A new hedge fund of funds is tapping into an old technology to boost chances of achieving the mythical 8% annual rate of return.
Three veterans of the former Salomon Brothers Inc. have formed Resolution Capital, a New York and San Francisco firm that employs surplus management methodology pioneered by bond guru Martin Leibowitz and others in the late 1980s. Firm officials boast they can create an optimized fund of funds designed to minimize the likelihood of returns falling below a set threshold.
The model is highly dependent on the quality of one-year expected returns for various asset classes. But it does increase the odds of meeting the actuarial rate of return for funding requirements - critically important, as most large corporate pension funds now are falling below full funding levels.
And while Resolution Capital executives want institutional investors to buy their product, either through separate accounts or through a pooled vehicle now awaiting approval from the Securities and Exchange Commission, they will offer to apply their methodology to clients' entire asset base.
The surplus management methodology was developed following new accounting standards that forced corporations to mark assets to market, incorporating surpluses into the bottom line and forcing companies to relate pension assets to their liabilities. "Nobody realized that suddenly the riskless assets might not be the Treasury bill," explained Roy Henrikkson, director of research, who co-wrote a seminal 1988 paper on surplus management with Mr. Leibowitz.
Resolution Trust officials figured out a way to build an optimized portfolio based on shortfall risk - defined as the risk of not meeting return objectives.
Instead of using a normal "bell curve" distribution of probable returns traditionally employed in mean-variance optimization, they rely on a skewed distribution of returns. "Mean variance works very well for normal distributions, but normal distributions rarely occur in nature," said Robert E. Kiernan III, Resolution's chief executive officer.
Based on an 8% minimum return assumption, the shortfall-risk methodology adds nearly 200 basis points a year in return, while risk increases 119 basis points, compared with the traditional mean-variance optimizer. Meanwhile, the odds of falling below the 8% threshold fell substantially, to 61% from 94%.
Using a universe of 200 to 250 hedge fund managers, Resolution officials slice and dice the performance data to see which managers are adding alpha. Managers also are checked for exposure to "tail risk" - the risk of an unusual event blowing up their strategies, such as the 1998 Russian ruble crisis.
Resolution officials take the top 60-odd managers and, based on a Monte Carlo simulation involving 1,000 scenarios, optimize the portfolio among them based on shortfall risk. They use one-year return projections, assuming managers will produce half of the alpha they've generated over the past five years.