IPE at 15: Winning the losers’ game
In an era where old certainties no longer hold, pension funds cannot afford to sit on the sidelines and let others do the heavy lifting, argues Amin Rajan
"The real voyage of discovery consists not in seeking new lands, but in seeing with new eyes." This timeless advice from the French novelist Marcel Proust sounds apt as one considers the future of investing after three body blows in a dozen years: the 2000-02 tech collapse, the 2008 credit crunch and the 2011 sovereign crisis.
Of the 20 biggest daily upswings in the S&P 500 since 1980, 10 have occurred in the past five years. Likewise, of the 20 biggest downswings, 13 have taken place in the past five years. Rarely have the stock markets been so wild and moved so little. With too many wild variables, investing has become an ever-bigger zero-sum game, where winners win only because losers lose.
This is a far cry from the heady days of the 1990s when the unrelenting chase for relative returns delivered double-digit performance year after year, until the ensuing crash in March 2000. It was a defining moment. Investors discovered that index hugging could not buy groceries in a bear market - nor could it prevent an unprecedented funding shortfall in the defined benefit pension plans worldwide. Thus, uncorrelated absolute returns became the new mantra.
Some 30 new product sets, asset allocation tools and hedging techniques were duly adopted, as listed in the 2011 Citi/Principal/CREATE report ‘Investment Innovations: Raising the Bar'*. They aimed to control risk and boost returns irrespective of market conditions - only to be overwhelmed by the crash of 2008.
That episode showed that the world of investing can be like a hall of mirrors: what you see is not as it is. Securitised mortgages in the US are a case in point. Even financial wizards like Alan Greenspan or Ben Bernanke could not intuit their disastrous end game.
Similarly, the growing de-coupling of the economies of the matured West and the emerging East could not prevent global meltdown in 2008. China and Russia notched up the biggest market falls in the immediate aftermath of the Lehman collapse. Globalisation has created greater economic connectivity and contagion susceptibility. These are hard to model in a world where technology has amplified investor mood swings and compressed decision spans from calendar time to real time. Nearly 65% of daily movements in key market indices are now driven by ‘noise' rather than ‘signal'. Politics, not economics, drives the markets.
Emerging fault lines
The succession of crises progressively ensured that:
• The buy-and-hold strategy was not working, as equities were outperformed by bonds;
• Nor was the bar-belling approach, as actual returns diverged markedly from expected returns for most asset classes;
• Nor was diversification, as correlation between historically low asset classes went through the roof, due to excessive leverage.
In hindsight, investors learnt that they were not managing risk, they were managing uncertainty. One relies on known probabilities of expected returns, the second on pure guesswork. As one pension plan participating in our 2011 survey observed: "We have lost money in every asset class we were advised to follow."
Understandably, investors' trust in pension consultants and asset managers took a heavy knock. Only a minority of pension plans rates these service providers' track record in meeting the needs of their pension clients as either ‘good' or ‘excellent'.
This is because few of them saw the bear markets coming; few detected the time-bomb concealed in cheap money; few understood the unintended consequences of the mark-to-market rules; few expected the asset class correlation to go through the roof; few challenged the validity of the bar belling model. That is not for want of trying, however. Quite simply, investing has become ever more nuanced in the face of systemic forces.
Using new eyes
Even so, around a third of pension plans still managed to secure decent returns on their investments in the past decade. Instead of blaming others, they redefined their own role - from distant buyer to thinking partner - by doing four commonsense things.
First, they recognised that, unlike their physical counterparts, investment products do not have a definable shelf life. They do not deliver predictable outcomes, they cannot be pre-tested in a lab, and they do not carry a fit-for-purpose certificate. What matter most are timing and market environment.
Second, as a result, their investment choices were guided by gut instincts on what would work and what would not at different phases of the investment cycle. Honed by years of experience, these instincts were also tested and refined by frequent face-to-face encounters with their asset managers.
Third, such adaptive learning had helped pension plans to enhance their skill-sets and governance structures to capture intrinsic value created by unique conditions - eg, the rise of BRIC economies and the acceptance of non-investment grade debt.
Fourth, armed with new capabilities, successful plans adopted a disciplined approach to buying and selling securities that avoided herd mentality. Dynamic asset allocation was their aim and trained intuition the means.
This ‘physician-heal-thyself' approach speaks to an important theme. Despite turbulent recent history, two core principles of investing remain rock solid: buy low and sell high; and low risk means low returns. What has changed dramatically, however, is the primacy of canny instinct over traditional models in the implementation of these principles.
At the time when pension fund portfolio turnover is between 70% and 120% each year, it is necessary, but not sufficient, to hire smart consultants and smart managers. What pension plans do also makes a big difference. It's time for them to have much greater engagement with their asset managers. This will help asset managers to:
• Understand their clients' dreams and nightmares;
• Solicit new ideas by tapping into clients' investment expertise;
• Manage expectations of what can and can't be delivered;
• Minimise ‘wrong-time' risks in buying and selling;
• Communicate bespoke research that addresses unique issues to clients;
• Highlight proactive buying opportunities in periods of big price dislocations.
It will also help pension plans to:
• Seek better alignment of interest via common beliefs and time horizons;
• Obtain a second opinion on their asset allocation and correlation risks;
• Gain deeper insights into what works at different stages of market cycle;
• Develop mental agility to capitalise on periodic market dislocations;
• Minimise behavioural biases and herd instincts provoked by periodic volatility;
• Understand the ‘health warnings' that are usually lost in the fine print of legal agreements.
"We are as far away from our clients as the man on the moon," complained an asset manager in our survey, lamenting its disintermediation by consultants. This is worrying at a time when the market turbulence calls for more joined-up thinking via greater engagement of all parties in the investment value chain. Without it, the chase for decent returns will remain illusive. By pigeon-holing asset managers, pension consultants and pension plans, the current approach works to the detriment of plan members. It is geared towards a world that no longer exists.
*Available free from firstname.lastname@example.org
Prof. Rajan is the founder and CEO of CREATE-Research