The next phase: P&I roundtable transcript

Pension funds executives are starting to loosen the reins on their fixed-income managers. In March, the $247.9 billion California Public Employees’ Retirement System gave its international bond managers permission to leverage their portfolios up to 130% of assets and to short up to 30%. Also, CalPERS board members said managers could invest up to 10% of assets in international high-yield bonds.

Pensions & Investments convened a roundtable on June 12 at CalPERS’ Sacramento, Calif., headquarters to discuss whether these changes are permanent or in response to market conditions.

Participating in the discussion were:

• Eric Busay, portfolio manager with CalPERS;

• Gregory DeForrest, senior vice president, global manager research group, Callan Associates;

• Andrew Phillips, managing director, BlackRock (BLK) Inc. (BLK);

• Albert Gutierrez, chief investment officer, SCM Advisors LLC;

• Paul A. McCulley, managing director, Pacific Investment Management Co.; and

• Olaf Rogge, founder and co-CIO, Rogge Global Partners PLC.

The moderator was Joel Chernoff, executive editor of P&I; reporter Raquel Pichardo also attended.

Mr. Chernoff: I’d like to thank everyone for coming today and participating in this roundtable. As you know, there have been a lot of changes going on in the fixed-income market. The genesis of the idea for this roundtable was the change CalPERS made with its $5 billion international bond portfolio.

Paul, why are bond managers adding hedge fund-type tools to their portfolios?

Mr. McCulley: The fixed-income market has become systematically more efficient over the years. If you have more and more players able to do more and more things, that’s been good from the standpoint of the efficiency in allocating resources in our economy, but it’s made life more difficult for fixed-income managers.

I sometimes joke what you want to do is to be the only man who can do a particular type of activity. So therefore you can extract an extraordinary risk premium because you are the only person who can do it.

You go back 20, 25 years, that would be the case in a lot of the new instruments, going all the way back to the beginning of mortgage-backed securities, etc. But now guidelines have been liberalized for everybody. You've also had the hedge fund community become deeply involved in the fixed-income arena. It is more efficient, but in order to have the opportunity to add alpha, you systematically have to stay at the frontier of, if you will, bringing efficiency to the marketplace.

Mr. Rogge: Actually, we can’t make out the difference any more between the good, the bad, and the ugly.

It is a problem for us, and I’m sure it is a problem to plan sponsors. If you can’t tell the difference, i.e., if the rising tide floats all ships, if everything is being arbitraged out, then clearly a plan sponsor has to look for higher returns, particularly if you only get5%...

It has been done 20 years ago... Investment banks have been doing it, hedge funds for 10 years and now pension funds. Let’s hope they’re not the last ones.

Mr. Busay: I think over the course of the last 15 to 20 years, we’ve seen tremendous developments in bond markets globally. It used to be that the U.S. was well ahead and had greater development of a variety of different instruments, and we’ve seen that happen now more ex-U.S. The rest of the world has caught up.

I think the other thing is, too, is that from a plan sponsor’s perspective, there is always comfort in setting up particular structures. The structures typically are there so you can give guidelines to your managers, and you can feel comfortable within therisk limits, but with structures potentially become inefficiencies.

If someone is slightly beyond that structure, you might not be able to take advantage of the most efficient risk-reducing way of being able to add return. What we are trying to do … is to be able to capitalize on those markets a little bit better than we have in the past.

Mr. Gutierrez: Yes, I think a little bit of the use of what would be considered as some of the riskier components, i.e., leverage, or incorporating other aspects that are not consistent with the traditional long-only strategy, is the fact that we live in what I like to call the relatively flat world.

You are able to move capital pretty efficiently throughout the globe. You have a lot more synergy between where rates are here and where they are elsewhere in the world, which is not necessarily the reality that you had 20 years ago.

So, as a manager, you have to look at more variables to try to eke out alpha. In my mind, the use of any of those tools, even some that we haven’t discussed yet, are probably efficient uses of the actual resource that any investment manager would have.

Mr. Phillips: I would agree with most of what’s been said. The bottom line is people are focused on alpha because beta is unattractive. I mean yields are low, spreads are tight. Not only are spreads tight, but spread volatility is tight. So, if you think about the traditional ways to make money — absolute return as a fixed-income manager — you focused on yield, what yields are low. You focused on spreads, what spreads are tight. Or if you are a relative value manager, you focused on the movement of spreads, buying cheap securities, selling rich securities, and that movement has also moved lower with lower volatility.

So, I think what folks have done is just a response to the lower volatility and tight spread and low rate environment we’re in, that they are pushing out toward enhanced techniques to take more risk because they have to.

The same portfolio structure that you had, you know, five years ago, today has less tracking error. So, you need to make more return, you need to push out further. So, I think that’s essentially what’s happened.

The question for us, is this a cyclical phenomenon or is it a secular change in the markets?

Mr. Chernoff:. Greg, did you want to respond to that?

Mr. DeForrest: Sure. It is secular change to a certain extent, and I believe that (in) most asset classes … there is a powerful trend right now where you combine traditional long-only strategies with techniques used by hedge funds, whether it is shorting or leverage.

We think that’s a powerful trend, and it is likely one that will continue. To me, it is more of an issue of guidelines as opposed to it being a new product development, though. These may not necessarily be new products, rather than whether this is just a liberalization of guidelines that are being applied to existing benchmark-aware strategies.

I generally agree that if you look at the data, it has become more difficult for certain types of bond managers to add value. If you look at the rolling three-year returns (for) international fixed income, it has been a little difficult of late.

If you look at other strategies like core-plus fixed income, it has been more successful, especially over the past five years. However, right now we are at a point in the market where spreads are so tight that taking on that extra spread risk is probably not going to give you the same amount of excess return that you experienced over the past five years.

Mr. Rogge: He said to get more alpha. … The problem is we all want to get more alpha, but if beta gives you 5%, how much more alpha are you going to get, 60 basis points, 70 basis points? Basically, I say domestic fixed-income management is a loser’s game. You can’t get what your client wants. So, I disagree with Greg. The only way to do it, to get really the excess alpha of 150, 250 basis points is lower fixed-income diversification, whether you like it or not.

The simple rule is at no time is either one market the best performing, or for that matter, the worst performing. There are huge cycles.

Since 1985 to 2007, we have just looked at the returns and every currency didn’t matter — dollar, deutsche mark or euro. For the six largest bond markets, you know what the annual spread is between the best and the worst? The six largest bond markets, (the spread between the best and worst performers) is 25% It is 25% every year ... Now, that is the opportunity set, that is where you all should be going in my opinion, where CalPERS is really on the forefront.

Domestic fixed income, I think, forget it. If you get 5% or you get 5.6%, what is the first-quartile excess return, 80 basis points? It is not worth it.

Mr. Busay: With that in mind actually, Olaf brings up a very good point. In 1985, it is important to remember that there were 12 more currencies just in the eurozone alone. Inflation was relatively high. We ended up seeing double-digit returns in most of the fixed-income instruments at that point in time, at least in terms of nominal yields.

They converged over a period of time, certainly over the course of the ’90s. We were able to see many games that could end up being played during that time when you had countries like Spain and Portugal and Italy were all converging and moving their 15%-plus interest rates down to levels that we’re seeing now, which are sub-5%. That game has been played.

There have been a lot of currency moves that have ended up taking place over that time, and at least 12 of those have evaporated. So the game has definitely changed and I think that it is important that structures be able to keep up with it.

Mr. Gutierrez: We don't have an international bent in our operation, but in listening to some of the comments from Olaf, I think consistent with the mindset that it is a flatter world, looking at some of the historical return patterns in which you had more currencies. You had greater barriers to entry; you would expect that you would have greater deviations from a mean, if you will, on the returns of various markets.

My contention is that’s not necessarily the case going forward across the board, in large part because global interest rates are relatively low. Risk premiums are relatively tight. And you’ve got the realities that plan sponsors have here and elsewhere due to the aging populations of their particular underlying countries in which you’ve got (liabilities) … that can’t be met by any of the traditional types of investment vehicles. It is all because you've got this compression on a global basis.

Mr. Chernoff: Do you think that will last, Andy?

Mr. Phillips: Well, there certainly has been a lot of compression. Olaf’s point about there being variation in return, currency is what you are talking about. So —

Mr. Rogge: Most of it.

Mr. Phillips: Yes, most of it is currency. Overwhelmingly, most of it is currency. The question is, is currency a separate asset class or is it fixed income. … The way we’ve managed fixed income in a lot of our mandates traditionally has been you hedged a currency risk so that would remove much of that opportunity set.

So, a lot of the opportunity that you are talking about really depends on the issue of guidance, are clients willing to take on that kind of risk because clearly you can up your risk in your portfolio very quickly by taking currency risks.

Mr. Rogge: You’re right, Andy, but roughly look at the U.S. treasury market and the bund, the German bond market. Something like three years ago, the U.S. bond market was (yielding) 100 basis points less than the German one. Now it is (yielding) 75 basis points more. So, there are micro changes coming all the time.

Mr. Phillips: Yeah, but it is moving very, very slowly, which is —

Mr. Rogge: Absolutely, but there is more opportunity than you get domestically, you know, moving into mortgages and into treasuries, you have much more opportunity in these kinds of slowly —

Mr. Phillips: Again, but slowtrending markets. I would submit to you that very few…relative value opportunistic managers really have been able to effectively capture those sorts of long trends because it has been an environment where, if you step back from it three years later, wow, you know, rates moved significantly. But they did so, so slowly.

So, take the phenomenon for example of the yield curve flattening. The Fed started to raise rates from the fed funds target rate of 1%, and this curve was very, very steep at that point. At that point you saw a lot of U.S. banks, for example, buying mortgage-backed securities, and everybody said, ‘Well, this is going to end it for the banks because the Fed’s raising rates. Everybody knows the Fed’s raising rates, and they are going to flatten the curve, and they are going to really eradicate the demand for mortgages.’

Well, it didn’t happen. Why didn’t it happen? Because it happened so slowly. It wasn't just the per se 200, 300 basis points of move, it was the timeframe of 200, 300 basis points of move. What that meant was that break-evens dominate. So, you can't answer the question any more, the market is going to move by 50 basis points, you have to answer it, ‘over what time frame is it going to move,’ because we have been seeing that these things are happening so slowly over longer cycles.

Traditional rules say that if rates are rising over 50 basis points, I want to be out of bonds. Well, not necessarily. If it happens over a long period of time, maybe I still want to be in that risk.

Mr. Rogge: If you buy a country, the best way to buy a country is actually — if you want the purest way — to buy the bond. That country’s external exchange rate is reflected in the currency. So, you know, there is a difference. Currencies move because one country will perform better or less well compared to each other. So, the bond and the currency (work) hand in hand.

Mr. Phillips: So, you consider them not two distinct asset classes?

Mr. Rogge: No.

Mr. Phillips: There are some very good arguments to be made in favor of what you just said, but the reality is that we have set ourselves up — and lot of consultants have set us up this way sometimes too — is that they are separate, that they (institutional investors) are looking for true value-added. They (institutional investors) are hiring BlackRocks and PIMCOs and other firms to decide not (to) bet on currency, but bet on what’s the relative value. Ex-currency, what has better relative value, Germany or the U.S.

Mr. Chernoff: Greg, I think you’ve been set up.

Mr. DeForrest: It’s happened before. My observation is that fund sponsors, consultants and investment managers have all come together. There has been a general understanding that fixed income is supposed to serve a certain role within a plan: reduced volatility of equities, diversify certain risk, etc. Because of that, historically, the guidelines given to fixed-income managers have been relatively narrow. It is true in international, and it is true in core bond as well.

I think this movement to expand the opportunity set while keeping an overall market exposure of one is a powerful one and an important one. However, it must be kept in context of what the role of fixed income is to be within a structure.

Is it there to diversify a certain risk or certain economic environment, or is it actually an absolute-return vehicle where it is just supposed to always generate attractive positive returns?

Mr. Phillips: That was actually more of a traditional approach. It’s country and currency. I mean you couldn’t separate out rates from currency. It was all one thing that managers of huge, largely global banks were managing funds on an absolute-return basis. In doing it, (they were) often taking a lot of currency risk. What happened is we moved away from that with a lot of the benchmarking that we went toward.

Part of the benchmarking meant that you had to control the currency risk. So, the name of the game was not overweighting currency, but we want to do everything on a currency-hedged basis.

Currency was sort of put to the side. I’m not saying right or wrong, that was the trend. Now what we are seeing, it is starting to open up again… A lot of it is really traditional, going back toward an international investing approach in which currency and the bonds were not separated, but were viewed as one and the same thing.

Mr. Busay: But I think to a certain extent, a lot of that is because there is more and more international investment, a point that you touched on.

The common element of that is not necessarily fixed-income-like, it is currency-like, in the sense that if you invest internationally, you have no choice but to have some currency exposure. The question becomes, what do you want to do with it.

So I think to a certain extent that is why currency has had a differentiated status within fixed income as well. It is attached to real estate investments, private equity investments and fixed income, and virtually every other asset class that might be around.

On a personal basis, I’m relatively agnostic as to whether currency is viewed as an asset class or not. Our view is that it is a choice. No matter what you do internationally, you are either making a passive choice that takes on currency risk, or you making an active choice, and you’ve got to know the difference between those two things.

Mr. Rogge: True. What I find fascinating in a way — I’m not spilling all my beans — but it is in the last 50 years, the capital markets were dominated by American banks and British banks and some kind of continental banks. It was traditional. We made the markets. You knew what goes up, goes down, and vice versa and so on.

Now, over the next five, 10 years, we have a complete new set of players in the market. Who knows how they are going to act. They are not going to play the way we used to play the game, and that is the fascination about actually why I am still in the business. I like to see actually what is going to happen, what are the Asians going to do.

They are very intelligent people, they are definitely not going to play by your rules or by my rules; they are going to play by their own rules. First of all, currency reserves is for them national savings, i.e., to maximize return. They haven’t started, because it is run by politicians or by employees of governments and they are scared of making the first step of going outside.

But eventually, it will happen. What will happen to the world? What will happen to the currency markets?

(Russian President Vladimir) Putin, who I like and Eric doesn’t, he is now calling — for example — for more than just a dollar reserve or even the euro. He wants a new kind of system, a new system where emerging markets have greater influence on currency reserves and so on. That is fantastic. We never had it before. There was only the dollar and occasionally, the pound or a little bit the deutsche mark. That was it, but it was the dollar.

Now there is the euro and eventually there will be a third major currency … What's it going to be? What pain will China go through to accept it? Japan declined, but China probably can't because they are even bigger. That (will be)fascinating over the next five to 10 years.

Mr. Gutierrez: I like the point that incorporating the notion of cultural differences and how individuals within particular cultures measure risk, take risk, react to risk. But then the other component that you do bring in is in my mind political. In my mind, it serves Putin to want to have another currency because anything that effectively weakens the dollar’s power (serves his purpose). At the end of the day, the West is still the primary game in town.

The U.S. capital markets are still the biggest game in town. It does serve all the other constituencies that are non-Western or non-U.S. to strengthen these other, let’s say, capital institutions, but that is a political initiative.

The cultural component that you brought up is a very fascinating one in which if you are exposed to, (say), a billion dollars worth of some currency or some security or some risk profile: How do you react when you start having the inevitable challenges to that particular market, whether it is a liquidity crisis or whether it is a change in the flow of funds? That is an interesting point that is truly based on the world being a flatter world. But we are not culturally homogeneous across the globe.

Mr. Rogge: But do you think it’s the only dance in town because at the moment, the countries are in an accumulation phase? They are accumulating asset reserves. They are not on the phase of managing it yet.

That's the uncertainty. At the moment, they are accumulating left, right and center.

Mr. Gutierrez: I agree with you that China will have a difficult decision to make, and it is really going to be synthesized down to: Do we do what makes intellectual economic sense for the long term, and the cost will be what will happen to its 1.6 or 1.7 (billion) in population of which — you tell me the number — $1 billion is still on an exponential upward swing of trying to improve its standard of living. The cost is on that massive political constituency, which, in my mind, just observing the Chinese political infrastructure, they are in it for one reason only, and that is their own survival.

How is it that you can perpetuate your own survival? I think that there are probably many in the political hierarchy in China that will say this is what makes economic sense for the long haul. This is how we as a country will be more powerful 50 years from now. I’m just not knowledgeable enough to know whether they have the conviction, the strength to pay the price. I do think that the price would be substantial because it does fall more unfortunately on that massive political constituency of the Chinese population that is still in its upward slope.

Mr. Rogge: It is not only China. It is the whole Asian countries. Just go there. Every time I go there it is amazing what they do. It took us 20 years to do what they achieve in one year. I went last month to Beijing and looked at the new Olympic stadiums, and it is fantastic, amazing. Coming from England and we just built for 900 million (pounds) a miserable stadium which we call the new Wembley. It is shocking.

So, anyhow, they moved a couple of million people out, just to clear up the population and the bicycles out of the center of the city. You can only do it with dictatorship, but it is not only China, it is India, it is all the Asian countries. They are thinking more and more like Asians and not just like, at the destiny of our good will that they are allowed to give the savings to us. I think that will change.

Mr. McCulley: What we are actually talking about is the merging of two secular forces. The secular force of guideline liberalization has been going on for 20 years, as you move from core to core-plus and effectively guidelines were liberalized, barriers to entry came down, and you got more efficiency in the marketplace. By definition, that makes it more difficult to make money because the markets are more efficient.

So, we’ve had this as a legacy. But what we have now, as Olaf says, is a secular turning point in the emerging market space where they've become fabulously wealthy as nations. It has been a byproduct of their de facto link to the dollar and the monetary arrangements and exchange-rate arrangements.

But now you have a confluence of two things facing us as an industry. No. 1 is that the domestic market has become hugely efficient. So, it is very difficult with simply a domestic set of guidelines —

Mr. Rogge: Every domestic market in the world.

Mr. McCulley: Every domestic market —

Mr. Rogge: That's important.

Mr. McCulley: — as people who do what we do have made it more efficient as well as you brought in the hedge fund community which has turbo-charged the whole process. So, you got that reality, that risk premiums are really skinny everywhere and how do you change guidelines in order to allow your manager to keep on trying to find the next risk premium to shrink.

At the same time, you have this parallel secular change of the sovereign wealth becoming so large that they are the marginal player. Americans, Brits as well, are used to being the marginal player, being the price setter, not the price taker. Increasingly, with these sovereign wealth accumulations, we have to put our mindset into being price takers. We also have to analyze what their political long-term objectives are going to be.

To me, coming back to what Andrew was talking about, this artificial separation between duration risk or bond risk and currency risk is going to come down because we know that all of these emerging markets that have done the ‘right things’ have undervalued currencies.

We also know that they are developing domestic capital markets where risk premiums are still wide. So, if you look at the emerging market space, you see structurally fundamentally undervalued currencies in the context of huge wealth. In answering how that plays out in the global markets is the most important question I think we are going to face as an industry over the next five years.

What we see both in our work as well as with our clients is a recognition that this is a new world and guidelines’ understanding of tracking error, understanding of diversification, fundamentally is different than what we’ve learned from extrapolation because human nature is to extrapolate. You can’t forecast the next five years through extrapolation, you really do have to take a fundamental view about how the world is going to evolve. To me, the duration decision and the currency decision have to be effectively re-merged.

Mr. Rogge: The question for Eric is CalPERS is clearly the leader in the global pension market. They are ahead of the curve of invention, of trying to protect the assets and so on. What they are doing — are they the leaders in what they are going to do, or are they behind or at the tail end of, long-short 130/30 leverage? This is a very interesting question we have to ask. From a pension fund point of view, CalPERS is early, but from what they are going to allow us now, they are late.

Mr. Chernoff: Eric, before you address Olaf’s question, how did CalPERS liberalize its guidelines?

Mr. Busay: One of the things we looked at was the managers said the concept of shorting in fixed income is not the same as shorting in equity. When you are short a stock if it effectively goes to the moon, you are going to be short that stock, and you could potentially end up having almost an infinite loss that is associated with it.

Bonds have this thing called maturity. So typically, when the bond matures, the price of that bond goes back to 100. All right, so it isn’t going to go to the moon and never come back. Trees don’t grow to the sky, at least in fixed income. They eventually get harvested.

I think that is a critical difference, that really the whole concept of risk is really a beta risk relative to a benchmark. Associated with a benchmark is a duration. In many cases, a manager potentially going out and taking a short position could actually be a risk-reducing element to a portfolio. It isn’t just adding additional risk all the time. We had more liberal guidelines with respect to duration management in the past, and we’ve now tightened those up in this process. By that, net-net, we have effectively allowed the managers to take less risk than they used to in the past. We are allowing them to take in a bunch of different places that we didn’t in the past.

The concept of the 130/30 in and of itself isn’t a demand that the managers be at 30% short and 130% leveraged. It is simply an opportunity for them … if they see fit. So, I think unlike other 130/30 programs, we are not expecting the manager to be limitup the entire time. We are expecting the manager to take advantage of it as and when they see fit.

With respect to issues like high yield and emerging markets, we’ve expanded the boundaries a little bit there to realize new realities that are in the market and have allowed a little bit more latitude toward our managers in those particular areas. Again, the benchmark didn't change. It is still the same benchmark we had before, which is a sovereign benchmark. It doesn't even include credit. We didn't want to introduce too many changes too quickly either.

What we are looking for is managers to be able to take a look at risk in a sober view and be able to look at the best risk-adjusted returns they can get over as wide an opportunity set as they possibly can…

Mr. Chernoff: (As Olaf said), you’re early as far as pension funds go, but are you late in the game in terms of the overall markets?

Mr. Busay: That’s a very good question. I guess better late than never is one answer ...

It would be great if we could see secular trends or grand trends that end up taking place in the market at time zero and be able to get on board and start right from the get-go and be able to jump onto these things. Any one of us at this table would love to be able to do that on a … consistent basis.

Unfortunately, all of us don’t have perfect knowledge, especially at time zero. So we have to see what develops in the marketplace and to some extent react to what’s happened, and in other ways try to extrapolate to some extent what could happen in the future.

So, to Olaf’s question, I'd like to think that what we've been able to do is expand the opportunity set enough that it reflects the realities that are in the marketplace now and at least for a little bit of the foreseeable future... I think this is a relatively big step.

In one sense, I was a little surprised after talking to so many managers — and there was a relative consistent opinion in terms of how to expand the opportunity set — that really when we finally did it, that it was as big a deal as it was.

Mr. Gutierrez: On a global basis, Olaf may have a point. … But in my mind, at least in the U.S. market, if CalPERS is late then basically the country is late. … I’d say the preponderance of relatively large plans have still what I would characterize as relatively constrained investment guidelines that do pigeonhole a particular manager…

Honestly, I am not aware if we are, as a country, late. But I think the side comment would be that if we are late, everybody is even later to the party than CalPERS. I still think that there are definitely opportunities that can be explored.

Mr. Phillips: These changes have been happening, but mostly it’s been happening under the alternatives umbrella. So what this represents as an innovation, (is marrying) what’s already been going… in hedge funds and the like under the alternatives umbrella and…with traditional long-only benchmark-oriented fixed income...

So I think it has been happening. I just think that what this represents is now bringing it into the mainstream of long-only fixed income. As a result, it’s going to cause it to grow faster and take up a bigger chunk of asset allocations as a result because alternatives still are a relatively small part of the pie.

As to the question of whether this is late, it gets everything to the issue of whether this is a cyclical phenomenon we are going through or whether it is a secular change in the markets.

I still believe that there is a cyclical component to this. There is no question that there’s a secular component, greater efficiencies. I believe more folks outside the U.S. are being the marginal buyer. Paul’s point is perfectly (on target), and that is a change in dynamic which isn't going to go away anytime soon. But we are in a world in which we haven’t experienced a recession in some period of time, a global economic downturn or an economic downturn in a major economy in a long period of time.

I have to believe that when that happens, that is going to be a cyclical element that is just going to change the nature of risk from where we are currently, which is low volatility. And even when we have events, while they are over a short period of time, there are these spikes, but they get corrected pretty quickly, and then the cycle just gets drawn out much more further.

You used to think about things like: What would be a world-changing event? Well, what if GM and Ford (investment-grade bonds) got downgraded? Wouldn’t that be a world-changing event? Well, we’ve had that, and what’s happened? Not much. I think a lot of that is masked by virtue that we’ve been in economic growth mode, that the cyclicals have been very supportive. When the cyclicals turn unsupportive, it may be a different question.

Mr. Rogge: Japan was 10 years in a depression…. You said we didn’t have a recession in a major economy. The second-largest in the world, 10 years depression.

Mr. Phillips: Well, look how it affects their attitudes about risk-taking.

Mr. Rogge: I know about that. But basically from a global point of view, it is fantastic. If the second-largest economy can just drop out of being a contributor toward world growth … and the world still goes on and pretends as if nothing has happened, it is amazing.

Mr. Phillips: So that means the first-largest economy can suffer a recession, and it won’t be anything. Well, that is your guess, but we don’t know that.

Mr. Chernoff: Greg, I wonder if you could address the cyclical vs. secular issue here, and do you think managers are going to embrace these tools on a broad basis?

Mr. DeForrest: We’ve really been talking about two things, like Paul pointed out.

One is alpha opportunity sets, what's going on in the marginal buyer, etc. That is categorically different from the opportunities that you give an investment manager.

Long-only managers, managers who have traditionally been long-only will continue to adopt techniques, including shorting, including forms of leverage, as their clients let them do so.

However, it is not for every manager, and it is not for every client. We have some clients who have international fixed-income portfolios who have very rigid guidelines, and they only want the manager to eke out 15 to 20 bps net of fees, and that's fine for them. They just have structural limitations to the amount of latitude that they can give their managers. So, it is not for everyone. Also, it is not for every manager.

Some managers do not have the risk controls in place or experience in shorting, the experience in using derivatives, etc. So not every manager should be given this latitude.

Is a very attractive option for a fund sponsor to give wider guidelines to the managers who have the skill and the risk controls in place ... You are probably going to have a lower fee than giving it to a hedge fund manager. It is probably going to be more transparent. You are going to be operating with an organization that you probably have a longstanding relationship with. There is a lot of trust between the fund sponsor consultant and investment manager, most likely.

On top of that, if it is wrapped up into a long-only portfolio, there is also beta embedded within the product. At Callan, we think there’s been a rush away from beta-based investing. So moving to portable alpha only, pure alpha only, has been to the detriment of some firms, some fund sponsors who have forgotten that over long time periods, equity should produce a real return. Fixed income should produce a real return. So, we don't want to throw the baby out with the bath water here and totally disconnect the alpha and beta of an investment management product.

Having said that, there are plenty of ways you can go about it, whether it is beta overlay or whether you buy an individual product that combines the two.

Whether or not this is a new product, 130/30 in fixed income, I agree with Andy’s point that the hedge-fund community has been using long/short fixed income, long/short everything, for a long time, so fund sponsors have some exposure to these sorts of strategies.

Mr. Chernoff: Paul, what do you see going on within the industry and within PIMCO?

Mr. McCulley: I think we've seen it throughout the history of our firm in that you’ve had an evolution towards core-plus. In fact, it was faster in many respects in core-plus than it was international because you would have plan sponsors say. ‘I want international and I want international against a sovereign benchmark, and I really don't want to do anything else.’ So, actually, the guidelines around international mandates could be tighter than they were around domestic mandates. …

But I think the bottom line is that the community is recognizing that risk in a portfolio can be measured and controlled from a top-down perspective along core risk vectors — duration, curve, credit, currency, convexity — that you can manage all of that stuff from the top down…

When I sit down with a client, I start out with a discussion of the top-down risk in the portfolio. After we have that discussion, then we will do a bottom-up assessment, as well as how did you get there. But the big issue from the standpoint of risk management is that you have very good understanding of where your top-down risk is.

If your manager can, through security selection on the long and short side, bring alpha to the bottom line from the bottom-up perspective, you can deal with any sort of risk additive or risk subtractive impacts at the toplevel…

The more fascinating question to me actually is, is this evolution that we are seeing accelerating because of simply global secular change, or it is because of that plus cyclical complacency. I think Andy put his finger on that very, very well in that you tend to see an appetite for liberalizing guidelines when no one has been burned for a long period of time by anything.

The question is, is what we see in the global space now the new normal, or is it a journey to a new normal? My viewpoint is it is a journey to a new normal, that where we are right now is not normal because we’ve been going through this wealth accumulation phase in the emerging markets as a consequence of their exchange-rate regimes.

We know they are going to be changing from accumulating wealth to moving (the) capital market line, and that is going to have a profound effect on a secular horizon in various relative risk premiums. So, to me, trying to get a grip on where the world’s going in the next five years and understanding the nature of risk premiums right now, which are artificially skinny, which are artificially wide, is the big issue, more so than guideline liberalization per se.

As a manager, I can work with any set of guidelines you give me as long as it’s not a T-bill-only portfolio. … The big issue is, do I get the global environment right. If I get the global environment right, then whatever set of guidelines I have, I’m going to add alpha. If you give me everything I want on the guidelines and I get the world wrong, I’m wrong. So I think the fundamentals and the question that Andy put on the table — how much of this is cyclical and how much of this is secular — is the most important question for plan sponsors and wealth managers these days.

Mr. Busay: But with that in mind and actually with what Andy brought up as well, I see these guidelines as potentially liberating the manager from being able to react to exactly those kinds of situations.

Mr. McCulley: I agree.

Mr. Busay: As a result, you know, people can look at this as potentially kind of a 130/30, that it should be more risky. My contention is that, in certain circumstances, it could actually be a huge risk-reducer, and it will allow the manager sufficient flexibility to be able to react in real time before a market has moved away dramatically so that they can make the necessary adjustments and do it quickly.

Mr. McCulley: I think that’s absolutely right. I certainly applaud what CalPERS has done and what other major wealth managers are doing, because if the guidelines allow you to be more responsive, then when the world changes effectively, you can act in a risk reduction way, not just in a risk additive way. So, when I say the fundamentals are more important to me than guidelines, it doesn't mean that guidelines are not important to me. I mean, I look at the guidelines basically is, what you are allowed to use in a kitchen.

You send your investment manager into the kitchen, and you say I would like to have a lovely meal, which is a high information ratio at the end of the day. Basically, the question becomes how many of the pots and pans are you allowed to use, how many of the spices are you allowed to use, and the more pots and pans, the more utensils, the more spices that are available to you as a cook, the better are the odds if you are a good cook that you will make a good meal. So, it is a good thing to actually be able to use all the tools in the kitchen. That is what we are seeing, I think.

Mr. Phillips: I think that’s right. If I could, I think you brought up the words I think we need to talk about: information ratio. I think these guidelines don’t automatically mean that you will produce a better information ratio because you will have to get the macro trend right.

Mr. Busay: Exactly.

Mr. Phillips: If you are moving toward higher returns and more risk at a time when volatility is falling, you are going to have a better information ratio. If you are moving toward lower returns and less risk when volatility is rising, you are going to have a better information ratio. These guidelines will not cause you to make the right decision, but what they will do in sort of a level market, on the margin, is enable you to implement a more efficient portfolio structure and generate, on the margin, a better information ratio, but it won’t be significantly better.

What is going to cause you to get significantly better, is just getting, as Paul said, the macro trends right. The tools in and of themselves won't lead you in that direction. They will, all things remaining equal, allow you to do a better job.

Mr. Chernoff: Greg, will managers use these tools to reduce risk in the portfolio or will they consume more of the risk budget?

Mr. DeForrest: There are different types of risks. It matters what you define risk as. I don’t mean to be too theoretical there, but I think there’s a little more administrative risk, there is some counter-party risk associated with shorting, especially over-the-counter market securities. You are probably increasing your tracking error in aggregate, but in a low-return environment, I think that is what people are looking to do.

Some of these strategies will be excellent diversifiers, when compared to the tools in the tool shed that have historically been used.

For instance, if you look at a manager that would typically significantly overweight credit, if they have an alpha opportunity set which includes currency or a currency overlay sort of strategy or international bonds … I think that is a very attractive option for the investment manager to start to utilize and I do think (you could argue) their total risk will be reduced because they are less of a one-trick pony.

Overall, I think that is a very attractive feature. If you look at some bond managers and their performance pattern over 2001 and 2002, a lot of fund sponsors were not happy with it because it was the pit of the credit debacle. Some of them significantly underperformed the benchmarks because of their cyclical overweight to credit. If those managers had both the ability and the skill to implement international fixed-income trades, whether it is currency or global rates, that negative excess return could have been muted somewhat.

Some fund sponsors might have a difficult time expanding wider guidelines to some managers, however, because some of them do not have a demonstrated track record in their ability to either short or their ability to implement currency overlay strategy.

Mr. Chernoff: Bert, what role do collateralized debt obligations and other structured finance vehicles play within an evolving fixed-income portfolio?

Mr. Gutierrez: The CDO structure and its various components can be a piece of what I would characterize as the new world or evolving world of alternative fixed income because I do think that segregation is going to go away and that vehicles — whether they be CDOs or whether they be leverage or whether they be shorting — are part of what will be available to the underlying bond manager as a way to … essentially have the ability to generate return for their individual clients.

What we’ve seen is, slowly but surely, you are starting to see plan sponsors embracing certain aspects of the capital structure. For those of you that are not familiar, it is very akin to a corporate balance sheet in which on the left side you have a collateral pool of assets, and on the right side you have an increasing risk, if you will, of liability structures, with the higher component to the capital structure being the one that hasmore credit enhancement underneath it. As you progressively move down, similar to in a corporation, you have the equity of an investment that is clearly the one that has the more potential for outsize returns, but is also the one that will bear more of the risk, similar to the way a common equity shareholder would in a corporation.

We've seen plan sponsors have different degrees of interest in various components of it. Those that are probably a little bit more open on the risk bucket will be probably more inclined to have a modest amount of exposure to the lower classes. Those probably who are more dipping their toes into the well are looking at higher-rated types of instruments.

Within the CDO space, I would say that the most common one that is relatively acceptable and has a place in a lot of overall asset portfolios is the bank-loan portfolio, bank loans being leverage financed vehicles that are clearly above traditional high yield in priority. It is a more efficient means of trying to access exposure to that collateral given that the bank-loan sector is a little bit more liquid than a variety of others in leveraged finance arenas…

Certain institutions have gotten into them, probably without a careful evaluation of the risks associated with it, and then there is the inevitable emotional overreaction in which there is a hiccup in that market — whether it is real estate or high yield or CMOs (collateralized mortgage obligations) in the early ’90s, emerging markets in the mid- to late ’90s, and now I’d say that the phenomenon has moved over to the CDO space.

It is one in which you’ve had kind of a dislocation, and what I would argue is that — and we’ve already begun to see it — it is a temporary dislocation. We, for many years, have been creators of these types of vehicles and managers of not only the underlying credit but also the underlying structure, and have been able to show a propensity to have a skill in that area.

But we’ve always been telling our clients that there will come a time in which there will be the inevitable liquidity (crunch)…

But the end result is going to be the same as we’ve seen with many of the other evolutions in the capital markets, it will be one in which there will be a substantial amount of capital sitting on the sidelines waiting for those opportunities…

What I would expect is over time, you will start to see more diversification away from the traditional bank-loan-type of deals or structures into those that have different types of risk profiles, whether they be commercial real estate, whether they be residential mortgages, whether they be other types of asset-backed securities in which you are parsing cash flows and are able to measure whether or not it is a return that is worthwhile for a given level of risk.

Mr. Phillips: CDOs are an arbitrage vehicle, so you are essentially trying to sell pieces off for more than the value of the underlying collateral, and I think most of us as investment managers are really focused on buying the collateral. Some of us are in a position where we actually take advantage of this arbitrage by sponsoring CDO deals.

There would be an environment in which buying the pieces might make more sense, but I believe that would be in an environment where the underlying collateral is significantly cheaper and across a variety of collateral types — high-yield, bank loans and the like. So, buying the arbitrage product off of that is probably not a good proposition, but recently, for example, with the cheapening in the subprime mortgage sector, there are probably opportunities for buying CDO classes (tied to) subprime mortgage deals now that the collateral pool has cheapened significantly.

Mr. McCulley: I think Bert’s point that securitization has got a long history and a long future is spot on. The technology is there, the slicing and dicing of risk is not new, but it is becoming ever more robust ... There will be the inevitable hiccups as you’ve got too many people chasing yield per rating as opposed to looking at the underlying value of the collateral. So, I think keeping the eyeball on the collateral is the name of the game because all it is an arbitrage against the collateral and the ratings of the collateral.

From our own perspective, buying Bert’s point that this has got long legs, the next big opportunity is not picking over what was already been securitized, but figuring out the next set of assets that are going to be securitized.

I think the next set of assets to be securitized really lie in the emerging markets space, and Olaf and I are in the same church, same on this whole thing in that the ability of the emerging markets, particularly in Asia, to leapfrog is absolutely stunning.

What will have taken in the domestic market here 10 years ago, five years to evolve, can actually be born and become mature inside of a year in the emerging markets space. So, to me, the whole area of securitization — and CDOs is just under the banner of securitization — the next big wave of securitization is going to be in the domestic markets of the emerging markets.

Mr. Rogge: The interesting thing will be in emerging markets; how do you get the domestic debts? They are not there yet.

Mr. McCulley: That’s the chief asset.

Mr. Rogge: That will happen. So we are actually this month actually opening up in our office in Singapore…to look for this. We will probably do it in three years’ time. Nevertheless, that is for us the opportunity.

Mr. Chernoff: There have been concerns expressed with regard to credit derivative swaps. Are these concerns justified?

Mr. Rogge: (Holds up a £5 note) This is Her Majesty the Queen, this is liquidity … There are two ways I can lose it — either I go to Las Vegas or I burn it — but this is liquidity.

What you are talking about nowadays, in my opinion, is credit availability. And credit availability fools you. Liquid markets today have most likely gone. Why, because it was only credit availability, and it doesn’t take much for the lenders to take the money back.

Who are the lenders now? It is not the domestic institutions, it is virtually (only) the global institutions, and that is why you have to look at it from a macro point of view. What do they think about us? Because we want their money basically …We give them a little bit, but we want more money for us. So, I think this kind of liquidity thing and leverage on a global (scale)is becoming more and more a high-risk factor, particularly if the new kind of wealthy countries are having different ideas than we have.

Mr. Busay: The gentleman sitting in the room here, Curtis Ishii (CalPERS’ senior investment officer for fixed income), has often ended up saying that the way to really make someone pay attention to something is put it in their portfolio.

We can sit around and talk about the theory of leverage or anything else that exists, but people — managers, plan sponsors, everybody — will pay attention to it a whole lot more if they have it in their portfolio.

I think with the 130/30, it’s a very moderate way. It is kind of the next step of sorts for people to get into it. I think when people talk about leverage, their great fear is not that it is not going to be 130% of the portfolio, but that it is going to be 200% or 500% or 1,000% of the portfolio that will be levered 10 times over...

So, I think the answer to your question in some ways is, are we concerned about leverage? I think it is important to understand what leverage is as a first step, and then you can make probably a more intelligent answer as to how much we should be concerned about it.

Mr. Gutierrez: Paul’s point is spot on with regards to it’s not so much liquidity, it is the availability of credit that creates liquidity.

The use of leverage in and of itself, I have no real negative opinion of it. I think it is really a function more of the overall process, what bets you are making, how well you are managing the bets. The ability to use leverage in the modest sense that we are talking about because 33% leverage is basically nothing in the practical scheme of things.

When you are in a world in which there are vehicles that traffic in 10, 20, 30 times that, when you have hedge funds that take exposure to bank debt on a long-only basis and basically can have six, seven, eight times leverage, their credit profile is one in which they are not really looking at principal recovery, they are looking at just the carry for the next quarter, six months, 12 months.

That’s a different type of leverage game than what we are talking about, thanI've seen at any point talked about within the context of the traditional plan sponsor. I really look at the ability to, say, have leverage up to 130/30, 33% or thereabouts, as basically (giving) the manager (the ability) to tweak on the edges what they can or can’t do and take advantage of opportunities as they present themselves.

Mr. Chernoff: What do you think of leverage levels in the global economy and the capital markets?

Mr. McCulley: There's a lot more leverage in the global capital markets than there is in the global economy. In fact, I would argue that the global economy, not the United States economy, but the global economy is underleveraged. Notably, the household sector in emerging markets (is underleveraged) because the reserves in all the emerging markets are national wealth. But you look at the balance sheet of the household sector in the emerging market space, and it is severely underleveraged. So I don't think the global economy has too much leverage in aggregate. I think it could be in the wrong places.

The systemic risk is not the leverage in the global economy, it’s the leverage in the global capital markets. I guess I am a little bit schizophrenic about the whole issue of leverage in the global capital markets. I think it makes the markets more efficient most of the time.

More efficient markets are a good thing. However, I think more leverage increases fat-tail outcomes. So I think more leverage and more efficiency is good most of the time, except when it isn't. And that’s what frightens me the most when I look at the next five years is, where's the fat tail? Because we have not tested these markets in a long, long time. The last time we tested them was in 2001, 2002 with respect to the credit side of things, which was a systemic issue and led (Federal Reserve Chairman Ben Bernanke) to have to give his deflation speech.

So, (what) I worry about — what I think the Fed does, European central bankers probably even more than the Fed — while greater efficiency, greater liquidity, greater access to credit, greater use of credit in the capital markets is a beautiful thing when it works, it could be a very ugly thing when effectively you get a change in sentiment where you have everybody on the same side of the market deciding to move to the other side of the market.

Mr. Gutierrez: The classic core correlations go to one type of situation.

Mr. Rogge: The door is not wide enough. It is a very narrow door.

Mr. McCulley: So it reduces the middle of the distribution from the standpoint of risk. It makes the world less risky around the mean and makes it more risky in the tail would be how I would describe it.

Mr. Gutierrez: Yes, there is in my mind today — with the speed with which money moves around in which credit can be created — clearly an implicit bet on the quality of the global risk management product. There are a lot of financial institutions that are out there generating a substantial amount of this liquidity based on the availability of credit. You wonder, as we've seen in the past, how much of it is based on artificial intelligence algorithms and how much of it is based on common sense.

Right now, there is a substantial amount of leverage in the capital markets. What I don’t have a good feel for is what will create that fat-tailed problem. If it is anything, it will be something in which we as a profession, not only here but globally, get complacent (about) as inevitably happens with any extreme of a marketplace.

Where it manifests itself, where that mistake is made that will then cause the domino effect, I don’t really have the soothsayer’s comment as to what it will be. But I always try to keep things simple: what makes common sense and what doesn’t. There are a lot of formulas out there that can give you an answer that might conflict with common sense.

Mr. McCulley: Well put.

Mr. Rogge: Will you call me once you find out where the risk is? I would like to be going out the door with you, not behind you.

Mr. Chernoff:: Any final words?

Mr. Phillips: A lot of risk management systems are value-at-risk systems and are very sensitive to changes in volatility assumptions. So people’s perception of how much risk they have can change pretty rapidly. So, if folks’ investment perspective is based purely on the value at risk in these risk algorithms, then there could be a lot of potential disruption. We've seen the VIX go up recently, then suddenly people show up next Monday and realize there is a lot more risk going on than they thought…

We feel pretty good that financial institutions have a handle on it because when we go to talk to them, they tell us about all their risk management systems, and they tell us that all their swap contracts are confirmed, and everything is knowable.

But what about all of the folks who are outside that regulatory apparatus. What about the hedge funds and how much of that is being properly incorporated into risk management systems, and how quickly would their perceptions change when volatility rises.

Again, this gets me back to the point that all of this stuff is good, on a secular basis. It is dampening volatility, it is happening. But is there still a cyclical element that when it pushes volatility higher, it will speed these systems, the feedback loop, which will change people’s perceptions of risk and could violently swing and create these fat tails that we are talking about.

Mr. McCulley: I think you can almost forecast with certainty that is going to happen sometime in the years ahead. Note, I said ‘years ahead.’ I don't know when, but the more these systems and global risk appetite in liquidity contracts risk premiums and reduces vol (volatility), the more systems effectively tell managers they can increase their footings.

Value-at-risk is the most inherently pro-cyclical risk management tool in existence because as volatility is coming down, they tend to bring volatility down because they expand the risk budget, which will lead to even greater leverage. So, effectively, it is a virtuous process when it is working to bring vol (volatility) down.

What we haven’t seen, and I think we can say with certainty we will see sometime in the years ahead, is this thing working in the other direction. Vol (volatility) doesn’t tend to be symmetrical. It tends to fall on a trend line and tends to increase on a spike. You can see that is a prescription for fat tails in the future.

I am reminded of the comment that (former Federal Reserve Chairman) Alan Greenspan made a couple of years ago when he was accused of being asymmetrical — that he did tend to respond to rising markets by tightening or at least not tightening very quickly, but responded very quickly to collapsing markets with easing. He said, no, I’m not asymmetric, the markets are asymmetric. They don’t tend to melt up, they tend to melt down, which then maps into effectively what is the Central Bank put.

It is going to be fascinating, and I agree with Andy 100%, it is important that none of us, whether on the money management side or on the other side, are beguiled into believing that where we are right now is the new normal world. I don't know what the new normal world is going to look like, but this ain’t it.

Mr. Chernoff: On that note, I guess we can't sleep any better.

Mr. McCulley: You’re not supposed to.