Wednesday, May 15, 2013

Short Term Results Aren’t An Effective Argument Against Alternatives

Short Term Results Aren’t An Effective Argument Against Alternatives

Many public pension plans are reporting their first quarter results, and the returns are generally positive, thanks in large measure to an ebullient stock market.  Moreover, strategies with a connection to equities are doing well.  Private equity should report favorable returns because valuations are rising and deals are being exited. Credit strategies should flourish because the spread between various forms of corporate and consumer debt have narrowed dramatically in relation to US Treasuries, thereby pushing up credit valuations.

Malaysian Prelude

A number of my regular readers have reminded me that pension returns would have done even better if it weren’t for the drag from hedge funds.  While this observation is, undoubtedly correct, it isn’t a meaningful statement.  Quarterly or even annual results tell us very little about the efficacy of an investment program.  In truth, near-term results are roughly 75% noise and only about 25% information.  Here in North Carolina, the State Pension was up 3.5% for the quarter and 8.8% for the last 12 months.[1]  Obviously, the plan would have been up more if it had a larger exposure to stocks.  Based on my thirty plus years of experience,  I’m not sure I can draw any other conclusion other than the North Carolina pension’s results were perfectly acceptable.

Yet the financial media will focus on, and many pension plans will tout the short-term results.  The endowments and foundations are even worse about emphasizing their one-year results.  If Harvard’s annual return is better than Yale’s, that actually makes big news in the endowment world.  However, investing is not a sprint, and looking at the results in this manner does a disservice to the beneficiaries.

The amount of information contained in investment returns begins to rise as you examined five and ten-year results.  It is only over these longer time periods that investment returns begin to capture complete market cycles, and that the amount of information overcomes the noise.  About a month ago, I wrote about CALPERS’s laudable attempt to evaluate its long-term performance (“Lessons from CALPERS: Taking the Long View [April 17, 2013]”).  Despite the boom and bust cycles of the markets, CALPERS found that stocks drove their returns, and in turn, helped drive their private equity results. 

As you’d expect, North Carolina has had the same experience.  Despite the deep sell-off in 2008-2009, stocks returned 8.7% in the past ten years and are the major reason that the overall portfolio is up 7.7%.[2]  Like CALPERS, the real estate debacle hurt North Carolina’s 10-year return for that asset class, which only gained 4.1% per annum.[3]  The alternative experiment that I helped to start more than a dozen years ago hasn’t done much.  It’s produced a 5.5% return, while its benchmark is up 7.9%.[4]  Neither the return nor its benchmark is inspiring.  Just as at CALPERS, North Carolina’s other strategies are too new to judge and are a mixed bag.  Over the past three-years the plan has had good success in credit (up 11.1%) and poor results from inflation-related strategies (down 8.5%).  Moreover, it should not come as any surprise that credit has boomed, while inflation has deflated over the past few years.

The long-term results provide a series of valuable lessons that pension plans ought to recognize.  First, in order to drive long-term returns you have to be exposed to the markets.  For all the talk about hedging risk or creating alpha (extra returns from active managers), the dominant source of returns comes from market exposure.  Public pension plans are dependent on what is known as beta to drive long-term returns, which requires them to take a great deal of equity-risk.  You can try to divide the risk up a bit by using private equity or credit, but at the end of the day, equity exposure is going to determine their results.

Second, like it or not, you have to rely on your predecessors.  Pension trustees seem to come and go every few years, whether they are appointed to a board or elected to the job, as they are in North Carolina.   While the public seems to think that the current trustees are responsible for investment results, it is usually decisions made year’s earlier that are actually driving a good part of the returns.  Here in North Carolina, Treasurer Moore has been gone for over four years.  Nonetheless, when you untangle the long-term results, a piece of North Carolina’s 10-year results are still due to his efforts.[5]  Similarly, if Treasurer Cowell isn’t our Treasurer in five year’s time, her influence will still be driving the state’s pension.

Third, the focus on the annual horse race is extremely detrimental to the well being of the pension plan.  By focusing on short-term results, we are encouraging fiduciaries to abandon investments that have temporarily failed to perform, and encouraging them to load up on investments that have been recent winners.  In other words, we’re pushing them to become traders instead of investors. 

And the trader’s mentality is where the alternatives, and particularly, hedge funds come into play.  These types of investments make it appear as if pension plans can deftly move between strategies in order to avoid the pain of a falling stock market or bond sell off as the Federal Reserve tightens monetary policy.  By committing capital to hedge funds, pension fiduciaries can pretend that they are going something to counter-act market forces.  In fact, all they are doing is fooling themselves at the expense of their beneficiaries.

The critics of alternatives who cite short-term investment results as an indictment of those types of investments are using meaningless noise as an argument, and are feeding the trader’s mentality that has infected pension plans.  I’m not fan of large doses of alternative investments in big public pension plans.  While they may work in any given quarter or year, I doubt they can work in the long-term, and it is the long-term that drives pension returns.

[3] CALPERs only earned 3.5% per annum
[4] I suppose the staff would argue that alternatives represent a mix of private equity and hedge fund of funds, and that private equity suffered from a long incubation period (known as the “J-curve”).   The counter argument is that the program is now 12 year’s old and the benchmark ought to reflect the both private equity and hedge funds.
[5] Setting aside any questions about the appropriateness of the benchmark (North Carolina doesn’t disclose the definition), the portfolio appeared to outperform under Treasurer Moore’s tenure

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