Even if executives at pension funds, endowments and foundations had seen the recent market turmoil coming, they probably couldnt have withdrawn from the hedge fund investments they might have thought were most vulnerable to losses.
Lockup agreements on investment funds prevent abrupt departures. Executives overseeing such funds sacrifice liquidity in exchange for the possibility of higher returns from long-term commitments. As a result, they pay the price of having to ride sliding markets and sustain unexpected losses.
So far, it appears that the big losses to investors in the recent panic came from U.S. and international portfolios, where most assets are invested and which fell in value as markets around the world plunged (although the effects on most hedge funds is still unclear). These investments, especially large-cap stocks, are liquid, generally enabling investors to sell.
However, for many investors, even if they anticipated a fall in the markets, a large portion of these portfolios were effectively locked up in these investments, too, through index fund strategies, which tend to be permanent allocations of pension funds.
But few managers saw the turmoil coming. And when it came, it revealed the difficulty managers have in valuing investments and assessing risk, especially in the new instruments investment banks have been creating. Investors must seek tools that allow them to independently value these investments.
The turmoil also exposed weaknesses in many black box investment models. How managers use their models to recover from the losses will reveal how confident they are in them. Fund executives will ask: Did the managers stick to their strategies, or lose confidence and abandon them for some other approach?
Such a switch would raise questions from fund executives as to how much confidence they should have in the models. Any transparency provided for investors is worthless if managers toss aside their models. Arbitrary approaches make it difficult to manage risk and to benchmark performance.
Fund executives shouldnt feel helpless because of lockups, whether contractual or strategic. Investors can still manage risks. A well-diversified portfolio mitigates risk.
Investors have other tools. Lockups might forbid withdrawals, but they dont prevent putting into place hedging strategies that try to offset potential losses.
Also, calamity in the markets often brings opportunities to buy, to exploit the many securities that are financially solid but have lost value because of investors extreme fear of holding any security with any credit risk, even investment-grade bonds.
The extent to which investors can take advantage of this opportunity depends on how well they are prepared to raise cash easily when conditions appear ripe. As David Kushner, deputy director for investments of the $16.7 billion San Francisco City & County Employees Retirement System, was quoted as saying: If you see an opportunity there, let me know and Ill raise the money.
Losses by some models shouldnt get give plan sponsors cold feet about all models. Sticking with a thoroughly researched model can pay off.
In 2002, Metropolitan West Asset Management LLCs fixed-income portfolio plunged in value when WorldCom Inc. filed bankruptcy following its announcement of fraud problems, causing even bonds of firms with sound financial outlooks to be crushed. But MetWest stuck with its strategy, even keeping the WorldCom bonds. Clients that decided to endorse the course were eventually rewarded when the managers portfolio recovered.
Plan sponsors should be able to weather a crisis if they have conducted thorough due diligence on strategies and portfolio teams, and have confidence in independent valuations, ready hedging tools, capital to take advantage of market falls, well-diversified funds and well-drafted investment policies to prevent emotion-driven decision making in a market crisis.