to recent financial turmoil? Yes, Patience Cash, and Corporate debt. Tactical moves have been more popular now. Most pension plans have not made many changes. But, they plan to as their demographics of plan member’s change. And the need to derive income becomes a greater need than deriving growth.

- What are the latest trends in Asset Allocation Policy? The new Fund objectives are 1) Security of benefits 2) Income management instead of Maximization of Long Term investment returns 3) Managing short term volatility of funding.

- Concerns around traditional Asset Allocation strategies? Efficient frontier is structured on PAST 40 years and is NOT useful now. The past correlations are not the same as present, mainly because of the presence of mire hyper active players in the markets, like hedge funds that need to derive a return every month, also because of the growth in index huggers. The traditional efficient frontier curve is now lower on the chart, due to inflation and bond yields being lower, and it’s also moved to the right because of Risk tolerance has decreased. Assets have become far more correlated, such that traditional statistics for correlation and risk are now quite meaningless.

- Our Risk tolerance now is much lower. Why? Because of declining interest rates increase the sensitivity to interest rate moves. Also many plans are now maturing having to pay income to retirees. Demographics have now changed plans horizons. Maturation of plans means less positive cash flow coming into plans, and less cash coming in to cover the short falls - this is the biggest risk. So, pension plans are running to income based products, and as the largest affecter on investment markets we will see the impact there. Pension plans that do not have short falls are happy to hold lower yielding bonds as long as they can continue to provide a yield to cover needs. They do not want to be sued for short falls - and are happy to have low yielding bonds. They are not sellers of these.

- Most pension funds have large embedded deficits. means that they have lots of losses and short falls.

- Cash flows from plan sponsors (the companies) is becoming larger and larger to cover the short falls, the coverage typically came from plan members, because of retirement, there are less of them. This larger and larger contribution is now affecting the operational cash flows of the sponsors.

- The next risk is Cash drag. The higher levels of cash in portfolios will not help in a recovery phase, It won’t be able to pick up the appreciation. Cash has never been a great long term asset performer. Cash drag could severely impact retirement and pensions.

- Optimizers and other tools that make it seem like there is a science to this, have been proven ineffectual, they do not increase alpha or reduce risk. They just make you think we have.

- The new products coming out will be Specialist Beta Funds (another derivation of hedge funds).

Predictions for 2009

- Hedging will be much lower

- Investment risk will remain

- Equity multiples are at “unsustainably” low levels. These technical lows are due to forced liquidations of bank portfolios redeeming cash to fund losses in their hedge programs. Deleveraging portfolios were for operational and not investment reasons.

- Cash is king is an illusion, it could easily turn into the joker. The new term will be “Cash Drag”. How much it will drag down the performance of a portfolio, becasue there is too much in cash.

- Regulatory friction will slow and disrupt market and increase prices of investments. The reason Canada has higher expenses than the rest of the world is because of our higher regulation, we have too many bodies to pay fees to, too many securities regulators etc.

What has changed

- Investment banks greatly reduced so financial engineering activity will be lower

- Deflation fears are now coupled with massive government spending programs

- Equity swaps and other leverage is now more expensive

- Credit spreads are stratospheric

- Commercial banks have been minimized but are still strong

What has NOT changed

- Still need diversification

- Still need reliable income and gains

- Still need better governance

- Still need planning

Should people continue to invest

The No argument
- Once burnt, twice shy
- Most of the investments were negative last year
- Future returns are highly uncertain

The YES argument
- Returns following a downturn exceed the average
- People are anxious for returns. You will still need to invest to fnd a retirement - Cash and GICS will not provide enough money.
- Future returns are ALWAYS highly uncertain - nothing has changed.
- Exceptional opportunities will overwhelm the costs.