The big problem facing US pension funds is the combination of lower bond yields and lower expected returns from equities, coupled with the shifts in the opposite direction on the liabilities side. “Funds are hurting on both sides of the equation,” says Goldman Sachs asset allocation guru Bob Litterman, based with the asset management arm in New York.
“The equity risk premium(ERP) is really the driver of this.” He defines this as the longterm expected return on equities above the risk free rate. So with the US 10-year bond rate hovering just over 4% and an ERP reckoned to be 3.5%, the total return expected on equities, he puts at 7.5%, implying a fund (with approximately two-thiurds equity) target total return at 6.5%.
“As many funds have gone from being 100% plus funded to being less funded than this, funds constantly ask: ‘What should we do about it and where do we go for the extra return?’”
Litterman is quite definite in his views about where expected returns are not going to come from. “You are not going to get these from equities. So we are focusing on private equity, hedge funds, currency management and global tactical asset allocation.” The question is how to arrive at expected returns for these areas.
“We arrive at these, as a result of modeling, on the basis of some assumptions – these are not necessarily always Goldman Sachs’ views. For any asset class, such as private equity, we start with an equilibrium approach.” The model used is a Global Capital Asset Pricing Model type, which he and Fisher Black worked on a decade ago. “Basically, that provides an expected return on assets to the extent they are correlated with the global market portfolio. You do have to make an assumption about the ERP or the return on the global market portfolio.”
For private equity, the first issue to be faced is what is its beta? “We typically claim it has beta of 1. We do not claim that this is overly precise, as with venture capital, the beta could be greater, but with a more traditional company it would be lower, so we say 1 overall. Then we assume there is a fair amount of uncorrelated risk associated with private equity, but as the returns cannot really be measured on PE, there has to be a guesstimate. We think there is about 25% annualised volatility of uncorrelated risk in PE.” Litterman sees this class providing an equity premium with a couple of percentage points in addition coming from the illiquidity aspects.
Hedge funds come in very different flavours, each with their own characteristics. “We aim to look at the market beta,” adding that in the case of market neutral strategies there is zero beta as expected return. “But in hedge fund investing, there is expected positive return, based on manager skill or some opportunity, which makes hedge funds attractive.”
He regards currency overlay management as real opportunity, particularly since it has not attracted so much capital, a feature that concerns him about hedge funds and their ability to maintain returns. “Currency is uncorrelated to capital markets, due the the fact that there are so many ‘non-economic’ players, such as governments and central banks, which makes it such an opportunity.”
As to expected returns, he says in currency it is a question of how much risk the investor is prepared to take. “I like to use information ratios, where good managers will have IRs of 0.5 or even 1. So if you are taking a 2% risk, and the manager has an IR of 0.5 or higher, giving a return of 1%, which can happen year after year.” This, he compares with equities, where the return per unit of risk is lower.
“We are saying to our clients who are obtaining IRs of 0.2 or 0.3, they should be taking much more active risk, as they can with currency managers, which are a good source of active risk.” Litterman believes that pension funds are not sure how to go about using active risk. Active risk comes from many different sources. “I define it as any risk that is uncorrelated with the market,” he says, adding: “The whole idea of risk budgeting is to manage your active risk. It is not about limiting risk, but about generating more return by managing it.” The danger with relying on the tracking error returns from active long equity managers is that they can cancel each other’s tracking error returns when measured at fund level.
“Funds need to crank up returns from active risk and the only way to do that is by strategies that have large amounts of active risk per unit of capital,” he says. “Currency overlay is good in that it has relatively unconstrained amounts of risk that can be taken, as it does not take a large amount of underwriting capital.”
Global tactical asset allocation is another good source of active risk, in Litterman’s view. He acknowledges in its old tactical asset allocation format, it was not the product it is today, which looks for relative value opportunities across markets. “We are seeing much more interest in it as an area.”
Commodities as a class has had some investor attention in the US, but as yet not on the same scale as in Europe. He sees these as having potential. “As a class, they are uncorrelated to equities markets. In equilibrium, there should not be a premium on commodities, yet historically they have appreciated significantly and provided real returns.” In addition to index-related products, Litterman says there are investors using actively managed commodity products, but “the swing in performance can be huge”.
Generally there has not been any diminution in the commitment of US funds to equities, in his view. “While actual allocations will have fallen as markets have come down, most funds have been consistent in reallocating back to their target levels.”
There has been no move to a fixed income only strategy. Some funds have tried to hedge the interest rate sensitivity of their liabilities, while others have to dedicate portfolios to take some risk out.
The overall concern is about when to take more or less risk in relation to the individual scheme’s funding level. “This has led to much discussion, but no firm conclusions as yet.”