I attended the Asset Allocation Summit in New York on May 17th and May 18th 2010. The conference brought together investment officers of endowments, foundations and pension funds as well as leading portfolio managers. The following article discusses some of the topics and speakers that I found particularly interesting.
Tactical asset allocation gaining momentum
It was surprising to hear investment officers of endowments, foundations and pension funds stress the need for tactical asset allocation to take advantage of volatile markets. Endowments, foundations and pension funds have very long time horizons and in the past, took a longer-term approach to investing by not changing asset allocation frequently. Don Steinbrugge, Member of the City of Richmond Retirement Funds’ Investment Committee noted “institutional investors used to move glacially, but in the last two years, they have started moving more quickly to target inefficiencies in the markets”. He said that his investment committee used to make asset allocation changes over three to six month period and now make changes in one month. Several investment officers at the conference thought that it was important for investment committees to widen the asset bands that can be allocated to a particular asset class so that investment officers have more flexibility to act quickly to take advantage of daily opportunities.
The average holding period of stocks at mutual funds and hedge funds has declined in the past several decades due in large part to increased focus on outperforming benchmarks on a quarterly basis. If the majority of significant asset allocators, such as endowments and pension funds, adopt tactical asset allocation strategies, this will only add to more trading by direct investment funds and create more volatility in the markets.
Importance of liquidity for endowments
Yale University popularized the use of alternative assets in endowment portfolios to maximize long-term returns. Unfortunately, in 2008, this approach ended up hurting the returns of some leading endowment portfolios. The allocation to illiquid assets, such as private equity, was too high in some endowment portfolios according to many of the speakers, which forced investment officers to sell other liquid assets at inopportune times, exacerbating the decline in the public equity market. Michael Sullivan, Chief Investment Officer of the University of St. Thomas, noted that it was very important to communicate frequently with the treasury department of their school to ensure that the risk of the investment strategy was in synch with the liquidity and spending needs of the school.
Active vs. Passive discussion
Several foundation and pension officers mentioned that they had replaced their active large cap equity managers with index strategies because the active managers were not outperforming the index. However, these same managers noted that they still invest in a lot of active managers in small cap U.S., mid cap U.S. and international equity funds.
Importance of diversification for all investors
Peter Gunning, Global Chief Investment Officer of Russell Investments, said his firm was focused on finding the best global equity funds and adding alternative assets, such as commodities and infrastructure assets to benefit from low correlation with equities and income generation. Several panel participants emphasized that the major benefits of adding asset classes to a portfolio were higher portfolio returns and lower portfolio risk levels.
Louis Morrell’s thoughts and strategies
Louis Morrell is a Managing Director at the Wake Forest University Endowment where he is responsible for the management of approximately $300 million in multi-asset class investments following a dynamic tactical approach based on global economic factors. Mr. Morrell believes that “rocky periods lie ahead” and expects massive inflation in the future, but not in the short-term. He also stated that “central banks are not running the show, politicians are” and that political decisions will have unintended consequences. For example, Mr. Morrell is concerned that more bubbles will be created as a result of massive money printing. He also expects bubbles to occur more frequently than every 20 years like in the past.
Mr. Morrell does not try to time the market and remains fully invested in different asset classes, but his allocation to asset classes changes depending on where he sees opportunities. As a result of the tremendous volatility in recent years, his endowment has given him more latitude to tactically move within asset classes, by widening the asset bands that are acceptable. Mr. Morrell believes that it is dangerous to be too risk averse and that he needs to take risk in order to achieve 8% long-term returns for the endowment.
Mr. Morrell has about 28% of his portfolio invested in alternative investments, including 14% in commodities and gold, 8% in real estate and 6% in currency. He does not believe that gold is in a bubble and instead views gold as a currency hedge. Mr. Morrell noted that the number of U.S. dollars and Euros in circulation is growing much more rapidly than gold production. His current target price on gold is $1,400 / ounce. When the price of gold is appreciating, he prefers to buy gold miners and when the price of gold is going down, he prefers to purchase bullion.
Mr. Morrell views commodities as inflation hedges and plans to increase his exposure in the future when he sees inflation increasing. He targets commodities that will benefit the most from increased Chinese and Indian demand and sometimes obtains specific regional commodity exposure through equities. For example, Mr. Morrell mentioned that he was playing Ivanhoe Mines because he thought the company would successfully mine for gold in Mongolia.
Emerging Markets: Cautious in short-term, positive long-term
Peter Gunning stated that his company was slightly underweight emerging market equities in the short-term due to concerns about inflation rising and central bank tightening. Xiao Song, Emerging Markets Portfolio Manager of Contrarian Emerging Markets, echoed that emerging market equities were a little overheated. He said he was concerned with the rise of inflation in China to around 3% and about the bubble in the Chinese real estate market, emphasizing that real estate prices had already appreciated 30% in the first four months of 2010. Mr. Song expected non-performing loan ratios of Chinese banks to increase as the real estate market deflates. Furthermore, he stated that when one stock market in Asia goes down, the tendency is for every other stock market in the region to go down due to the exit of “hot money”. Both managers were confident in the long-term outlook for emerging market equities based on their abundance of natural resources, high level of infrastructure spending, favorable demographics, growing middle class and low sovereign and personal debt levels.
Commodity Investments: Should benefit from eventual rise in inflation
Andrew Karsh, Co-Lead Portfolio Manager for the Credit Suisse Total Commodity Return Strategy, summarized the benefits of adding commodity exposure to a portfolio, including protection against inflation and non-correlated returns with equities. He pointed out that although commodities and equities both declined in 2008, that was the first year since 1970 when both commodities and equities fell in the same year. Christopher Burton, who manages the fund with Mr. Karsh and who did not speak at the conference, was quoted in a news article on May 10th saying “Because commodities are inherently a driver of inflation, and are therefore positively correlated to unexpected changes in inflation, we've seen a growing number of investors increasing their exposure to the asset class over the past few months."
Adam De Chiara, Co-President of Jefferies Asset Management and Jefferies Financial Products, pointed out that although spot prices of major commodities have risen 10% to 15% on an annualized basis over the last five years, major commodity indices have generated flattish or even negative returns in the same time period. He explained that this was due to major indices’ use of futures contracts and explained that index returns were often hurt by “negative roll”. Every month, futures contracts expire and in order to replace the exposure, new futures contracts need to be purchased. Negative roll occurs when the price of the futures contract is higher than the spot price, so index managers have to pay more to regain exposure, which decreases index returns. It was interesting to see in Mr. De Chiara’s bio that he was involved with designing the Dow Jones AIG Commodity Index at his prior firm.
Mr. De Chiara recommended investing in CRBQ, an ETF that contains commodity-linked equities to gain exposure to commodity spot price appreciation. Although this ETF has a low correlation with commodity spot prices on a day to day basis, over longer periods of time the correlation is higher. He also recommended investing in talented active managers of commodities futures, who could add 5% to 15% of outperformance annually relative to passive futures strategies.
Hedge Funds: Positive attributes should result in greater inflows
The panel participants highlighted the advantages that long/short equity hedge fund managers have over long-only managers including the ability to short stocks, use leverage, trade more actively and not be tied to an index. Bruce Ruehl, Principal of Advisory Services Americas, said that the top tier of hedge fund managers add value and he is very positive on the long/short equity space right now.
It was interesting to hear several speakers mention that long/short equity hedge funds were no longer placed in a separate alternative investments “bucket” within institutional portfolios, but were instead placed in the equity allocation. This suggests that institutional investors will allocate more dollars to hedge funds going forward since the equity “bucket” in most institutional portfolios is significantly larger than the alternative investments allocation.
Several speakers also pointed out the positive impact hedge funds had in a portfolio based on their ability to decline less in bear markets and therefore dig out of a smaller hole to recoup losses. Stephen Rich, Executive Vice President of Mutual of America Capital Management, said that if a fund was down 20% in a given year, the fund would need to generate 25% return to get back to breakeven point. However, if a fund lost 50%, the fund would need to generate 100% return to break even. Therefore, if a hedge fund manager can fall less in a down market, it will be easier for that manager to recoup losses. This point was confirmed by another speaker who stated that 65% to 75% of hedge funds are now back above their highwater mark.
David Bailin’s Views on Hedge Funds
David Bailin is Managing Director and Global Head of Managed Investments at Citi Private Bank responsible globally for alternative and traditional investments. Mr. Bailin said that the average hedge fund was down 18% in 2008 in a very challenging environment in which liquid public equities were sold indiscriminately to raise cash and the rules for shorting financial stocks were changed overnight.
Mr. Bailin noted that it was easier to conduct due diligence on hedge funds following the crisis because hedge funds are now more willing to provide information more frequently and have their results tracked via external services. He said that institutional investors from emerging markets, including sovereign wealth funds, were increasing their exposure to hedge funds, while ultra high net worth investors were slightly reducing their exposure. However, he expects more ultra high net worth investors to invest in hedge funds over the next five years.
Mr. Bailin estimates that hedge fund assets will double to $3.2 trillion in 2015 from $1.6 trillion currently. He believes that large institutional hedge funds with great risk management will gain assets and that new hedge funds will form locally in select emerging markets, including India and China. Mr. Bailin also mentioned the potential for hedge fund managers in developed markets to relocate to emerging markets, if regulation intensified in developed markets.
Real Estate: Watching and waiting for opportunities
Several panel participants said that they are watching the real estate market and waiting for opportunities. Mr. Morrell stated that the U.S. real estate market remains a disaster and that nothing has changed at Fannie Mae or Freddie Mac. Michael Dean, Senior Associate of Meketa Investment Group, noted that the U.S. represents 35% of global property stock currently. He expects the international proportion of global property stock to increase as a percentage of total over the next decade, providing exciting investment opportunities.
Private Equity: Timing and manager selection critical
Anjum Hussain, Director of Risk Management at Case Western University, said that the time to invest in private equity was after markets have blown up, not when markets are at their peak levels, like in 2006 and 2007. Several panel participants noted that one of the dangers of investing in private equity was the additional layer of capital that was required of institutional investors during times of crisis, such as in 2008 and 2009, to maintain their equity stake. Mike Hennessy, Managing Director of Morgan Creek Capital Management, stressed how important it was to find skilled private equity managers. He believes that a private equity manager with no skill will only generate similar return to the public equity market, while a skilled manager will deliver 500 basis points of outperformance relative to the public equity market.
