There are some expressions you read about in magazines and hear regularly at conferences these days that most people had never heard of a few years ago. One such expression now heard regularly is: “the search for alpha”. Another is: “absolute return investing for pension funds”. Even now, few of us really understand or can explain exactly what is meant by such strategies.
‘Absolute return investing’ is often used when we mean ‘hedge fund investing’ and vice versa. Even investment experts often have to make a great effort to explain exactly what a hedge fund is in simple terms. So is it any surprise that lay trustees struggle? I have even heard apparently expert investment professionals struggle to explain the term ‘derivative’ and there is certainly quite a debate over how they can best be used by pension funds.
Oh for the days when pension fund investment was merely a case of deciding the bond–equity split and diversification simply meant making sure you had an exposure to overseas equities.
So what is ‘absolute return’ investing? According to Bruno Crastes, chief investment officer at Credit Agricole Asset Management in London, absolute return is a product concept, not an expertise. A product turns ‘absolute return’ when its active risk (tracking error) is greater than the volatility of its benchmark. Very simple!
Another even simpler explanation is that a product is an absolute return strategy if it has a cash benchmark.
And what about alpha? Alpha is created if one takes away beta or the relevant index return. The move to absolute return investing goes hand in hand with the search for alpha. Alpha investing relies on a belief in skill. A belief that was, and to a certain extent still is, sorely tested by the move to index investing. It does seem terribly ironic that after many pension funds gave up active investing years ago because they found they couldn’t beat their benchmark – the index – those same funds are now investing so much money into absolute return strategies because they believe there is manager skill.
Actually there is logic to the process, but it is a pity that it has taken so long to discover it. The problem was, and to an extent still is, an abundance of poor quality investment management. The good stock pickers are now beginning to find themselves in hedge fund houses earning very good salaries. On the other hand a few investment houses, like Legal & General, realised that they could make good money by piling it high and selling it cheap. So now you don’t have to go to one place to get your alpha and beta exposure.
You can now go to an index provider or buy derivatives to get your market or beta exposure and go elsewhere for your (expensive) alpha. Overall you probably pay the same fee but life has become a little clearer.
However, you can focus too much on this side of the ball game. The bigger problem for most pension funds is asset allocation and I doubt whether any amount of alpha allocation can really replace good asset allocation, but that is an article for another day.
There are many problems still to be overcome before more pension funds move over to separate alpha from beta. For a lot of funds it is education that must still be provided. Performance will always be a question. There are retail and institutional conflicts. There are certainly questions over liquidity, but should this really be a problem given the long-term nature of pension fund liabilities? Transparency really is an issue, however, and with funds increasingly having to disclose information about themselves, investing in a non-transparent vehicle can pose problems. Key to investment, however, is an understanding of process and good risk management.
At the moment demand roughly meets supply, but can the quality of absolute return funds be maintained if demand really increases?
Will the relatively predictable high alpha from a number of strategies remain high as demand increases for such strategies?
A particularly intriguing perspective on the potential role of absolute return strategies in institutional investment portfolios was recently given by Crispin Lace, head of investment consulting at Watson Wyatt’s Stockholm office.
Lace argues for most pension funds the biggest problem is short-termism and benchmark dependency. He argues that short-termism is judging investment decisions by reference to short-term benchmarks and that getting more long-termism into investment should be helped by absolute return or benchmark insensitive mandates.
He believes there is too much trading in the markets and that low portfolio turnover would mean lower transaction costs and funds would be better placed by buying companies not share prices. This is an area of the market that is not highly populated and inefficiencies no doubt still exist if a fund can access premium investment skill. The risk/return trade-off appears to be highly attractive when compared to matching assets!