This RogersCasey position paper examines the inflation-deflation debate, and the strategic role of real assets in portfolios, concluding there will be higher volatility around long-term average inflation, and that clients should diversify away from US treasuries to protect against sovereign risk.
The similarities between Canada and Australia are often remarked upon, and they could be about to extend to pension management if an ambitious plan for a ‘mega-merger’ among Australian state-based funds comes to fruition. (more…)
The precarious seesaw that is pension fund asset-liability management is demonstrated in the latest results of the giant Dutch pension fund, ABP, with the fund’s coverage ratio falling, despite positive investment returns, and the fund being only slighly ahead of its recovery schedule.
In the first six months of this year the fund’s pension liabilities rose €28 billion due to a historically low interest rate level of 3.2 per cent, compared to 3.9 per cent for 2009. The fund now has €218 billion ($282 billion) in capital.
This means that for the fund’s recovery plan, ABP is only slightly ahead of schedule, and a higher level of funds will need to be set aside to pay future payments.
In March 2009 the fund submitted a recovery plan to De Nederlandsche Bank, when a drop in the actuarial interest rate at the end of 2008 to 3.6 per cent, and a return on investments for the year of -20.2 per cent meant the fund’s coverage ratio had fallen to 90 per cent.
At the end of 2007, the fund had a coverage ratio of 140 per cent; with an actuarial interest rate of 4.9 per cent and a return on investments of 3.8 per cent. Once the coverage ratio falls below 105 per cent the fund is required to report to the Bank on its plan to eliminate the underfunding within three years, and that the value of the assets will be on the level specified by the Pensions Act within 15 years.
The fund has allocated almost 4 per cent more to fixed income in the first half of this year, compared with 2009, with the allocation to real assets being reduced.
Real assets incorporates developed and emerging market equities, real estate, private equity, alternative inflation, opportunity fund, illiquid commodities, and infrastructure.
ABP investment portfolio
| First half of 2010 | 2009 | |||
| Asset class | weight % | return % | weight % | return % |
| Fixed income | 42.3 | 4.1 | 38.7 |
12.7 |
| Treasuries | 10.2 | 3.0 | 9.0 | 5.5 |
| Index Linked Bonds | 8.3 | -0.2 | 8.7 | 11.2 |
| Fixed income credits | 23.8 | 6.3 | 21.0 | 16.1 |
| Real assets | 51.8 | 1.0 | 54.7 | 24.6 |
| Developed market equities | 23.7 | -2.8 | 29.8 | 30.0 |
| Emerging market equities | 6.0 | 9.0 | 5.7 | 74.1 |
| Real estate | 7.9 | 1.7 | 7.5 | 13.2 |
| Private equity | 5.4 | 13.7 | 4.4 | 8.2 |
| Alternative inflation | 4.8 | -4.8 | * | * |
| Opportunity fund | 3.3 | 1.7 | * | * |
| Illiquid commodities * | 0.4 | -1.6 | * | * |
| Infrastructure | 0.3 | 15.2 | -4.8 | -0.1 |
| Other investments | 6.4 | 5.7 | 6.3 | 10.8 |
| Hedge funds* | 4.3 | 8.9 | * | * |
| Global TAA* | 2.1 | 0.0 | * | * |
| Overlay | -0.5 | 1.9 | 0.3 | 0.9 |
| Overlay –duration | 2.6 | 1.9 | 0.8 | -0.4 |
| Overlay – cash and other | -3.1 | 0.1 | -0.5 | 1.3 |
| 100.0 | 4.6 | 100.0 | 20.2 | |
As recent events in the EU spark anxiety in financial markets, researchers at EDHEC Risk Institute examine various performance attribution models and the relation to currency decisions and overlay management.
A chief architect of the A$68 billion ($60 billion) Australian Future Fund‘s investment strategy will leave in two weeks to form a new business offering asset allocation and macroeconomic strategy advice to large fiduciary investors globally.
Tony Day, who joined the Future Fund in its early days of 2007, said that at 44 years of age and a career entirely in the public service, it was time to “chance his arm” in the free markets in which he so passionately believed.
He said he hopes he will continue to generate ideas for the sovereign wealth fund, which in the meantime will replace him with his understudy.
Day will go it alone in a new business offering asset allocation and macroeconomic strategy advice to large fiduciary investors. He said he was “in negotiations” for the Future Fund to be an early client, as well as other major institutions, both here and overseas, with whom he dealt during his tenure at Future Fund and before that in his 12 years as chief strategist for Queensland Investment Corporation.
Day will be replaced by the Future Fund‘s current senior strategist, Stephen Gilmore, who joined last August after previous experience with Morgan Stanley, AIG Financial Products, International Monetary Fund and the Reserve Bank of New Zealand.
Day hoped that the Future Fund would “continue to get the best third of what I do”, which was generating thematic investment ideas as opposed to being part of a senior management team.
“It’s probably no secret to anyone that I’ve got a distaste for bureaucracy,” he said. “But the guys [at the Future Fund] have set up a fantastic mandate,” he said.
The chief investment officer of the Future Fund, David Neal, said that Day had “played a critical role during the important establishment phase of the Fund, building a highly skilled team, shaping the long-term asset allocation and helping to protect and grow the Fund in an enormously challenging environment.”
Asked to name the highlight of his Future Fund tenure, Day said it was “hard to beat” the decision to pause the process of getting set in equities in late 2008.
The Fund instead maintained a high weighting to cash, and so was one of the world’s few investors to make a positive absolute return for 2008-09.
“There was that myth around that we got lucky, but I can tell you, we’d been on the march to 70 per cent [growth assets exposure] and to stop it was a really big team call,” Day remembered.
He added it was a “false rumour” that any former QIC colleagues would join him in his new venture, insisting he wished to “keep it small and focussed”.
Using performance, even as a filter, to hire or fire funds managers is a dangerous game, according to head of the international division at Enhanced Investment Technologies (INTECH), David Schofield.
Choosing any partner, whether personal or business, can be fraught with complexity, and the process of hiring and firing managers does not escape those selection perils.
While most sophisticated investors pay more attention to investment process, over performance, the latter still acts at least as a filter for most shortlists.
A recent paper by Enhanced Investment Technologies (INTECH) explores how insidious chasing performance can be.
The paper aims to provide a framework for mitigating the detrimental effects of chasing performance; by putting historical performance in its “proper analytical perspective”, where the focus is on the investment process and historical performance plays a secondary role.
David Schofield, president of the international division for the firm, which adopts a unique investment process based on the mathematical foundation of Stochastic Portfolio Theory, believes a rudimentary screen on process should be preferred over the common default screening on numbers only.
“Investors have to have some sort of screen to narrow the field but by basing it on performance you are probably excluding some good with the bad. The key thing is to attempt to identify the process that makes a priori sense, but most are based on financial theory and equity assumptions,” he says.
“Most sophisticated investors pay more attention to investment process, over performance, but it is still often a secondary attention – the short list still arises through a performance filter. And even those institutional investors hiring on process will fire on performance.”
In the INTECH paper, “Chasing performance is a dangerous game,” authors, Robert Ferguson, Jason Greene and Carl Moss, use a mathematically-based parable to demonstrate the shortfalls of using performance to measure managers.
In the working example (see the paper here) it shows the probability that the good manager beats 20 bad managers over a 10-year period is only about 9.6 per cent.
“This implies that chasing performance leaves the investor with the good manager only about 9.6 per cent of the time and with a bad manager about 90.4 per cent of the time. The investor’s average relative return will be only 19.3 bps annually, his tracking error will be 980.7 bps and his information ratio will only be 0.024. This compared with 200 bps, 800 bps, and 0.25 for the good manager.
“Sceptics might argue that the number of managers at a finals presentation typically is far less than 20. This misses the point. The adverse filtering on historical performance begins early in the manager selection process. The universe of investment managers that the finalists are drawn from far exceeds 20. The problem may actually be worse than depicted here.”
The paper also explores the argument that a good manager may beat bad managers over time and all that is required is a longer historical performance record.
“For manager skill to have a proper opportunity to assert itself there has to have a reasonable length of time and three to five years is nowhere near long enough,” Schofield says.
In fact, the paper, shows that based on numbers alone it would take 157 years to have 75 per cent confidence that the good manager, in the paper’s example, will beat all the bad managers.
Given the fact it is common practice to filter managers using performance, Schofield believes at the least the limitations of doing that need to be more transparent, and further, that academic studies to assess managers according to process are needed.
“Given the fact an initial focus on numbers is almost unavoidable, people doing that analysis need to be aware of limitations of that analysis, and the role of luck,” he says.
Ironically, for the firm whose corridors are filled with mathematicians, INTECH’s view is a focus on more qualitative rather than pure quantitative analysis for manager selection would be beneficial.
“There is no real certainty in choosing a manager, but the starting point should be the process and then the context of that should be the performance. Investors should look at what needs to happen to deliver the alpha. If not, you may as well throw darts at a dart board. If a manager has had an unusually good or unusually bad run you need to look under the bonnet. Are they still doing the same thing, is the company the same, is the market the same.”
Schofield says this is true of listed products, but perhaps more so for unlisted asset classes where the numbers are less transparent, and it is difficult to measure performance.