There had been no letup in the events roiling the financial markets in the days leading up to May 17, when six top investors gathered for lunch at the Union League Club in New York. Later that evening each would receive Institutional Investor’s U.S. Investment Management award. To earn that prize, the elite group had successfully steered their institutional portfolios through what might be termed “interesting times.” On May 6, for example, the still-mysterious so-called flash crash had brought the Dow Jones industrial average down nearly 700 points before its dramatic snapback the same day. Greece was on the brink of default, and the Standard & Poor’s 500 index was halfway toward its worst monthly performance since February 2009.
[Click here to listen to the Investor Roundtable Audio Outtakes]
Against that backdrop the panelists sat down to share the challenges they’ve faced in securing the safety of the university, foundation or pension assets in their charge during one of the harshest investment environments on record. Even before the most recent spate of market volatility, these investors were busy delivering top performance during the 18-month market tumble from October 2007 to March 2009. This experience led to a lively debate about whether the markets are undergoing a sea change and how best to position a portfolio to benefit from — or at least mitigate — the unrelenting volatility hammering their assets. Hedge funds and private equity went under the microscope, along with the prospects for global markets,and the participants reevaluated risk management techniques in light of recent events.
The energetic dialogue, which was leavened with humor and an eagerness to learn from one another, featured Peter Adamson, then CIO of the Eli and Edythe Broad Foundation and the Broad Art Foundation (now CIO of Oprah Winfrey’s family office); David Erculiani, director of corporate finance for Constellation Energy Group; Kristin Gilbertson, CIO of the University of Pennsylvania; James Martin, CIO of the M.J. Murdock Charitable Trust; Frederick Rogers, treasurer of Carleton College; and David Villa, CIO of the State of Wisconsin Investment Board.
Americas Editor Michael Peltz, London Bureau Chief Loch Adamson and Senior Writer Frances Denmark moderated the focused yet freewheeling discussion, excerpts from which follow.
Institutional Investor: Mohammed El-Erian, co-CEO of Pacific Investment Management Co., recently wrote a paper about the painful process of moving toward a “New Normal,” a period of time in which global growth will be subdued and unemployment high, and the heavy hand of government will be more visible in the markets. How closely do you subscribe to that view?
Kristin Gilbertson: The most surprising thing to me, looking at the current investment environment, is how everyone seems to feel that we’re back to normal and we all feel pretty good — or at least we did up until last week, with Greece and the craziness in the market. And yet nothing really has changed that much. Our financial system is still a mess. The authorities have done a great job in putting a gigantic Band-Aid over the problem, but we still have to work through all of that. And we’re only just getting started. At least they prevented a repeat of the Great Depression, but we haven’t gone through the structural adjustment that we need to, and we haven’t begun to pay for all the losses that are in the banking system. That certainly is going to weigh on growth going forward.
James Martin: I want to put a little different spin on what you said because, as the markets continued to go up and we all felt pretty good, I felt worse and worse and worse. I thought the markets were getting ahead of themselves a little bit, for all the structural reasons that you suggested, and another downturn was more likely to be severe. Whether it’s a new normal or not — I don’t know that I’m ready to say that. But I do think it’s a long-term problem.
Peter Adamson: We generally agree with the Pimco view, except that we’re not really in a normalized environment for monetary or fiscal policy. We’re still on steroids and morphine. And if you listen to the people who’ve been inside the Federal Reserve for a long time, it’s a huge experiment. They don’t know how they’re going to unwind the mortgages they bought, and with rates at zero percent, it creates a lot of yield chase and capital flows. So I don’t even know if we can test the new normal yet, because we’re in an artificially stimulated environment in the U.S., and it’s going that way in Europe even more so now.
Frederick Rogers: The changes that have taken place are deeper and more widespread globally than we’re used to. The whole ground moved, and I don’t think we’re coming back yet. I also think that issues in Asia and in Europe will have much more impact on the U.S. in the next 20 years — not that we’ll lose our capacity to be a strong, vibrant producer and economy, but it’s in a different context than it was. There’s a whole different set of expectations about where we’re going and how the U.S. will play into that; I don’t think we know what it will look like.
David Villa: I’m amused by the popular attraction to this “new normal” phrase. It seems a consensus is forming around that, which makes me skeptical about what’s going to happen over the next five years. It seems logical that you would expect growth to be low if you’re going to have a government that’s more intrusive because of regulation and antigrowth policies and losses that haven’t yet been written off. But we just don’t know. It could surprise on the upside, and you have to be ready for that.
What’s been the most surprising thing for us is that in the face of declining bank debt, the issuance of high-yield debt is on pace to hit an all-time high. A lot of it is replacement of bank debt with high-yield. Borrowers need to roll their debt, and the market is willing to absorb it. That’s telling us the zero-interest-rate regimen is working and there’s capital on the sidelines that’s ready to take on risk. The new normal is very popular, but we are already back to record levels of risky debt.
Do you see the best investment opportunities in the U.S., Europe or emerging markets?
David Erculiani: We’ve moved away from separate buckets for U.S. equities, international and emerging markets and launched an all-world mandate. Perhaps our timing is not good, but if you look out into the next five, ten, 15 or 20 years, you have to ask yourself, where is the growth and what is happening here in the U.S.? And our view is that over the next ten or 20 years, we’re going to get more growth outside the U.S. — in China and India, for example — than in the U.S.
Martin: We began using global mandates a dozen years ago, at a time when they were extremely unpopular. Turned out to be a pretty good decision on our part. A lot of the allocation decisions are in the hands of our managers on a bottom-up basis. I think they are probably better equipped than I am in making these decisions.
Adamson: We’ve focused on emerging markets and have had a big overweight there since 2004. The tactical opportunities like credit have been very short-lived, we’ve found, largely due to the zero-interest-rate environment, the [Term Asset-Backed Loan Facility] and Fed buying. There are very few back-up-the-truck opportunities we’re seeing right now that are dislocated, with no real buyers and a lot of sellers. So it’s hard to put money to work.
Is this a good time to be looking for deeply out-of-favor assets?
Gilbertson: We’ve been top-slicing a little bit of our portfolio, both in equities and credit, on the large recent gains, with the idea that, during the crisis, we were more fully invested than we thought. At the University of Pennsylvania, our liabilities are in fixed dollar amounts, whether that’s the payout rate or it’s unfunded commitments that might be called over the next three or four years. We’re making sure that we have the freedom to be tactical when we have opportunities.
Rogers: The investment committee chair of Carleton College is a pretty established value investor, so he’s always looking for value. We have tried to be able to rebalance actively into our long-term asset allocation, and that’s actually worked out pretty well. But it’s not viewed as a tactical kind of decision.
Martin: In the 23 years that I’ve been CIO of the trust, we’ve always had a certain portion of our portfolio that we used to take advantage of opportunistic investments — until now. We’ve just been nervous about deploying cash in areas that we might be excited about, no matter how excited we are, because we may need that cash down the road to meet our operating requirements and to meet our grant expenses. We’re very conscious about holding onto our cash and not making new investments, because we think it’s going to take some time yet to work out of some of the structural issues that we’re seeing.
Adamson: We would like to be opportunistic and find these things, but it’s been difficult. It’s hard to deploy money in distressed sectors. On the commercial real estate, loan-to-own side, a lot of those markets are tied up in CMBS, and the services that are selling them are sort of stuck. The banks aren’t selling anything in volume. Our managers haven’t been able to get anything done on that front.
Gilbertson: It seems that the crisis in real estate hasn’t passed yet. Whether it’s a year from now or two years from now, we may start to see more distressed real estate come to market. Regulatory changes and accounting for capital adequacy have enabled them to hold on to assets rather than being forced to liquidate them at fire-sale prices. But we haven’t seen the main act in distressed real estate yet.
Do you have a certain percentage of your assets ready to deploy in cash or cash equivalents when these opportunities arise? How much would you want to have?
Adamson: We are pretty fully invested now. My preference would be to have 20 percent cash.
Martin: We don’t set aside a set amount of cash to jump on an opportunity. But we might take money from another area to seize one. We use our cash to meet our operating expenses, fund our grants program and satisfy capital calls within our private equity and real estate programs.
Gilbertson: I think that having some cash — whether it’s Treasuries or very safe, core fixed income, something that is liquid and safe and that holds up in time of crisis — is an integral part of a policy portfolio. The question for us will be, Where do you want to be relative to your target on that? And do you want to spend your mad money now, or are you going to hold onto it? As I said earlier, we’ve been top-slicing a little bit on the portfolio — adding a little bit to cash and Treasuries and reducing equity and credit investments.
Rogers: We just actually increased our fixed-income allocation slightly, up to 10 percent including cash and Treasuries. Partly because of this desire to both fund all the commitments we’ve made and have the opportunity to rebalance.
Villa: We’re fully invested, so we’re not holding any residual cash. Our demographic profile in Wisconsin puts us in a position where we’re going to pay out 2.5 to 3 percent yield on an ongoing basis for about ten years. Ten years of liquidity is about 30 percent of the fund that needs to be very, very liquid, and we’re willing to sell liquidity on 70 percent of the fund. The liquidity can be in Treasuries, or it can be in cash with futures on top or something that’s very easy to liquefy. We learned that government bonds with securities lending may not be as liquid.
Erculiani: At any given time, we’re probably at 1 to 2 percent cash. It’s twofold — for benefits over the next few months and for potential opportunities.
Let’s turn to hedge funds. The 100 biggest hedge fund firms in the world manage a combined $1.1 trillion, according to our most recent ranking. As hedge funds have become large institutions in their own right, has it become difficult for them to generate alpha?
Villa: It’s interesting to us that if you take the hedge fund index data from 1994 and look at the performance of hedge funds over five-year increments, in each five-year period investors’ returns declined. It’s hard to say why that is, but a lot of money’s flowed into the space, and it makes sense to us that when a lot of capital flows into a space, the marginal dollar receives a lower return.
The other thing that we’ve observed is, if you backward engineer the gross margin of the largest hedge funds, probably the same ones you’re talking about, the result seems to be that they have a gross margin north of 35 percent. That seems to be a bit high if you’re concerned about alignment of interests.
Martin: My gut was telling me for a long time that hedge funds had to be the next bubble because there were so many assets flowing into hedge fund–land and expectations of investment returns that didn’t seem to be repeatable. I think that institutions have learned that there may be another home for hedge funds within the spectrum of investments.
All of our hedge fund exposure is in what I would call our two lowest-risk buckets. We’re using hedge funds more to manage risk than we are for return. And I think that maybe there’s been some increasing sentiment in that direction, which has kept the asset levels a little higher but driven return levels down somewhat.
But in that context, then, you’re perfectly happy getting lower returns because you’re looking to lower the risk in your portfolio.
Martin: Yes, I’m getting great risk-adjusted returns, based on my perception of how this hedge fund should be slotted in my risk spectrum. I’m totally happy with it.
Erculiani: Hedge funds are the liquidity pool within our alternative investments. So from that point of view, we can get in and out pretty quickly. But if you don’t get good hedge funds, you’re probably not going to make any money. Right now we’re going to be overweight in hedge funds until the opportunity arises to move some of those assets into real estate.
Martin: To the earlier question, do you hoard cash waiting for an opportunity? I wouldn’t do that, but I might put it in a hedge fund or in a different form that I expect to draw on as those opportunities arise.
Adamson: If you look at the hedge fund returns over the last three or five years, they’re a lot better than long-only equity or credit. At least, our hedge funds have been. That’s one reason why capital has flown to them. We tend to focus on bottom-up, fundamental equity and credit-type managers, and size is a big problem in those types of strategies. It’s probably less of an issue in macro funds because those markets are so deep. We don’t have a lot of macro managers with whom we’ve been comfortable. But they’re the most talented investors out there, so you have to hold your nose. We view hedge funds as a core piece of the portfolio, but we find it very difficult to trade in and out of them, to weight things differently. It’s hard to get in the funds we want to be in, and if you take money out a lot, the managers get annoyed.
What are your views on private equity? Arguably, no other alternative asset class was hurt more during the financial crisis. Is there value there now?
Martin: We’ve been investing in private equity for 30 years. We love private equity. Currently, nearly half of our portfolio is in private equity and real estate. I believe it’s a great way to make money in the long run. You’re going to get an excess return over the public markets that’s going to be significant. And that’s going to be extremely helpful in achieving your overall objective. You are going to ride through some tough times from a liquidity perspective. The last couple of years were a huge challenge in funding capital calls on the private side. This year we’re about dead even between capital calls and distributions.
Gilbertson: When the crisis was unfolding, we continued to make new commitments to private equity. We’re excited about a couple of investments with distressed investors, people who had operational turnaround experience and could aggressively manage portfolio companies. And by implication, firms that did not rely on excessive amounts of leverage or securitizations to earn their returns. The third category would be funds that have some expertise in financials and might be able to capitalize on some of the bankruptcies and shakeout in the banking industry.
On the other hand, capital called today would be invested at better valuations than anything that was called three or four years ago. But I am worried that some of the firms are not organizationally stable. They have a lot of legacy portfolio issues. And then they may not be able to manage their way through all of that and raise new funds. Then your money may just be dead in the water.
Villa: The Wisconsin portfolio and possibly other large state pension plans were overallocated to the big megafunds. We’re attracted to the current vintage years as well, but there’s a lot of overhang from previous uncalled commitments. Those are the two management issues. We prefer private equity to public equity because of the corporate governance and agency issues. They’re better able to manage that in a private structure.
Martin: I love the smaller to midmarket, very specialized managers who know an industry better than anybody else and, regardless of the economic times, are probably going to do just a little bit better. And I don’t mind paying a 30 percent carry if that’s what I have to do to get that kind of access and enjoy the kind of net results you might get with those kind of groups. So don’t let the fees scare you away. The bottom line is not about fees, it’s about net return.
Erculiani: I absolutely do believe that the timing for private equity is good given what’s happened the past few years. There are excellent opportunities as long as you can withstand the lack of liquidity.
Most investors look at hedge funds and private equity as alternative assets. Is it time to stop segregating them from traditional assets when doing asset allocation?
Rogers: We actually just moved our long-short equity hedge funds into the equity portion of our asset allocation. We now count them as part of our overall active exposure. That has helped us realize how large our equity exposure was. Under our old way of counting, we had 30 percent in equity, but when we add this back, it’s actually closer to 50 percent.
Martin: I think it gives you a much more realistic assessment of what kind of risk you have in your portfolio. Just because people call them alternatives, they don’t have the same type of risk that venture capital might have. I think it’s better to classify them in the appropriate spot based upon your assessment of the risk.
Adamson: I agree you could get rid of the alternative classification. We have kept the alternatives in separate classes for measurement purposes. But we always do a look-through analysis of every holding to measure our total equity, credit and currency exposure from traditional and alternative assets.
Erculiani: At Constellation Energy, we now look at return-seeking assets, which includes everything but our liability hedge. So it’s public equities, it’s private equities, it’s real estate, it’s hedge funds, it’s high-yield fixed income.
Rogers: What’s the alternative to that, return-seeking assets? Return-fleeing assets?
Erculiani: On a bad day.
Gilbertson: Could you talk a little bit about your liability hedge? In the midst of the crisis, pension plans not only had the asset problem but the liability problem as well, with the discount rates dropping. How do you use the liability hedging in your investment strategy?
Erculiani: We launched a liability-driven investment strategy and have a derisking schedule, which is really a glide path. As our funded status improves, we take assets out of the return-seeking portfolio and put them into the liability hedge. The hedge component consists of long-duration bonds and derivatives including Treasury futures. Depending on future legislation, we may have interest rate swaps — or not. The hedging part of the portfolio responds in a like fashion to the liability. As the liability goes down, this hedging asset goes down and vice versa. Over time we’re going to increase that, depending on funded status. We’ll take the risk off the table as we get closer to our end state. There’s very little benefit on the upside to having a really well-funded plan, because the Pension Protection Act says you’ve got to get to 100 percent funded, so you manage your downside. You’ve got to worry more about your downside than fantastic capture of upside.
Villa: How much is allocated to the hedge?
Erculiani: Right now, 33 percent of our portfolio. But as our funded status improves, then we’ll put more in. And it’ll be a combination, once again, of long bonds and derivatives. It’s a way to try to minimize risk or try to keep risk under control. But the primary risk we’re trying to mitigate is projected cash contribution volatility. The PPA accelerated the corporate contributions, and the recent period of market volatility increased the contribution requirements.
Rogers: Do you think there’s any application for that in the endowment world?
Gilbertson: The interests are almost opposite. On the pension side you’re worried about the risk that interest rates go down. On the endowment side we’re more worried about the risk that interest rates go up or that inflation spikes. And we should probably be doing a deal among ourselves to hedge our different risks, do it without the middle men and do it a lot cheaper.
We manage a little bit of pension money for the university, and we completely shift gears when we look at the duration of our bond portfolio because on the endowment side we don’t want to be in a long bond, because we’re worried about the risk that interest rates will go up. Whereas on the pension side, it’s a little bit more costly to have it, because we lose the natural hedge if the discount rate goes down. In pension management you have to be more conscious of the liabilities, whereas in the endowment world, the liabilities don’t depend on the interest rate.
Villa: In Wisconsin we have a dividend process that goes up and down for the retirees, depending on the five-year credited earnings rate. And the hurdle is 5.8 percent. So if the five-year number is above 5.8 percent, the retirees receive a positive dividend. That actually increases their monthly check. If we earn less than 5.8 percent, it’s a negative dividend, which auto-adjusts the liability. So if we earn less than 5.8 percent, retirees receive a smaller monthly check. I have to think about this liability hedging in that context.
Gilbertson: Well, you almost have created a natural hedge, then.
Villa: Yes, the beneficiaries share the risk with the employers.
Erculiani: But you still have to discount that liability.
Villa: Yes.
Erculiani: So you still have interest rate risk. This is just a tool to help control it a bit.
Villa: Right. The liability can go up and down, but it won’t move against you as badly because there’s a dividend adjustment.
Have the events of the past two years changed your views on risk management?
Villa: In Wisconsin we think of risk as, you’re hunting, it’s 2 o’clock in the morning, and a bear comes into the tent and wakes you up. You can’t measure that. I think that is a lot of what has been going on in risk management in the last couple of years.
Gilbertson: The bear coming into the tent.
Villa: Yes, risk is the outcome that is unacceptable. It’s not the standard deviation, it’s not the volatility of your monthly or your quarterly or your annual returns. It’s defining what is the unacceptable outcome. And then having a process and infrastructure to deal with that.
Is there a way to prepare for that bear?
Villa: My personal view is that it’s a lot more about culture and governance than it is about quantitative measurement techniques. We have a couple of Ph.D.s that help us with the quantitative measurement, but a big part of it is just sitting around a table like this and talking about positions and outcomes, and doing that across asset classes.
Gilbertson: I think for us the most important thing over the last two or three years was being willing to ask the stupid question and to not necessarily accept the highfalutin answer. Whether it was securities lending, where there was risk in the cash investment vehicles, or whether it was prime brokerage, where you had to make sure that you really were in a Reg T account and your managers knew where their cash was and anything that was a fully paid asset was in a custody account. You just had to ask very basic questions and keep pushing people.
Rogers: I think there were operational issues as well, where people didn’t understand what happens if you have no liquidity in your investment pool at the same time that you’ve invested all your operating cash in that pool. Or you have capital calls that accelerate their schedule because values decline at the same moment when you have this liquidity issue. Some people got into serious trouble over that. It’s about operational risk. Have you separated these risks enough, or can you afford to be in a circumstance where, when values decline and you most are in need of cash, you have to pay premiums to go raise that much? A number of institutions ended up doing so. I think keeping those separate and clear is a key piece of risk management.
Gilbertson: It is important to have a board that’s willing to let you leave money on the table. And not to try to squeeze every penny out of your operating cash or put caution to the side in making new commitments in private equity and real estate. Right now it seems like it was a smart thing to do, but four or five years ago, it was sheer idiocy to be leaving money on the table.
Adamson: Most high-net-worth families kept a lot more liquidity. We’ve never used a lot of the risk metrics based on normal distributions that got people into a lot of problems. We use position sizes, we look at all our exposures. It’s a lot more qualitative than any sort of report that drives decisions.
Erculiani: At Constellation Energy we did make significant changes by adapting the liability hedging model and derisking schedule. And the utilization of strategic partners that are now involved in asset allocation and fund selection decisions within their respective areas.
As you look out over the next six to 12 months, what is your biggest fear?
Gilbertson: I think obviously if another wheel comes off the global economy. I think that the central bankers have done a good job shoring up the financial system. But there are so many outside-the-box things that can happen, whether it’s a volcano disrupting air traffic — you don’t even want to think about a terrorist attack or some geopolitical instability. I think we’ve all learned that absolutely anything can happen and it usually does.
Villa: As much as I think China is the biggest issue I should be worried about, in fact there’s a higher-level issue that I worry more about. There’s been a general attack on the defined benefit model that seems to be misplaced. It would be the biggest risk or the most disappointing outcome if this attack were to get traction. Wisconsin has a very well-funded plan. It has a risk-sharing mechanism which is fair to the employers as well as the beneficiaries. It provides professional asset management at a very low cost. It provides a pooling of mortality risk and a pooling of different time horizons.
These benefits are significantly diluted in a defined contribution plan, and you still have the social obligation of taking care of the elderly. Those all seem to be very, very important social benefits, which are at risk of being lost if this attack on pension plans continues.
Rogers: I have a similar business issue, but a different take. The volatility of the last three years in endowments has in many cases gone beyond the bounds of what we thought was tolerable. That is, the spending rates were supposed to be independent of investment returns, and you could have volatility in investments and spending would just continue monotonically increasing. That hasn’t been the case. So we’ve now got market volatility that’s driving spending decisions, which are driving budget decisions. A lot of institutions are making what fundamentally are very important decisions about their competitiveness with faculty, the number of faculty, what kind of students they can recruit, what programs continue and don’t continue. And we’re just not used to having those decisions directly derived from whether we think the markets are going to go up 10 percent or go down 10 percent.
Adamson: China could turn out to be a house of cards with all the stimulus that they’ve generated the last couple of years. I’d say of equal concern is that either the sovereign or the municipal debt crisis continues to grow and it’s so big that no one can backstop everything, and that would create a cascading impact in the capital markets.
Erculiani: Over the next six to 12 months, my biggest fear is a double-dip recession. I think that if for some reason we ultimately have a serious crisis throughout the world and actually have a double dip, it’s going to have long-term implications. My long-term fear is, over the next ten years, we’re going to have extreme volatility that’s going to be extreme in both directions and we’re going to lose a lot of investors, similar to the 1930s.
Martin: If six months from now my opinion changes and I say, “Wow, maybe we’re still only in the third inning of this global economic downturn,” then that’s going to change our demand for liquidity, and we may have to do some things that otherwise we didn’t think we’d have to do. But it’s all liquidity-driven when you have 46 or 47 percent in private equities.
If you could make only one investment decision for the balance of the year, what would that be and why?
Erculiani: Megacap U.S. equities. If you think about what’s happened the last couple of years, all the major corporations had to go through significant cost-cutting measures. Their balance sheets are probably stronger than they have been in years. And they have an ample supply of cash that they can do several things with, such as buy back equity and make acquisitions.
Gilbertson: You stole my thunder. I was going to say large-cap quality stocks. They held up reasonably well during the crisis. What’s really come back is the lower-quality stocks, which have rebounded dramatically. The megacap stocks have regained what little they lost and haven’t done much from there. I think that there’s still value, and I also think there’s still safety there. You also get an option on the growth of emerging markets by holding large international companies.
Villa: That’s a very hard question to answer because we tend to think in terms of having lots of bets, lots of decisions and being right only 52 percent of the time. So boiling it down to a single one is kind of hard. But I think if we take our internal positions and we take our external managers and add it all up, we’re running a fairly significant underweight to financials.
Rogers: We’re looking at investing in hard assets and commodities. We’ve not done much of that, so I think that’s what we’ll do. We’re looking at energy issues — oil, gas and other kinds of commodities.
Adamson: I’m going to say bank loans, because if the economy double-dips, you’re senior in the capital structure and you’ll probably get your money back. And they’re floating-rate, so if things take off and rates go up, you’re protected that way. Bank loans have rallied a lot, but you’ll probably get 5 percent or close to it. We agree with the financials. We’ve been buying the [Troubled Asset Relief Program] warrants as a levered play on those. But if I had to pick one for an all-weather scenario, I’d pick the bank loans.
Martin: Right this minute I like distressed credits; I like venture capital. And I like some things that I think will pay off near term in probably the next five to seven years in terms of a private equity program. If I had to make one investment decision the rest of the year, it’s keep the long-term focus. Have a long-term focus that makes sense and that you understand.
