TO: The federal government
FROM: Top money managers
RE: The $25 billion public health trust fund from the huge tobacco settlement
Don't blow it. Use stocks, stock index futures and bonds, and use modern investment concepts such as duration to invest the assets wisely and efficiently.
This was the advice of four top money managers asked by Pensions & Investments to recommend an investment strategy for the money to be paid by tobacco companies as part of the $368.5 billion settlement of state lawsuits against them.
In crafting their scenarios, most took into account the sensitivity of the investment program to politics, including whether the trust fund's investment policy automatically should exclude tobacco-related investments.
All of the investment managers qualified their suggestions because of the lack of information on cash outflows.
The 68-page tobacco settlement agreement - requiring an enormous $368.5 billion in cash contributions over its first 25 years and a bigger sum in perpetuity - makes no mention of how the money will be managed. Of this amount, $25 billion has been earmarked for a public health trust fund.
Congress and the president still have to approve the settlement, and details on how much of the $368.5 billion will be spent have yet to be spelled out.
Under the settlement, funding the $368.5 billion would start with a $10 billion cash payment on the day legislation enacting the settlement is signed by the president. In addition, in the first year, the companies would pay an additional of $8.5 billion.
Clearly, the money at stake is huge. But Robert D. Arnott, chief executive officer, First Quadrant L.P., Pasadena, Calif., said the figure was "still relatively small in the pension fund universe."
"When you look at how much a state like California invests each year (through its huge state pension funds), you understand that the annual amount of money involved in this settlement isn't extraordinary in the pension world," he said.
Use the capital markets
Investment experts expect the federal government will want to invest the money conservatively in Treasury securities, but many believe there is a better way - use the capital markets.
In terms of developing a portfolio strategy, Philip Schettewi, managing partner, Loomis Sayles & Co., Washington, echoed the comments of the other investment managers interviewed: "Before you can start an investment program, you need to understand a number of things about the settlement, especially when it is going to pay out and how much."
"With a pension plan, you have to establish what your payout will be to enable you to set your asset allocation."
In other words, said Donald G.M. Coxe, chairman and chief strategist, Harris Investment Management Inc., Chicago, and chairman of Jones Heward Investments, Toronto: "For every asset, there is a liability.
"You start the investment process by analyzing the duration of the cash outflows. Then you decide the duration of the assets you want."
At extremes, Mr. Coxe said, "the current duration of the yield curve of the outstanding Treasury securities is 5.4 years. In the best estimate I've seen, the duration of the (Standard & Poor's) 500 is 18 years.
"So with a fund like this you figure a duration of liabilities. Then you would construct a laddered portfolio of Treasuries that is about seven years" to use as the source of payment for the first five or six years, presuming that outflow will be known.
"The advantage of this is you have a source of cash flow to make payments," Mr. Coxe said. "But since this a long-tail liability, you'd have some equities. So you might end up with 40% to 60% in the laddered portfolio and 60% or 40% in the S&P 500."
Liabilities beyond the six years would be funded from equity futures rather than the stocks themselves, he added.
No political interference
"This strategy gives you a certitude of cash flow, matching assets and liabilities, and no political interference in the marketplace," he said. "There would be no continuing wrangles in administration."
"You balance the pure investment decision with the recognition of political and social pressures," Mr. Coxe said. He added this idea also eliminates the anticipated call to invest in economically targeted investments.
If government officials demand the funds be invested conservatively, all in bonds, "you automatically raise the cost of meeting the liabilities," Mr. Coxe said.
"This would be a perfect chance to see how you can have a fund under government ownership but with no government control or influence of pressure groups," he said.
"If you do it through anything but futures contracts, you create a situation where someone owns voting rights," Mr. Coxe added. Mr. Coxe said the funds could be managed with an internal team of about a half-dozen investment professionals.
"The portfolio would run itself," he added.
"An immunized portfolio like this you're not supposed to play with except to rebalance as you get new information on the payments."
"I'm quite sure an investment process like this would work," Mr. Coxe said.
"A portfolio like that would be low cost to administer and manage," he said. The entire investment management of equity index futures would cost 10 to 15 basis points; the laddered portfolio, five to 10 basis points.
Cover near-term liabilities
First Quadrant's Mr. Arnott said: "One of the key factors in any investment management decision regarding funds from the tobacco settlement" is ensuring near-term liabilities are covered.
"I would imagine it would be prudent to examine how quickly the funds will be flowing into and out of the respective state accounts," he said. "At that time, you could examine what the best investment options would be. I would also think that, given the current level of the stock market, investments would remain short-term in focus and rather light on the equity side of things."
Mr. Arnott sees three main issues.
"The first issue is the question of duration and liabilities, establishing how much funding will flow in and out of each state," he said. "The second question is that of valuations and examining their impact on returns. And the third pivotal decision is which investment direction to go in, either a conservative approach or a more aggressive one."
"Each has its potential downside. If the market remains strong, a conservative approach will not produce the best returns. On the other hand, if the market tumbles, then an aggressive approach will have bad results. The question is which will have the least economic and political fallout?"
Diversifying the funds' allocation also would be a wise move, Mr. Arnott explained.
"An appropriate allocation strategy might have a short-term duration focused more heavily on bonds and cash, and some international diversification to reduce volatility," he said. "That would be different than a state pension fund, which has a much longer-term perspective."
'Good portion in equities'
Because the fund is long term, Loomis Sayles' Mr. Schettewi said, "it should have a good portion in equities."
He noted the historic annual return on equities is 12.5%. "Their nearest competitor is corporate bonds at 6%."
The equity representation "can be as low as 20% and as high as 80%," he said. "But you can't set a mix without an anticipated level of payouts."
"Intellectually, it's hard to come up with the best mix if we have only part of the cash flows," Mr. Schettewi said. "If you have a long-term time horizon, you're going to get the best return in equities.
"It should be a program to allow you to put money in the equity market regardless of market levels," he said, assuming the horizon is long and the payout low each year.
He recommends a diverse allocation with a mix in growth and value, small- and large-capitalization stocks. In bonds, he suggests long, short and intermediate and investment-grade corporate, high-yield and governments.
"I wouldn't own any tobacco stocks in the fund," Mr. Schettewi said. "It would be hypocritical given the fact the money is coming from a tobacco problem."
Mr. Schettewi would use all active managers. "I come from a firm where active management is our forte," he said.
"I would have multiple managers with different styles. So you are getting the right asset mix and style mix."
Another equity proponent
William J. Landes, chief investment officer-global asset allocation, Putnam Investments, Boston, would allocate 60% to 70% in equities. He would put up to 50% in U.S. equities and 20% in international equities.
He would put the other 30% of the fund in diversified fixed income, including investment-grade and high-yield bonds.
"Some might describe 70% in equities as pretty aggressive," Mr. Landes said. "You have to be diversified in terms of growth and value and large and small cap." He defended the international allocation, saying, "there are a lot of good non-U.S. companies."
He also would rely solely on active managers.
He declined to recommend whether the fund should investment in tobacco-related stocks and bonds.
"Since it's a politically charged issue, there is a tendency to be conservative" in investing, Mr. Landes said. "This would be a mistake. Most people err on the side of conservatism for all the wrong reasons," such as "'This is a trust for the public to be preserved from the volatility of the market.' But that strategy would lose a lot of potential growth for the fund. This is a fund that may be long term and have plenty of time to ride out volatility."
