GREENWICH, Conn. - When it comes to using alternatives to mitigate risk or add returns to a portfolio, plenty of pension funds are going about it the wrong way and might be earning lower returns as a result, according to a new paper on absolute return and private equity strategies.
The paper was written by Michael Litt and Eric Grannan, of Greenwich, Conn., hedge fund manager FrontPoint Partners LLC, and Jason Perlioni, an investment analyst for the Northwestern University endowment fund in Evanston, Ill.
In it, the authors argue that many pension funds do not accurately account for the offsetting and correlating tendencies of various alternative investments. As a result, many pension funds overestimate their portfolio risk, and might be investing more conservatively than their risk budgets would otherwise allow.
Additionally, pension funds need to embrace the concept of flexible risk limits that move up or down based on macroeconomic trends, according to the paper.
But the most important part of the paper - and the part Mr. Litt said he believes will be the most widely discussed - is its asset class matrix, which plots investments in quadrants based on their liquidity and correlation with the Standard & Poor's 500 index.
Distinct asset classes
"The big issue with a lot of plan sponsors is they're taking venture capital, private equity, real estate, oil and gas, timber, distressed debt, absolute return (hedge fund) and managed futures and lumping them into a category called `alternatives,' " Mr. Litt said in an interview. "In fact, they should be thinking of them as very distinct from one another."
The asset class matrix is divided into four groups: liquid and illiquid market-correlated asset classes and liquid and illiquid non-market-correlated asset classes.
Not surprisingly, large-cap, midcap and small-cap U.S. equities; international equities; emerging markets equities; long- and medium-duration fixed income; high-yield debt; and emerging markets debt all fall in the liquid, market-correlated quadrant. Emerging market debt tends to be less liquid than and less correlated to the market, while emerging market equity tends to be less liquid than but more correlated to the market. Medium-duration fixed income is highly liquid, but less correlated to the market, according to Mr. Litt's chart.
Also as expected, real estate, oil and gas, timber and distressed debt are all considered illiquid, non-market-correlated asset classes.
Cash is highly liquid and has a low market correlation.
Then come venture capital, private equity, hedge funds and managed futures. This is where the discussion is sure to start, Mr. Litt said. Often, these asset classes are lumped together. In fact, according to Mr. Litt's chart, private equity and venture capital have opposite characteristics from hedge funds and managed futures. While private equity and venture capital tend to be illiquid but highly market correlated, hedge funds and managed futures are liquid but not correlated to the market.
It's that offsetting characteristic that many pension funds don't consider, Mr. Litt said.
"If you're invested in private equity and venture capital, it really demands that you at least consider investing in absolute return and managed futures," Mr. Litt said. "Absolute return and managed futures make private equity and venture capital more efficient and give you the ability to put more money in those strategies."
Three-phase process
In general Mr. Litt, who formerly ran the global pension group at Morgan Stanley Dean Witter & Co., New York, said pension funds go through a three-phase process in grasping this new approach to looking at risk. In the first phase, the pension fund starts looking at absolute return strategies and figuring out how they fit in the overall portfolio. In phase two, the fund starts moving these alpha-generating strategies into the core of the portfolio and combining them with pure beta strategies. The third phase is characterized by an acute awareness of the risk budget and of how to use offsetting alpha and beta strategies to maximize risk and returns.
"The best performing pension plans overlay market exposure through futures or other types of simplistic ways to get market exposure and take the risk to levels that's concomitant with the policy benchmarks and enhance returns," Mr. Litt said.
Of the few pension funds that have advanced to phase three, the Weyerhaeuser Co., Federal Way, Wash., is the most prominent. Although company officials won't discuss their $4.5 billion pension fund publicly, they have incorporated hedge funds and derivatives into the portfolio for the past 15 years. People familiar with the fund told Pensions & Investments in June that Weyerhaeuser overlays hedge fund investments with derivatives - like equity and fixed-income futures. This allows the fund to invest in alpha-generating absolute return strategies and also get equity and fixed-income exposure.
Strategy working
The strategy seems to be working. Weyerhaeuser had the best-performing corporate pension fund between 1989 and 1999, with annualized returns of 20%, according to Piscataqua Software Inc., a Portsmouth, N.H., research firm. The fund earned an 11.3% return in 2000, as the stock market began to dip, and 28.7% in 1999.
Weyerhaeuser has used those return figures to project a long-term rate of return of 11.5%. That's the highest of any company in the Standard & Poor's 500 index, higher than the average of 9.2% cited in a 2000 Watson Wyatt Worldwide survey of 400-plus corporations, and higher than the S&P 500's average return for the past 75 years.
"It's good to have a range of investments from pure beta to real skills-based investing," Mr. Litt said. "The Weyerhaeuser portfolio is heavily laden with skill-based managers."
Mr. Litt said that in the course of writing the paper, he and the other authors worked with a couple of "very large" pension funds and discovered through value at risk analysis that they were running at anemic risk levels relative to their established risk limit. This isn't uncommon, he said. What happens is a pension fund sets a risk limit and gives it to all its various managers. Each attempts to operate at that risk limit in isolation.
But at the micro level, managers do not take into account the various offsetting correlations. What winds up happening at the macro level is that the portfolio runs at 80% to 85% of its risk budget, Mr. Litt said.
"One manager might be focusing on different macroeconomic factors in his portfolio than another. One may have a small-cap bias and another a large-cap bias. One might be interest-rate sensitive and another not. One credit-spread sensitive, the other not. They would be offsetting one another," Mr. Litt said.
Closer look
Participating in the writing of the paper prompted Northwestern University to take a closer look at the risk framework of its $3.5 billion endowment, Mr. Perlioni said. The paper used Northwestern's asset allocation - and its use of alternatives, in particular - as a baseline.
Of particular interest to Mr. Perlioni and Northwestern was the contribution venture capital made to the portfolio. According to the paper, venture capital is a highly illiquid, market-correlated investment. Its annualized volatility was about 6.6% as of September, more than 600 basis points higher than the annualized volatility of the S&P 500 at the same time.
"The notion that private equity and venture capital increases your risk was intuitive. That the numbers bore that out made sense," Mr. Perlioni said. "The degree to which venture capital amplified the risk - six times - was surprising. I didn't expect it would be that high."
And that's the whole point of doing such analysis, said Kelsey Biggers, former vice chairman of Measurisk LLC, New York, now with K2 Advisors, a New York hedge fund of funds with $1 billion in assets.
"There tends to be a bias in the investment committee environment of large funds to be scared by these styles without really looking at them in the context of the larger plan," Mr. Biggers said. "In isolation, they look at the risk numbers and say that's way high."
Of course, Mr. Litt could be accused of having a product to sell, and publishing a paper that supports buying that product. Mr. Litt said that is not the case. He said the goal of his paper is to get pension funds to examine their portfolios, the risk in those portfolios and whether absolute return strategies might help them generate better returns while lowering risk.
"It may not work for everybody," Mr. Litt said. "If they think about it and decide not to do it, that's OK. At least they gave it some serious thought."
