Goldilocks or stagnation?
Overall, financial markets have been supportive to pension funds in 2006. By mid November, most pension funds' assets had produced good returns, lead by equities, real estate and private equity, while commodities and bonds fell behind. Earlier hopes on a substantial reduction of the value of defined benefit (DB) liabilities through rising discount rates have not materialised.
During the year, there were some reminders of the risks in the markets. The period of scare in spring, which led to a sharp sell-off of risky assets, turned out to be rather short-lived. The skies turned brighter in summer and into the autumn when equities started another leg of the bull market. Earlier warning signals faded away: the US equity volatility index sunk to a level near to 10% while the gold price fell temporarily below $600 (€468).
Credit spreads for both emerging and high yield bonds narrowed again to historical lows while junk bond issuance broke records. The M&A boom reached new highs. In bullish mood, markets easily shrugged off events like the collapse of hedge fund Amaranth, nuclear activity in Iran and North Korea or high profile murders in Russia.
In the second half of 2006, inflation fears subsided somewhat in the face of falling oil prices and only minor
second-round price effects (at least so far). The slowdown of the US economy put an end to the 17 ‘baby steps' of 0.25% rate hikes by the Federal Reserve since 2004. The European economies are recovering well, by their own standards, but may already have seen their peak. (With broad money supply growing at a 15% rate, the UK remains the odd man out.)
China is believed to make efforts to restrain excessive growth. Earlier news of the end of Japanese deflation was a bit premature, and markets moderated their expectations of further rate hikes after the first one in July. In fact, the resumption of carry trades (ie, borrowing cheap in yen and investing in higher-yielding assets) is reported to fuel the strong autumnal run of risky assets globally.
Over the last three years, we have experienced a period of strong economic growth (5% real annually) and world trade growth (10% annually in value). Looking forward, economists expect the world economy to loose a little bit of steam in the coming years. Consequently, yield curves have flattened, or even inverted, as central banks try to prevent inflation from rising much further.
A lot of the good news for 2007/8 seems to be discounted. Currently, markets do anticipate neither a resumption of interest rate hikes nor a hard landing in the US. In such scenario, good returns are easily extrapolated into the future. The change of the year gives a good opportunity for pension investment committees to reassess the medium-term investment outlook with their fund managers. Key questions include:
q Main economic scenario for 2007: Goldilocks or stagflation?
q Equity market valuations: still moderate?
q Concerns about systemic risks due to the growth of debt and financial leverage
q After a period of relatively quiet exchange rates, could the pension fund stand a real stress test in 2007?
q Upside potential of various asset classes from here?
or most pension funds in Europe, a lot has happened in the last 12-18 months with an impact on the strategic and actual asset allocation. More changes are underway. It is easy for trustees, sponsors, pension managers and their advisers to get a bit lost in the process. It often helps to have check-up from time to time to consolidate information and identify potential oversights. Just to highlight a few areas:
q Regulation. What is the impact of new funding rules and negotiations with the regulator about recovery periods etc?
q Timing. Unfortunately, there is never a neutral starting point for changes in strategic asset allocation. How to best schedule?
q ‘Traffic lights', ‘triggers', limits. Is there a need for a more asymmetric management of the downside risk?
q Diversification. Investing in a broader range of asset classes is a slow process. Is it one-by-one or is there a time plan for adding new asset classes (and managers)? Is the risk management up-to-speed with these changes?
Equity markets have had run a bull market since the lows of 2002/03, offering investors attractive returns by simply being in the market. Guess what is happening: the renaissance of good old ‘beta'.
Beta had become rather discredited in the pensions world in the early 2000s, when the stock markets collapsed, while ‘alpha investing' became en vogue. It promised to spice up the more pedestrian return prospects of the new century. Now the pendulum seems to be swinging back to beta.
The delivery of alpha strategies, often expensive, has frequently not been up to the promise. At the same time, pension funds can get beta returns almost for free these days, eg, through passive funds or index products. Is it time for institutional investors to review their investment thinking - again? This could be a fascinating special session for those pension trustees and investment officers who occasionally like to think ‘outside the box'.
The terms beta and alpha were originally developed by modern portfolio theory. Beta captures the exposure of a portfolio to market risk, ie, investment risk that cannot be diversified away, while alpha should measure the outperformance due to fund manager skill.
There is more to beta than just the passive exposure to mainstream bond or equity markets. Much research had been devoted since the 1970s to identify factor betas, in addition to simple market beta. Typical examples are size (excess returns for small caps), style (value versus growth stocks), credit (spreads paid for default risk of debentures), volatility and liquidity.
Investors demand premiums for the exposure to such risks. Pension funds seem ideal candidates for this because they can commit money longer term. In fact, over the years, most pension fund investors would have started to access additional sources of beta returns either by:
q Introducing particular style characteristics in equity and bond portfolios, eg, size, value or credit portfolio tilts; or
q Broadening their investment universe, eg, investing in real estate, private equity, corporate and emerging bonds.
But there is more to come: the discovery, or invention, of ‘alternative beta'. It means sources of risk-adjusted return that have traditionally not been accessible to investment managers. This area is so fresh that you find all sorts of confusing labels like exotic, clever, dynamic, hedge fund beta, structured alpha and some more.
So, what is really new with alternative betas? It is probably best to define them as systematic risk factors that are not available through the passive exposure in asset markets. Instead, they are captured via trading and hedge fund strategies such as:
q Volatility and correlation trading;
q Merger, convertible, fixed-income ‘arbitrage',
q Insurance against downside risk or extreme events,
q Provision of liquidity, eg, to hedgers.
The distinction from the traditional betas is through the involvement of trading techniques and hedge fund practices (eg, derivative instruments, shorting, leverage) rather than exposure to another asset class.
But with timing decisions involved, what really distinguishes alternative beta from alpha? Arguably, this is a bit of a grey area, and the answer given by some experts is: when alpha skills become repeatable processes, more widely known, they become alternative beta. Human decision-making is substituted by a trading engine.
There would be far-reaching implications. Alternative beta could be seen an attempt to institutionalise hedge fund investing via a manufacturing approach, able to
operate at higher capacity, consistency, transparency and lower fees. After all, chasing alpha (unlike beta) is only a zero-sum game. In addition, there is a scarcity issue: many trustees are sceptical about the recent mushrooming of "exceptional investment talent" in alpha-shops.
Investment banks are already starting to offer ‘strategy portfolios' or similar that aim at gaining a more direct exposure to trading strategies than through hedge funds. Other people work on passive or synthetic hedge funds indices, so called ‘clones', to replicate hedge fund returns.
Such purer alternative beta products could well be interesting for pension funds with an advanced asset allocation and risk management process. However, a number of questions will be asked by pension funds. What is the economic and financial rationale behind any supposed alternative sources of return? How much of returns are really traditional betas, disguised as ‘alternative'? How can the active and passive element in trading strategies be separated?
It may be early days, but the discussion around old and new beta offers a good opportunity to start a rethink about the underlying factors driving the returns of your asset allocation.
Georg Inderst is an independent consultant based in London.