It's time to look at absolute returns
If ever an asset class's time has appeared to arrive it is that of absolute return investments.
We all know the dangers of fashion investing, but many pension funds have made good money out of TMT stocks. Of course, many funds have lost out, especially those funds that had a manager who was late into the sector and did not reduce exposure in time.
What are absolute return investments? Many people in the industry simply say it is an alternative, and possibly more acceptable expression of the more familiar term “hedge funds”, although that does little to elucidate.
So just what is meant by either term? Well, absolute return investments are certainly one of the range of classes of alternative investments that normally include private equity, commodities and even real estate. But, while these categories are alternative, they cannot all be classified as absolute return strategies.
Marcus Stadlmann, director of global asset allocation at WestLB Asset Management, succinctly defines absolute return strategies as those skill-based strategies that attempt to maximise long-term returns independently of a traditional securities index. The focus is effectively on pure alpha by removing or significantly reducing market risk. In other words, by exploiting market inefficiencies, you have the potential to make money when markets fall.
It is interesting to consider what most commentators regard as absolute return investments. First, we have relative value strategies such as convertible bond arbitrage and volatility and convergence plays; then there are the possibly better known long-short strategies which includes market neutral strategies that can be in either equity or fixed income. Then we can have event-driven strategies such as merger arbitrage, corporate restructuring or distressed securities, as well as selection and timing strategies such as global tactical allocation. Finally, we have managed futures.
But none of this answers why such strategies are now under much closer scrutiny by the leading pension funds in Europe. To be of interest to European pension funds like ABP, PGGM, Kodak, KLM and Swissair there must be some good reasons why such investments might be suitable to fit within an asset allocation structure.
So, what benefit might pension funds see in absolute return investments? The funds appear to have looked for evidence of enhanced risk-adjusted returns, consistency, low volatility, diversification and low correlation and if they can find these features in a new asset class it is clear why it should start to find its way into asset allocations.
Most funds start by asking to see the evidence of enhanced risk-adjusted return. According to IPE in July last year, the best-performing pension fund during the 10 years up to December 1999 was the Weyerhaeuser Corporation’s.
Where have those assets been invested? Apparently, for the last fifteen years Weyerhaeuser Pension Fund has invested 100% of its assets in alternatives including all types of hedge funds and private market investments.
But, we cannot just rely on performance numbers. We need to investigate further. According to Morgan Stanley Dean Witter, who recently recruited the investment management professionals from the Weyerhaeuser Pension Fund, the distribution of returns for the Weyerhaeuser Pension Fund compares favorably to its benchmark for all periods and other measures show superior risk-return characteristics as well.
So, if one fund can do it why not others? I am not aware of any other fund that has been quite as brave, or dare one say, as foolhardy, as the Weyerhaeuser pension fund as to invest 100% of its assets in alternative strategies. However, quite a number of pension funds have invested 100% of their assets in equities and thirty or less years ago that would have seemed an outrageous suggestion, so who knows?
There is one feature which is the same across the board in all the pension funds in the sector and that is the way in which they invest. They certainly do not just appoint a single hedge fund manager. Everyone is very aware of manager and skill risk which, although hard to estimate in the sector, is felt to be higher than in other sectors. We also have illiquidity, inaccessibility and often large minimum investment requirements. As a result, investing pension funds require a broad diversified exposure by strategy, geography, sector/industry, vintage year, size and most importantly, manager. The result is exposure through a number of different fund of funds.
But why the focus now? With current equity market droop after such an extended bull market, with high volatility combined with the alternative of low bond yields, funds need to look elsewhere to find the positive return they need to meet their liabilities. Most funds are not just interested in pensions in payment but need to finance the accrual of liabilities due to salary increase and general indexation.
How can pension funds exploit the investment opportunities of hedgefunds? First, they need education and information. Indeed, members of the European Pension Fund Investment Forum have indicated a desire to study alternative investments and they would be keen to hear whether other pension funds would be interested in joining them in such an initiative.
Please contact me if you have such an interest.