Tuesday, November 20, 2012

The Impossible Task of Resisting the Consensus View


The Impossible Task of Resisting the Consensus View

Over the past decade, investment returns have not met expectations, and there’s growing pressure to do something about it.  If you’re managing a public pension plan, you have three choices.  Two of your options are painful both politically and financially, and one of your options is easy.  The first option is to ask the legislature, local government, and school districts for more money to properly fund the pension plan.  That’s not going to win anyone any votes.  The second option is to restrain benefits either for future retires or current retirees.  In this day and age, this is a politically more palatable option but causes extreme damage, especially for those near or in retirement.

Major Clean Up (1999)

Thankfully, there’s a painless solution, and it is hard to resist.  If you read yesterday’s post, you know what it is: alternative investments, the magic elixir that promises higher returns and lower risk.  Indeed, relatively small applications of alternative investments have been helpful to university endowments and charitable foundations.  Now we’re talking about the widespread application of alternative investments to stave off some very unpleasant decisions.  In my view, public pension plans would be far better off in the long run doing a bit of options one and two rather than relying on the promise of alternative investments.

However, the easy “solution” is going to be hard to resist, because it has powerful advocates.   The investment consultants are going to make a forceful case for alternative investments.  They will ply pension trustees and investment professionals with all sorts of charts and graphs showing the virtues of adding alternative investments to the pension portfolio. Moreover, the consultants will warn the pension trustees that you can’t hire any old alternative manager.  They’ll tell the trustees that they need to hire top quartile managers to make the strategy work.  Who do you think will assist in these searches?  The consultants; they know that this will be good for their business, because they’ll have to help the pension plan find and gain access to the top managers.  Do you really think the consultants, or for that matter anyone else, really knows who is going to be a top quartile manager in the future?  This is dubious advice, but it’s easier to go down the alternative path and put off dealing with the real problems facing pension plans. 

The consultants have powerful allies: alternative managers.  Even if the trustees remain skeptical after the consultant’s presentation, they are going to be dazzled by the arguments and presentations of the world’s elite money managers.  Never mind the fact that the argument for alternatives is entirely self-serving.  The Harvard educated ex-Goldman Sachs investment banker turned hedge fund manager is going to be hard to resist.  Even if the trustees don’t understand all the fine points, the alternative manager will come highly recommended by all sorts of powerful politicians.  Those campaign contributions to House, Senate, and Presidential races bought a lot of friends, and those friends will now be very helpful in helping to “educate” trustees and predispose investment staffs to the case for alternative investments.

I hope you’re not shocked by all of this.  The option of finding the easy answer through new investment strategies has been going on for over 30 years.  The consultants have been practicing the art all along, and the alternative managers are simply updating the playbook successfully used by conventional managers.

The Chief Investment Officer and the staff can’t possible resist the twin forces of consultants and alternative managers.  Frankly, most pension professionals aren’t going to resist.  Rather, they’re going to be attracted to the increased sophistication and cachet of alternatives.  Who wouldn’t prefer to be associated with strategies that involve private equity investments in India or complex credit strategies in leveraged loans.  A due diligence trip to Bangalore sure beats another conference at the Copley in Boston or monitoring an equity manager who invests in Proctor and Gamble.  For many pension professionals there’s also the tantalizing chance that you might be plucked from relative poverty of public funds to the opulence of a job with an alternative manager.  In other words, the staff is going to join the chorus.

Public pension plans are going to do a whole lot of alternative investing.  With fees of 1.5% to 2% and profit sharing on top of that, alternative investing is a winning proposition for the people who matter.

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