By Rolf on 23 September 2014
After a series of posts that were rather critical of the media, it seems only fair to praise an article that makes its points succinctly. This week’s Buttonwood column in the Economist discusses hedge funds and pension deficits in the context of the decision of CalPERS to abandon hedge fund investment. It makes for rather depressing, but also very interesting reading.
The most provocative part of the article is the assertion that pension funds allocate assets to hedge funds as part of a “Hail Mary” bet, i.e., a desperate attempt to improve performance to justify their often unreasonable return assumptions. As an example, CalPERS return target is 7.5 per cent, which seems rather ambitious in the current environment. It is indeed rather unlikely that a traditional 50/50 or 60/40 portfolio of equities and bonds will offer more than, say, four to five per cent per annum in USD terms over the coming years. Additional return sources would need to be identified to meet their higher target. But active long only strategies are unlikely to make up the difference.
This is where the attraction of opaque private market investments and hedge funds comes in. Hedge funds, private equity, infrastructure and even insurance linked strategies are rather less well understood than traditional investments; it is often not very clear how their returns are generated. The ignorance about their true characteristics encourages some investors to overestimate their performance potential, which leads to unreasonably high return forecasts. But there are no miracles either in private market assets or in hedge funds; only a minority of them will provide positive added value. Winners always need losers. But maintaining the illusion of vastly superior return potential allows politicians to delay the day of reckoning for public pension funds at least past the next election.
Some people will praise CalPERS for their “courage” to abandon hedge fund investments. But they continue their “Hail Mary” bets with substantial positions in private markets. If one applies reasonable return assumptions, CalPERS’ actuarial position is desperate. Pity the poor tax payers in California. They are not alone but that is never a great consolation (I know, I live in Geneva).
By Rolf on 13 May 2014
Ten days ago, a teaser on the cover of The Economist proclaimed the “Death of the fund manager”. Inside, there was a leader – which is what The Economist calls its editorials – and a lengthy article. Given the tone of the teaser, the content is hardly surprising. It berates financial intermediaries for their greed as demonstrated by the fact that, forty years after the first index fund, most investors are still sold active products even though they are more expensive and lead, on average, to worse performance than passive products. The Economist is right, of course, that many active products underperform their benchmarks and that many (some would say most) active managers are clueless. But is that enough to proclaim the death of an industry? In this case, I think that The Economist is missing the point. Active management is but a venal sin, even for the clueless. The main culprit for the poor performance of many investors must be found elsewhere.
The article quotes a study by PwC in which they use an example of a young Chinese woman in 2020 who “uses her smartphone app to buy, in a single click, a range of funds that most meet her needs and risk appetite”. What the quaint image does not elaborate on is how the young woman will determine what her needs and risk appetite are. But this is the fundamental problem of investment. It is one that the missionaries for a world without active management tend to ignore. But there is no such thing as a passive solution to asset allocation. Any asset allocation is the result of an active decision. And we are pretty awful at this decision. Behavioural factors tend to get in the way. We buy what has recently done well. We increase risk when things go well. We bail out at the worst moment, at great cost. I am convinced that poor allocation decisions cost investors rather more, on average, than the selection of actively managed products. As an example, did the endowments of certain US universities have a disastrous 2008 because of poor manager selection or because of a poor asset allocation decision? The evidence seems quite clear: the problem was not that they had bad private equity managers, they simply had much too much private equity.
The role of an intermediary, or to use a less tendentious term, of an advisor, is not limited to product or manager selection. It also includes advice on asset allocation and perhaps most importantly, the protection of the investor, institutional or private, against his or her own greed and fear. The Economist presents the intermediary as the enemy. They suggest that if only investors could liberate themselves from the shackles of that oppressor, they might finally achieve better returns. I beg to differ. The US experience with 401k plans shows that many investors, left to their own devices, are either overly conservative – investing mostly in cash – or unreasonably concentrated – investing mostly in their employer’s shares. Let us not forget that it is just as easy to generate poor returns with an overly timid allocation as it is with one that is too aggressive.
In my mind, the discussion on the merits of active vs. passive management is a pointless distraction. The most important unsolved problem for most investors is to find a strategic allocation that has sufficient performance potential to give them a reasonable chance to reach their return objective while being subject to a level of risk that is “survivable” even in periods of crisis. In this area, there is a continued role for advisors. So yes, The Economist really missed the point this time with its love song for ETFs.