M&M and pension fund liabilities
As if Detroit did not have enough problems, a gap of several billion dollars has appeared in its pension fund (see the New York Times here). Actually, US public funds have long been notorious for using unrealistic return assumptions in their actuarial calculations where it is not unusual to see expected long term returns of eight or even ten per cent per annum. Since actuaries use the fund’s expected return as the base to set the discount rate that is applied to the liabilities, optimistic expected returns automatically reduce the present value of a fund’s future liabilities and therefore seemingly improve its financial health. But it is not just US public funds who, with the connivance of their actuaries, use unreasonable return assumptions. Many Swiss pension funds use a 3.5 per cent rate to discount their liabilities in an environment where government bonds yield below one per cent, which is obviously not a reasonable way to estimate the required capital to meet future liabilities. Actuaries will argue that the current situation is abnormal but, unfortunately, any transition to a more normal situation – higher yields – will first inflict additional pain.
But quite aside from the question of whether the return assumptions are realistic, should the rate that is used for discounting pension obligations be determined by the fund’s expected return, i.e. its investment policy? Actuaries certainly seem to think so. But when we apply some basic results from the theory of finance, we actually arrive at a very different conclusion. Thirty years ago, I sat on the board of an institutional mutual fund with Merton Miller. When the investment strategy and the funding assumptions of a particular US pension fund client were discussed, he commented wryly that they had obviously never heard of his and Franco Modigliani’s work. What he meant was that, according to the Modigliani & Miller (M&M) theorem, the discount rate that is used to determine the present value of future cash flows should depend exclusively on the market risk of those flows and be independent of how the investment required to generate the flows is financed. This is one of M&M’s basic results: investment and financing decisions can be separated (subject to some small print).
Reader beware
Lessons from the Reinhart-Rogoff saga
The controversy about the mistakes in the Reinhart and Rogoff 2010 paper has left their reputation somewhat in tatters and has provided ample scope for expressions of Schadenfreude among economists. But there are actually also some interesting lessons in this sad development for those of us who are interested in economic and financial research.
If by any chance, you should not have not heard about this story, you may want to go here, if you are on the political left, or here, if you are on the political right, or here for the new paper by Herndon, Ash and Pollin that is responsible for the saga.
Risk adjustment as an excuse
Risk adjustment is a fundamental element of modern portfolio theory. Alpha is defined as the return left over after the impact of all sources of risk, including strategic biases, has been accounted for (see the examples in my series on alpha). But a positive historical alpha alone is not sufficient to conclude that a particular product would have been a desirable holding. Yet I frequently come across managers of multi-asset portfolios who proudly proclaim that they have generated superior risk adjusted returns. What is generally left unsaid is that, on a raw return basis, they actually underperformed their benchmark. This usually happens when risky assets offered a positive risk premium and the manager was underweight those risky assets, but was good at picking securities within the asset classes. Should existing clients consider the superior risk-adjusted performance as a consolation in this case? Should we invest with such a manager? I would argue that “no” is the correct answer to both questions.
Perfectly aligned interests?
Their performance has been disappointing lately and they are too expensive but, at least, their managers’ interests are perfectly aligned with ours. This is a widely held view on hedge funds. But in fact, two of the three statements are false. The only one that is correct is that they are too expensive. I will discuss the disappointing performance in an upcoming post. Today, let me focus on that alleged perfect alignment of interest. Investors like it when hedge fund managers invest substantial assets in their own fund(s). According to the traditional view, this helps to align the interests of the manager with those of the clients. But does it?
Manager selection and college football
Some years ago, Goyal and Wahal published a somewhat depressing article that suggested that pension funds and their consultants added no value, on average, in their manager hiring and firing decisions. In particular, replacing poorly performing managers with new ones actually led to worse performance than if the fund had stuck with the old managers (sticklers may insist that the difference was not statistically significant). While these results should not be surprising – remember that the average manager and therefore the average selector of managers must underperform – they still rankle in terms of the professional image of our industry. All this effort, all these consultant billed hours for less than nothing. Embarrassing, to say the least.
To the extent that misery likes company, a study quoted in today’s New York Times, published in the Social Science Quarterly, on the impact of the firing of unsuccessful college football coaches on the subsequent success of the teams comes as a bit of relief. (more…)
Black Monday 1987
Just over twenty-five years ago, stock markets crashed on what has since become known as Black Monday, October 19, 1987. At the time, I ran an investment boutique in London that offered a single type of product – small cap equity funds for institutional investors. Obviously, our clients were somewhat concerned by the losses that they were suffering (the Dow Jones index lost over twenty percent in one day). I too was scared: had certain key clients decided to withdraw their assets, the firm might not have survived.
Consequently, I spent a good part of that Monday night re-reading J.K. Galbraith’s excellent book on The Great Crash 1929 trying to understand what might be going on. Actually, I came away somewhat reassured; the world and the markets had changed a great deal since 1929. Institutions had replaced private speculators as the dominant market participants and, as a result, investors were rather better informed. But on Tuesday, newspaper headlines proclaimed “Bedlam on Wall Street” (Los Angeles Times) or “Wall Street Goes Mad” (New York Post) and even the Financial Times talked of “panic selling”. Under the circumstances, we felt that we should communicate our views on the situation to our clients. I wrote a short memo, which we mailed to our clients on Tuesday evening. Just recently, I found a copy of that memo (pdf) in my files. It looks very dated with its primitive daisy wheel printer font. But, somewhat to my surprise, I still agree with its basic message. Investors should still assume that they might not be able to change their allocation in periods of stress. Dynamic strategies that depend on the precise timing of transactions may fail in distressed markets and pro-cyclical tactical moves can be very costly, particularly in terms of missed gains if the moves are badly timed.
By the way, we did not lose a single client in 1987. I do not know if the memo played any role in their decision to stay invested. Perhaps sometimes one simply does have the clients that one deserves…
Low beta anomaly – some early evidence
Some of my readers have expressed the view that I am occasionally unnecessarily harsh in my posts. However, it is very unlikely that this post will elicit such a response since it is taking a rather critical look at the entrails of my own dissertation. While that was obviously a very long time ago, what I did then or rather what I did not do then is perhaps still worth looking at today. Basically, I must have been so preoccupied with the main result of my dissertation – the small cap effect – that I completely missed documenting a second result that was staring me in the eyes and that would have been as interesting.
Ethical…?
The two big public pension plans in Geneva are in dire straits. The local legislature is considering a bill this week that would merge them and would also provide a capital injection of almost a billion Swiss francs. The funds have pursued what is euphemistically called a mixed financing strategy. Their assets cover less than sixty percent of their liabilities with the remainder guaranteed by the local government, i.e., the taxpayers of Geneva. (This is where I should perhaps declare an interest: I am one of them.) The bill also proposes higher contributions by members and employers to raise the fund’s coverage ratio to eighty percent over the next forty years as required by federal law. To keep the required capital injection and contribution levels at a politically palatable level, the assumptions underlying these changes are rather optimistic. Consequently, I fear that Geneva taxpayers may well be asked to refinance their public pension plan at regular intervals over the foreseeable future.
The asset cover of the two funds had gradually eroded over the years due to a combination of benefit promises that were too generous (the funds are and will remain defined benefit plans and used to promise full indexation of benefits), contributions that were substantially lower than those of comparable funds elsewhere and disappointing investment returns. No serious measures were ever taken to stop the erosion until now.
There are two issues in this local saga that are perhaps of broader interest. One is the fact that a government guarantee may provide perverse incentives to the boards running such funds, and the other is the policy of the funds to invest exclusively in socially responsible investment strategies despite being seriously underfunded.
Alpha in tactical asset allocation
It is easy to beat the benchmark of a balanced portfolio in the long run. All we have to do is systematically overweight the riskier asset classes to capture their higher risk premiums. This may add some volatility but will almost certainly lead to a better long-term performance. Many years ago, I suggested this approach to an investment team that had been managing balanced portfolios using a timid, defensive approach. They were not convinced and argued that my proposal was unethical. In fact, a strategic overweight of the riskier asset classes in a balanced portfolio makes sense (as long as it respects the client’s investment guidelines). It is not unethical, but, naturally, the long-term outperformance that results is not skill-based alpha but just the consequence of the bias.
Untangling true alpha from such strategic biases in portfolios that include an element of tactical asset allocation (TAA) is not easy, particularly since managers have an obvious interest in considering all of their (positive) active return “alpha”. This post seeks to provide some guidance on how to separate TAA alpha – rare and valuable – from strategic bias – abundant and cheap. I will try to keep it as simple and non-technical as possible. An attachment contains a set of relevant formulas for those who prefer algebra to English.
Radio silence
By Rolf on 24 April 2014
An unreasonably long time has elapsed since my last post (23 July 2013). There is no excuse other than a bit of writer’s block. I have looked at the previous posts and have discussed their content with some of my most faithful readers. Their feedback suggests that the posts suffer from four main weaknesses:
All of these problems can be corrected. I will still occasionally include a longer or more technical piece but plan to have more short posts on current issues. I also hope that with less tame posts, there will be more comments. I have had almost 20’000 comments; unfortunately, all but a handful were spam.
Thank you for your patience.
Posted in Comments/ramblings | Tagged Housekeeping