By Bernard Winograd
What happens when a portfolio with an AIMR-compliant 20-year track record that routinely ranks in the top decile for fixed income pops up to the top of fixed-income search screens?
Once institutional investors or their consultants realize the investment strategy is a private one, they generally make an equally quick decision to discard it from the search process. The fact that the portfolio might be a good way to make money is typically regarded as, at best, a curiosity, because most fixed-income searches require that only public-market strategies that can be modeled and evaluated against public-market benchmarks should be considered for investment.
This public-market bias is the standard technique used by modern portfolio theory-based processes to create risk controls. That is, institutional investors look to carefully and precisely describe a benchmark and search for managers to beat it.
The Prudential Insurance Co. of America started a commingled fund called PRIVEST for a handful of pension funds more than 20 years ago. The portfolio invests in private placements and nothing else except for a very small portion in bonds — and continually ranks in the top decile for fixed-income portfolios.
Because of investors' reliance on Modern Portfolio Theory, however, more than a decade has gone by without any pension fund interest in the portfolio outside of the original group of pension fund investors — until the last two years, when the increasingly wide-ranging search for investment ideas led a few new pension funds to join in.
Most major U.S. insurance companies that use private assets have a long and comforting history. Private placements, or the making of loans to private companies, usually investment grade, is a business that was the bread and butter of every insurance company in America before the public market's reach made it harder to find qualified borrowers. But its top-performance characteristics remain compelling.
To a former corporate treasurer like me, this is hardly a surprise. Loans are typically made at a spread to comparable public securities and, unlike public market bonds, they still require meaningful covenants from borrowers. Hence, adverse credit events often enhance returns rather than detract from them, by allowing the lender to earn extra compensation or be made whole when paid off by a more accommodating refinancing source.
I think the main explanation for the lack of interest in such a well-tested investment idea is widespread misapplication of MPT, which clearly teaches that the main job of a portfolio manager is to create sources of uncorrelated alpha, not ignore the ones that are hard to evaluate. The central insight of MPT is that mixing together allocations to uncorrelated asset classes can increase the expected return of a portfolio while also reducing the volatility of expected outcomes. The tools that have been developed to allow plan sponsors to anticipate the effect of different asset allocations have been enormously helpful in increasing the sophistication with which these decisions are made. Yet, at the same time, these tools often have been used in ways that limit the range of alternatives that are considered.
I've used the private fixed-income markets as examples of investment ideas that deserve a broader hearing, but there is a range of investment approaches — in public asset classes as well as private— that plan sponsors that think too narrowly inside the box of MPT often are precluded from considering.
While there is no requirement in principle that asset allocation optimizers use only public-market asset classes, in practice they are likely to create such a bias for several reasons. Public-market investments can be studied in great detail because of the availability of a rich series of performance data based on daily values. Their expected returns and their correlations with other public asset classes are relatively easy to estimate over the longish time horizons that drive MPT-based institutional asset allocation methodologies. These tools have a harder time assessing private market investments that cannot be so easily modeled.
Now, one can argue about whether the size of the market for private placements makes it a big enough opportunity to warrant attention. But there is no way to make that argument about the commercial mortgage market, which is as large as the market for Treasury securities and has similar performance attributes. Yet we can count on our fingers the number of pension funds that have explicit allocations to mortgages. Why? The usual answer from pension fund chief investment officers is that market requires two kinds of expertise — real estate skills to evaluate collateral and fixed-income portfolio management — and these are hard to find in combination. Yet almost every insurance company in the world finds ways to invest in this asset class, so the operational issues can't be that hard to deal with.
Portfolio construction was too easy in the 1990s because the biggest asset class, public equity, provided outsized returns. In the next decade, plan sponsors will have to look harder for asset classes that can improve results — and they are there for those who look.
Bernard Winograd is president of Prudential Investment Management, Newark, N.J.
