P&I Round table: The post-traumatic credit disorder

The credit crisis has roiled stock and bond markets last since summer. Financial stocks have taken a pounding, while much of the debt market remains seized up. Some investors thought the worst was over with JPMorgan Chase & Co.’s takeover of Bear Stearns Cos. in May, but markets lately have been taking a turn for the worse.

On June 9, Pensions & Investments brought together five leading investment experts to discuss prospects for markets and opportunities for institutional investors.

Participating in the “Post-Traumatic Credit Disorder” round table were:

• Jeffrey Gundlach, chief investment officer, The TCW Group Inc., Los Angeles
• Martin L. Leibowitz, managing director, Morgan Stanley, New York
• Jeremy Grantham, chairman, GMO LLC, Boston
• Joseph S. Nankof, partner, Rocaton Investment Advisors LLC, Norwalk, Conn.
• William N. Goetzmann, Edwin J. Beinecke Professor of Finance and Management Studies and director, International Center for Finance, Yale School of Management, New Haven, Conn.

Joel Chernoff, executive editor, moderated the discussion, which was held at P&I’s New York offices.

Mr. Chernoff: Thank you for coming today. The credit crisis has left markets and investors reeling, but it has also created some extraordinary investment opportunities. We’ve seen tens of billions of dollars committed to distressed debt funds. Hedge funds and bond managers are buying up discounted mortgages and bank debt. But is the credit crisis over? Are pension funds and institutional investors stepping up to the plate or are they holding back? Most importantly, what have we learned from this situation?

Today, we will discuss these and other issues at our “post-traumatic credit disorder” round table. Jeffrey, is the credit crisis over?

Mr. Gundlach: Clearly, it would be impossible to say if the credit crisis is over. All one has to do is look at the centerpiece for the credit crisis, which was the subprime mortgage area. It’s interesting how few people seem to understand that the prices for subprime securities are at new lows today. A lot of people seem to think there’s some sort of rally that’s gone in that area. In fact, I was listening to the TV this morning and someone was talking about the need for some investment banks to maybe take losses on their shorts because the shorts had rallied in the ABX index (which is based on subprime mortgages).

Sorry, but that’s not the case. The ABX index, except for certain AAA areas of it, when you get to AA, A, BBB, BBB-, they’re at new lows today. That’s appropriate because the path of delinquencies and foreclosures continues completely unabated. If anyone is really paying attention, they’ll notice that the prime mortgage market has alarming delinquencies and foreclosures ever since last fall.

Mr. Chernoff: Thank you for coming today. The credit crisis has left markets and investors reeling, but it has also created some extraordinary investment opportunities. We’ve seen tens of billions of dollars committed to distressed debt funds. Hedge funds and bond managers are buying up discounted mortgages and bank debt. But is the credit crisis over? Are pension funds and institutional investors stepping up to the plate or are they holding back? Most importantly, what have we learned from this situation?

Today, we will discuss these and other issues at our “post-traumatic credit disorder” round table. Jeffrey, is the credit crisis over?

Mr. Gundlach: Clearly, it would be impossible to say if the credit crisis is over. All one has to do is look at the centerpiece for the credit crisis, which was the subprime mortgage area. It’s interesting how few people seem to understand that the prices for subprime securities are at new lows today. A lot of people seem to think there’s some sort of rally that’s gone in that area. In fact, I was listening to the TV this morning and someone was talking about the need for some investment banks to maybe take losses on their shorts because the shorts had rallied in the ABX index (which is based on subprime mortgages).

Sorry, but that’s not the case. The ABX index, except for certain AAA areas of it, when you get to AA, A, BBB, BBB-, they’re at new lows today. That’s appropriate because the path of delinquencies and foreclosures continues completely unabated. If anyone is really paying attention, they’ll notice that the prime mortgage market has alarming delinquencies and foreclosures ever since last fall.

So no, the credit crisis isn’t over. In fact, in the areas away from the MBS market, I would say in some sectors the credit crisis is nearer the beginning than the end. If you look at the commercial mortgage market, it looks a lot like the residential market looked about a year ago, with some cheapness having shown up but a lot of more hope than reality underneath the prices. Credit cards and auto loans will be a major victim of a repricing downward and probably some sort of an opportunity.

No, the credit crisis isn't over and there are opportunities because prices have fallen a lot, but I think that there is no urgency in investing money in the opportunities that exist.

Mr. Leibowitz: The credit crisis that we just saw is over. The question is, (are) all credit crises over? Things were changed dramatically for the better in terms of credit crisis control, if you will, by the actions of the Fed and the spirit with which they were taken and also by the European central banks. But I don’t think that the issues of credit extension and credit supply are over for sure. Those issues are going to be with us for a long time because we have gone through a massive reintermediation and process of deleveraging, which is going to affect us in all kinds of ways, both in the real economy and financial markets as well, for many months to come.

Mr. Grantham: The stock market never does lags very well. They always expect that the first impact is the whole ballgame. So you have the first impact of the credit crisis, the first round of the effects on the housing market, and then people missed the point that the longer-term effects of less credit burn through very slowly over two, three — and even longer — years. For me, that’s all part of the credit crisis.

Step one is you recognize you have a problem in housing. Step two, in consumer debt. Step three, that the whole debt structure was much too high. Step four, you bring the debt leverage everywhere down. The debt-to-GDP ratio in ’82 was 125(%), one and a quarter times GDP. The cumulative debt rose to over three times. So we had a dazzling rise and people learned to adjust their businesses to live in a world where all kinds of debt — financial debt, consumer debt —were rising. Now they have to change all that and the changing period is lumpy and long-winded and painful. I expect we’ll have a lot of unexpected consequences because we never had this collection of problems before.

The idea that you would solve a long-term problem of too much debt by paying people to take debt, by having a negative real rate, brings to mind the hair of the dog that bit you. The guy is a drunk and you’re offering him a kind of early morning pick-up. It may get him to the office feeling reasonably good but it doesn’t do much for his cirrhosis of the liver.

Mr. Nankof: We would say that there’s a long way to go. The false bottom the market seen in March and the comfort that the market had taken from the opening of the discount window to dealers by the Fed has now abated. We’re seeing the markets woken up to that fact … If you look at financial institutions, commercial investment banks’ balance sheets, there’s nearly 10 times the amount of non-agency mortgages on their balance sheets than they’ve written down to date.

A lot of attention has been focused on the subprime sector of the market and less so on … prime and home equity loans. Those shoes have yet to drop, and if you look at it just on the face of it, the classic providers of capital have become consumers of capital in recent months with the recent announcement that Lehman is raising as much as $5 billion in capital. We’re looking at probably a long way to go with the credit crisis and potentially significant impacts on future growth given the lack of availability of credit.

Mr. Goetzmann: I don’t know whether the credit crisis is over or not. My colleagues have expressed a range of views and I agree with everything so far. So let me tell you what I am worried a little bit about.

I am concerned that this crisis has brought about a weakening of financial architecture, domestically and globally, that will make it difficult longer term to recover. I’m also worried about what I’ll call the blame game that we’re really in the midst of: trying to track down the culprits and punish them. Inevitably, this is going to be the financial sector. I worry that that is going to have a big hangover in terms of the willingness of financiers to think of creative ways of restructuring debt, of creating new instruments.

If you cast your mind back about five years, what we heard (was) a consistent drumbeat: there’s just too much capital in this world. There’s money sloshing around. That money will take a lower premium. Therefore, returns going forward in the future are going to be lower.

Where did that money go? Well, I think the money is still there. I think we’re in a very long-term growth in the demand for savings in the world and I think what we're looking at is a temporary setback. But the money that is draining out of financial funds and institutions has got to go somewhere and it’s going to continue to look for longer term returns. So we’re going to see a setback in the creation of financial product because of this real shaking of the financial architecture. But longer term there will be some creative development in the financial sector that will address this demand for savings — and not just the United States, but China and India and South America and southeast Asia. The money just has to go somewhere.

Mr. Chernoff: Let’s turn to the bond markets and the economy. How will they play out over the next 18 months? Marty?

Mr. Leibowitz: There’s a growing view that inflation — certainly headline inflation — is likely to be much worse than it has been and possibly core inflation to follow. That’s not just a U.S. but it’s really a global phenomenon …

We recently had a conference (for institutional clients). Paul Volcker spoke at it and he asked “What are the prospects?” We had these electronic devices that could poll the audience. People were asked what were their views on inflation by the end of the year. Amazingly, very few thought it would be in the 3% to 4% (range), a minority thought it would be in the 4% to 5% (range), and a surprising majority thought it would be over 5%. Everyone had their views … but they were stunned to see that others felt that way. It was a pretty striking event which you don’t get to see very often.

That’s starting to emerge as a view that’s held by many just in the course of the past few weeks. That augurs badly for long-term interest rates. They should go up, but of course the extent to which they are pinned by efforts to keep short-term interest rates low to try to address the growth issues becomes the question.

But it’s pretty hard not to argue that the risks are in terms of long-term rates going higher, perhaps significantly higher, depending upon how that rubber band, how much tenacity is in that rubber band between long-term and short-term rates. It is hard to believe that (short-term rates) will in the U.S. get much lower. I guess the only question is how long would they stay low before they start to move back up. ...

Mr. Grantham: The inflation vs. deflation argument is the central issue for investors for the next two or three years.

Whether the credit crisis cools down the economy and commodity crisis and so on: Is that the central issue or is the inflation coming through — particularly on the Middle Eastern and some third-world countries — induced mainly by huge sustained demand and pressure on commodities? Which of those two is going to tilt the scale the most? I don't know. It’s what I spend my nights waking up sweating about. The consumer polls now say they’re expecting 7% inflation, which is higher than almost the last 20 years. Whether they’re right or not, I’m not sure. In general, I think the economy over 18 months will simply play out weaker globally than expected by a little bit.

I would like to, however, back up. You mentioned before, “What have we learned?” No one addressed that, and I would like to.

We've learned that there aren’t too many adults around. There’s nothing but easy solutions and easy answers. I think we’ve learned that the Fed is intellectually nearly bankrupt, that it’s stretched the law in bailing out investment banks and in the process compromised, as (Mr.) Volcker said, some long-established principles, which he obviously valued.

We’ve learned that the Fed has to think about asset-class bubbles, with the problem being that we have such academic members of the Fed that they’re not sure that bubbles could exist in an efficient world. It would be a real help to have a Fed boss who lived in this real world.

I have a job description for the Fed, which is a lot simpler than the compromising combination of growth and inflation, and that is to protect the integrity of the U.S. financial system. It does seem to me entirely appropriate for the Fed to have that on the list. They have totally allowed the integrity of our financial system to erode in the last 20 years and they should be ashamed of themselves.

Mr. Nankof: I’ll move back to the simpler question of how the bond markets and economy will play out over the next 18 months and, again, to the central issue that Jeremy raised of the balance of deflation and inflation.

Not being paid to forecast markets over an 18-month period as consultants, it’s hard to say we have a crystal ball into that. I would say if we were thinking about probabilities of either, we would be more concerned about the deflation scenario and much slower economic growth or, worse, a more protracted recession in the U.S. than we are about inflation. Commodity price inflation certainly is real. Largely it’s driven by demand out of Asia. I’m not sure that that’s going to abate but, broadly speaking, inflation is probably less of a concern to us than the deflation scenario.

Mr. Goetzmann: Well, I can’t forecast the bond markets. I am an academic, so I’m starting to wonder what’s the matter? What we’ve seen a tendency toward is a reduction in illiquidity of certain instruments. As Jeffrey said, the prices may be low but we’re not in this sense of freefall across the board that we might have been in a few months ago. The forces of arbitrage will eventually create a floor for fixed-income securities. That floor may be really low, but I think that we’ll see in the next 18 months some kind of logical equilibrium, if you will. At least that’s what I'm hoping for.

In terms of the economy, what we really should do is take a broad, long look. By that I mean across different countries and long — hundreds of years — and say, “What could happen?” We should open up the possibility in terms of forecasting of events like the 1970s, like the 1930s. We should at least consider what we should do in the event we begin to tip toward those periods of distress, because I suspect that the 21st century is going to be a lot like the 20th century. That’s a scary prospect for investors.

Longer term, the markets went up but there was a lot of fundamental institutional change. It was at any given time hard to forecast a continuity in the institutional structures. We ought to be prepared for those kinds of changes and occasional serious crises.

Mr. Gundlach: The longer-term inflation/deflation argument is very important. It’s my view that the bond market is carving out a very long-term bottom in yield. It’s been under way actually for about six years, back to ’02. I think it’s going to go on over the next 18 months.

I don’t expect interest rates on government bonds to rise meaningfully at all … over a six- to 12-month timeframe, because the economy is limping along. We have five months of negative job growth. Even the most optimistic forecaster doesn’t think that that's about to turn around. We have a major stagflation problem for the middle class and this has been the case for quite a while with obviously (rising) gasoline prices and food prices.

Yet, there is no concern on unit labor costs, which are only up 0.7% over the last year. A year ago, the 12-month number was over 4%. So we have a major problem with the middle class and lower middle class. That’s starting to play out politically, which is manifesting itself … in tremendous anti-business rhetoric and taxation schemes being put forth, which really are not going to solve the problem over the long term but might make some people feel good at the voting booth or over the short term. The government bond market is not likely to go to much lower yields, but I don’t see them going much higher.

Marty talked about the dollar-defense rhetoric that came out of the Fed. Sure, it’s interesting to hear them say that, but when it comes to dollar-defense rhetoric out of the government, I’ll really believe it when I see it. These guys have been talking about supporting a strong dollar policy and the euro has doubled over that timeframe. I don’t think it’s possible for the Fed to raise interest rates with negative job growth … There’s almost no or maybe literally no historic precedent for that.

So with this “on the one hand and on the other hand” (dilemma) facing the Fed, it would seem to me that we’re back to the “rates on hold for a considerable period” type of regime where it will be very interesting to see how the trends change. We do know that headline inflation is going to be a problem. Gas prices alone are already going to add, at $4 a gallon, about eight-tenths (of a percentage point) to the CPI headline over the next three months. If it goes to $4.50, which is entirely possible, then you’re talking about 1.25 (percentage points) being added over the next three months.

So that inflation problem is out there, but the economy is very weak from the long-term hangover of an economy that’s been deficit-financed for 30 years, with the government spending more than it takes in, with small exceptions along the way, and the consumers —particularly in the last several years — spending more than they take in.

The economy in the U.S. has hit the wall as regards to spending your way to prosperity. One thing you know for sure is that airlines are in trouble, the auto industry is in trouble, retail is in trouble. One thing you know for sure is middle America is not going to get in the car at $4.50 a gallon to go to the mall to buy more stuff that they don’t need with money that they don’t have. I don’t see how we're going to get a spike up in interest rates even with the headline inflation problem from energy and food prices.

Mr. Chernoff: That provides us a good segue into looking at equity. I'm getting more and more depressed as this goes on. I don't know about other people but —

Mr. Gundlach: You have put together the wrong panel.

Mr. Leibowitz: I loved your last comment. It sounded just like poetry — ominous poetry, but poetry.

Mr. Chernoff: Jeremy, would you kick things off looking at both the U.S. and the global stock markets?

Mr. Grantham: Yes, I would. I just want to add about the poor Americans paying four bucks a gallon, I pity the poor Brits’ $9.50 a gallon. They've been paying over $4 a gallon for years.

Mr. Gundlach: I didn’t say I feel sorry for them. I said they feel sorry for themselves.

Mr. Grantham: On the stock market, I would say, one, I’m pretty certain that the equity investors globally will be disappointed, perhaps even very disappointed, with their returns (for) some time out in the future. … my guess has always been since ’98 that the likely low of a major bear market would be 2010. That would give us 10 years from 2000. That would be a fairly ordinary long-term bear market following the biggest bull market in American history. Perhaps, if that doesn’t work, 2014.

Great bear markets that follow — exclusively incidentally — the great bull markets always take their time and work through and tease the bulls and the bears to death. But profit margins are abnormally high; they’re just coming down now from the highest they’ve ever been globally in history by a lot.

When you look at the pressures on profit margins, it’s virtually certain. The U.S. market, of course, is in denial. Jan. 1, (profit margins were) going to be plus five for the first quarter, came in almost -20. Second quarter, April 1, (they were) going to be plus four. (They) will almost certainly be down double digits, and, yet, the estimate for the fourth quarter is still plus 15. I don’t get it, but they do denial very well. There’s plenty of room for disappointments.

We try and focus on what I would call near certainties. It’s nearly certain that the risk premium — which was globally at an all-time low, even perhaps negative in June of last year for the previous 12 months — would widen a lot. Obviously in the fixed-income market, the risk premium has widened dramatically but within the equity market everywhere it has not. The junky stocks stood off the high-quality stocks last year and this year they’re ahead. It goes hand in hand with these loony earnings forecasts but I think it’s setting up a period of several years where quality stocks and conservative stocks are going to beat the pants off risky stocks.

Just a word about perma bulls and perma bears. We were just looking at the 10-year data. The 10-year data for U.S. equities is plus 1.5 (percentage points) real. For 10-year governments, plus 3.5 (percentage points). For EAFE, plus 5 (percentage points), and for emerging (markets), plus 9 (percentage points). There’s hardly a country in the world that the U.S. has not underperformed in the last 10 years, and 10 years from March of ’98 — that was far and away not the top of a bull market. So, in a reasonable test, U.S. equity bulls have just been disappointed and disappointed over 10 long years and have not been held to task. Whereas perma bears have, even though in general we have been right.

It’s an interesting testimonial to the enormous positive spin that everybody has developed in the investment business. Give them half an excuse to have great earnings and imagine great returns for the stock market and put a positive spin on everything and they have learned to do it. It’s part and parcel of the great credit bubble.

We’ve had this bubble in euphoria, often inexcusable euphoria, and we are in the process of paying for that over many years.

Mr. Nankof: If we look at the way we forecast markets for our clients, the shortest time period we tend to look at is a 10-year period. But this year, 2008, marks the first time that a traditional 60/40 portfolio is forecasted to return below 6% for our clients or for investors who are in a non-diversified 60/40 portfolio. And that’s not taking into account mean-reversion, as Mr. Grantham would point out as certainly a serious potential (threat) facing institutional investors ...

If you look at return assumptions for pension funds across the U.S. — broadly speaking around 8% — many of them will be very sadly disappointed, if you look out five, 10 years from now at the returns that they do realize from non-diversified or even diversified portfolios across the global equity markets and fixed-income markets. Return expectations, given the environmental we’re living in now, must be lower than they’ve been for a long time …

The exceptions would be the emerging markets. It amazes us all the time when we’re criticized for having a 200-basis-point premium for emerging markets over the U.S. or developed markets when growth in those markets is well in excess of 200 basis points above the U.S. and other developed markets. So we’re not optimistic for institutional investors to realize returns much north of 6% or 7% from diversified portfolios across fixed-income and equity markets over the next five to seven years.

Mr. Goetzmann: I’m going to be a contrarian and make a case for what I think is a positive medium-term outlook and longer-term outlook for equities. I think equities in the United States fell out of favor with the bursting of the tech bubble, and I think that throughout the early part of this decade we’ve seen a quest for alternatives to equities.

We’ve seen the growth of the hedge fund sector as a diversifier but also a source of expected returns. We’ve seen U.S. households turning toward their home as an investment as opposed to the equity markets.

Thirdly, what we’ve seen this decade is growth in the private-equity sector, the likes of which we had just not seen before. The belief that some really smart investors could come in and find undervalued corporations, fix them up, leverage them up and sell them back to the market is just a surprising concept if you believe that the markets are efficient. But if you believe that perhaps equities in some sense were undervalued in the early part of this decade, then a private-equity sector makes some sense that perhaps there were companies that were undervalued and could be purchased and the value realized.

We hit a peak in the late ’90s or mid-’90s in the belief of the long-term equity premium. We had a lot of indexed money at that time. There was a sense that the equity premium going forward would be equal to the equity premium looking back, which was something like six (percentage points) real over much of U.S. and global market history.

But the faith in that equity premium was dashed by the bubble and crash. Therefore, the prices we’re looking at in the equity markets now are really rather pessimistic prices. If I’m right, then what we should see is a modest positive expectation consistent with the long-term historical equity premium. That would put it in the range of six (percentage points) real, so that would make me a wild optimist in this world.

Mr. Gundlach: I’m sort of in Jeremy's camp for a secular view. They say that a second marriage is the triumph of hope over experience. I think equity investors are living in that same type of a mindset. The statistics that he points out are things that I think about frequently: just how puny equity returns have been for 10 years. As Jeremy said, if you roll a year and a half forward from now, the 10-year numbers are going to look much worse … The S&P this decade … (is) flat on a total return basis. Some days it’s slightly positive. Now, thanks to last week’s (return), probably back to zero or negative.

What Will says I have some agreement with, but I think the overarching issue that I agree with … is the shaking of confidence. You mentioned the shaking of confidence from the tech bubble. Certainly, that was the case. You certainly haven’t seen retail flows going into the equity market for a long time. That’s one reason for optimism. If that would ever change, that would be a positive.

But the bigger issue is the shaking of confidence … in the financial structure, this idea that you’re going to innovate new product your way, slice-and-dice, private-equity-buyout your way to prosperity, has come under some pretty serious question in the last 12 months.

I keep going back to the political environment, which I think is really important here. There’s a tremendous mistrust of Wall Street … now on Main Street and growingly in Congress where (Sen.) Chris Dodd said something that I thought was very well put. He said it seems like we have privately owned reward and publicly owned risk. I think that that strikes a chord with a lot of people. The greatest thing about the U.S. financial system, one of the great things for being long-term positive on the U.S. economically and in securities markets is (that it’s) the best, the most innovative, the most flexible financial system.

But if that’s under attack, which I deeply believe it is increasingly, I see that as pulling out one of the substantial benefits of the investment thesis. I think the stocks have been in a bear market since ’99 and 2000. You could look at the nominal value of stocks and they look flattish on a total return basis. If you compare them to anything else like gold or real estate, even though it’s down a lot, the purchasing power of a share of stock is down 75% vs. real money since the top of the market. So we’re in a mega bear market. People are in denial about it. There are opportunistic things always, but broadly speaking, I’m not optimistic on the real purchasing power improving for the equity markets, at least the United States market.

I’m less qualified to talk about some of the emerging markets … I do think your two (percentage point) excess return, Joe, sounds completely reasonable to me. I wouldn’t challenge that for a second, a two (percentage point) return premium on emerging markets would be sensible. I would think it’s on the low end, not on the high end. There are others on this panel that probably have more facts and figures and deeper concepts in that area than I do.

Mr. Leibowitz: Will, I was intrigued by your earlier comment about this century may end up looking more like the last one. If I recall, you were one of the co-authors of a paper called “Survivor.” When you’re talking about periods where wrenching change goes on, that’s the kind of thing which is well (worth) paying attention to — that the extrapolation of the past may be a very bad gauge to the future in such environments.

Jeffrey, on the quote about second marriages: I must tell you that one of my friends, who I will not name, was asked what he would do if he had the chance to do it all over again. His comment was: “I would have married my second wife first.” I think that's worth thinking about; this triumph of hope sometimes does play out.

A lot of the discussion we’re having here depends upon the flow of savings funds and where they’re directed and misdirected and where they’re coming from and the momentum force of those flows themselves vs. the intrinsic values — that’s an old-fashioned term — that exist in the various asset markets. The intrinsic values always take a longer time to play out. This may pertain a bit to Jeremy’s theme than the short-term flows of funds. The flows of funds these days are indeed awesome and they’re coming from many sources ...

Sovereign wealth funds are much discussed, but I think another one, which is a very, very important phenomenon, is the growth of defined contribution funds, something dear to P&I’s heart. Throughout the world, (there are roughly) $28 trillion in total retirement assets. I heard a surprising percentage worldwide — we know it’s happening in the U.S. in terms of rollover IRAs and so forth — but the growth of various forms of defined contribution (plans) throughout the rest of the world is eating into a higher percentage of that.

Certainly, the new flows are coming into that type of format. DC funds are fundamentally different in terms of not so much their current investment strategy, but in terms of the resilience, stability and vulnerability that investment strategy (has). People getting closer to retirement find themselves in a more fragile environment in terms of their ability to take risk. Basically, they have what is not a continuously long-term view that a defined benefit plan can at least tend to have. Although, that’s changing too these days.

That is a powerful factor to give serious consideration, because the flows of funds are one thing, the intrinsic values and intrinsic risk premiums (are another)… You can have risk premiums shrink under the flow of excess money, but that doesn’t necessarily change the risks that one is facing. One of the questions is: Does excess flows, or additional flows like in private equity, … is it not just raising the pricing, lowering the risk premium, but is it creating more intrinsic value? And there are some areas where it does and there are some areas where it doesn’t. Where it doesn’t … whatever you call it — a bubble or not — it’s basically robbing from the future to pay the current past owners.

I hope that’s a clear answer about what the future holds.

Mr. Chernoff: It raised about 50 questions in my mind, but I think that will be a whole different panel. But I’m really glad you brought in the institutional angle because that advances us to the next question. Joe, how have institutional investors changed the way they manage their portfolios to take advantage of market dislocations. Are they better situated now than in the past?

Mr. Nankof: We would say that if you look at recent market events and how our clients and institutional investors have responded by putting capital to work, they probably exceeded our expectations … in their ability to move capital in a historically rigid framework that institutional investors lived in. The mobilization of capital into funds that we prefer — longer lockup funds that are not going to be subject to regular liquidity (demands) like hedge funds. We don’t think hedge funds are the best-positioned vehicles to take advantage of some of the market dislocations that we’ve seen recently. We think longer lockups make a lot of sense.

Let’s match assets and liabilities here … either within broad alternatives allocations in their portfolios (or) changing allocations in their portfolios to move capital into areas where they perceive there to be greater opportunities.

Part of it is the realization of what we discussed earlier: The public bond and equity markets in the developed world are not going to provide the returns that they’re looking for, for the next five to seven years. (Those markets won’t) preserve or possibly improve funding levels in their plans, which are now at much lower levels than they were eight years ago.

Beyond that, they’re adjusting to create opportunistic allocations. There’s been a lot written on this recently — Andrew Lo, Peter Bernstein — the idea of being more flexible in your allocations as opposed to looking at them as they have historically in a more rigid framework. So we see a lot of change going on among the leaders in the institutional investing world where people will be more opportunistic going forward.

Mr. Goetzmann: No doubt that institutions have over the last few years been changing their portfolios. I think much of that has been healthy. We did a survey at Yale about four years ago where we asked institutional investors about their interest in real estate and what else they were moving into. There was quite a broad desire to increase exposure to real estate. A lot of people said that they were not at the allocations they wanted to be.

The other thing that was really curious about that study was the extent to which institutional investors really didn’t have a good idea about what the risk of and return characteristics of the other asset classes were that they were investing in. Let’s just take hedge funds. We don’t have a long history of hedge fund returns. People just sort of said they didn’t know what the risk and return characteristics were.

Venture capital is a really important asset class, but the time series of returns for venture capital investment is just not of the quality that you have for other asset classes. It’s fascinating. We’re in a period when institutional money is flowing into things that we have a difficult time measuring long-term performance.

It may not be a bad thing, but we’re dealing with uncertainty on a regular basis. What’s the long-term payoff to private equity? We have a few funds around that can show us some great returns. But do we know as an asset class that this is the right thing to do? I just don't think we have the evidence yet.

So this pushes you against the notion of top-down asset class allocation and the notion that anybody (who) hangs out a shingle within an asset class might be able to replicate the average returns for that investment.

Mr. Gundlach: Those are two really good points from Joe and Will. I agree with Joe that institutions have become more flexible and seem to have carved out so-called alternative buckets, either outright or within fixed income ... It’s just a fact: institutions have become more flexible in the way they handle their allocations.

That may be a good thing and it may be a bad thing. The good thing: Perhaps they will receive the benefit of higher returns in exchange for (investing in) emerging markets or being paid for (being) a liquidity provider. But what Will said is really on point. Investors have increasingly bought into things that they simply really don't know what the outcomes are, what the risks are.

In fact, it’s occurred to me over the past several years that the less investors seem to know about an area, the more willing they are to go into it. Nothing can show that more definitively than hedge funds that don’t tell you what they’re doing. The more you tell people what you’re doing, the more they have the ability to seize upon a perceived risk or complexity that’s frightening to them. I think that that’s dangerous.

Also completely missing from the calculus that people are making are transaction costs. Institutions lose tremendous amounts of return through transaction costs. My personal experience is very rich in this regard. I’ve managed institutional money for almost 25 years. You just see a regime change in institutions for whatever reason — some new person in, some new consulting firm in … you see people that say, “I want to sell bond portfolio A and buy bond portfolio B.”

Only in the smallest microscopic way of thinking about it have they made a substantial change to what they’re doing. Yet, they’ve probably incurred a transaction cost when they do that that optimistically eats through six or eight years of hoped-for incremental return, because in fixed income your incremental dream is not that robust.

It’s amazing how much money is lost. Even if the paper portfolio concept of shifting from A to B was successful, the implementation is very ugly and is very exposed to leakage. How much more must that be the case when people move from private equity fund A to venture capital fund B?

So I think there’s a little bit of a mismatch between short-term opportunism and what rationally you should be thinking about in terms of staying power and transaction costs and these opportunistic ideas. I certainly do see greater flexibility and moving around more opportunistically from institutions.

Mr. Leibowitz: I have the vantage point of sitting on a number of endowment and foundation investment committees. A couple things are quite notable. Every single one of them, to varying degrees, have achieved extraordinary returns over the past three, five and, in some cases, even 10 years. I should quickly say this is not anything that I could claim credit to doing much more than just observing.

They’ve all had a combination of interesting asset allocations, which I won’t touch on, and very, very good chief investment officers (and) staffs who have been able to go into some of these alternative investments in a thinking way. That's key, because to just try to throw darts at alternative investments broadly is a prescription — I think David Swenson, in his book, wrote about this, the wide returns you can get — for being on the left-hand side of whatever distribution exists there.

There are several (common) characteristics, but, first of all, they have very low U.S. equity allocations. They have very low traditional-type U.S. fixed-income allocations. Their investments in other forms of international emerging market equities, private equities … venture capital … commodities of various sorts, real assets in real estate or, in some cases, timber, have been great productive investments over the past period of time.

A couple of things are worth noting here. First of all, these are not huge pools of assets. One of them obviously is $40 billion, and your $12 (billion), whatever it is.

Mr. Goetzmann: 20.

Mr. Leibowitz: OK, going well. Good year.

In the scheme of things, these are not comparable to the sovereign wealth funds. They’re not comparable to the big DC plans. They’re not comparable to the big DB plans, the governmental plans. They’re small potatoes, which is a great advantage in the sense that the monies they can deploy … takes a lot of work and a lot of effort.

If institutional investors as a group were to pour into some of these asset classes in a willy-nilly way, it would create some dislocations. (That) would create opportunities, but would also create basically the analog of bubbles, would create shrinkage of risk premiums and would not be a positive experience for large investors to try to follow the so-called endowment models.

Another thing that’s worth noting is that the endowment or foundation model tends to have what you might consider a single client. You could quickly amend that the single client sometimes has multiple points or very strongly articulated views. But it’s still one basic entity that they’re trying to serve, as opposed to many of the institutional investors or managed funds, which have many different agendas in some ways and many different stakeholders who can push them in various ways, especially with regard to short- vs. long-term horizons.

Again, I would just say that the movement toward the endowment model is not for the world at large, even though I think that’s been a kind of a fashionable thing to talk (about).

Having said that, it doesn't follow that, A, sticking with the standard 60/40 type model for pension funds makes sense in this environment, or, B, sticking with any model rigidly, any strategic policy portfolio without more flexibility, makes sense either. Those are going to be great subjects of discussion going forward because it’s not a question of strategic rigidity vs. tactical chaos. It’s a question of finding the balance between the two.

Mr. Grantham: Before I get to that, which is a great topic, because I spoke first, I missed an opportunity to respond. Emerging came up quite a bit and our last quarterly letter had something called “The Emerging Emerging Bubble.” We have a wonderful fascination for top-line GDP growth and for that matter top-line sales growth in corporations.

Clearly, emerging (markets equity) has it. Clearly, the developed world, including the U.S. now, is suffering from what I call an irretrievable case of middle-age spread. We’re last year’s story. If you want to be conservative, buy a few dopey blue chips, utility companies and some U.S. and European stocks. If you want to make money, buy the top-line growth in emerging. It’s a great bubble story.

I’ve never called a bubble. I look at the last two bubbles. Nasdaq sold at three times the p/e of the rest of the world and Japan in ’89 three times the p/e of the rest of the world and they were crummy bubble stories. This is a great bubble story. So how much of a p/e premium are you going to give me? Surely it’s going to sell at a 50% p/e premium sooner or later. If the credit crisis gets in the way, they may get whacked first, but they’ll probably get there in five years, and if we stumble through, they may get there quicker.

Now, to get to this delicious issue. No one is really talking about what the clients are doing to take advantage of market dislocation. They’re not doing much. What they are doing and what we’re all talking about is, in a sense, much more long term and much more powerful. It’s what I’ve called, “Let’s All Look Like Yale.” I have a couple of pieces, which are totally free at GMO.com. The “Let’s All Look Like Yale” is a huge factor. Marty was talking about it.

The early movers have outperformed by five points a year over 10 years; the top dozen and sophisticated, mainly endowment, funds — but a couple of Ontario Teachers thrown in. Everybody who has any aspirations in the medium-size endowments and foundations has been following them as fast as they can. Now, the pension funds with aspirations of following and even some state plans are moving pretty emphatically. So there’s a wall of money moving into “Let’s All Look Like Yale.”

What that means is diversification, broad-based permanent diversification. Not asset movement, which Yale basically does not do, but a fairly permanent, more efficient, more diversified portfolio. A lot of these new investments are not asset classes; obviously private equity and hedge funds are not asset classes in any straight sense of the word.

Some of them are like forestry, but forestry and others are desperately illiquid. You simply can’t have everyone owning a decent forest portfolio like Yale and Harvard. It does not compute. At the top of the market in 2000, the world’s forests … totaled together didn’t have the market capital of Microsoft. So if you all try and buy forests, you’re going to do what you’re doing, which is to say that the price of a forest today is over twice what it was three years ago. Even though lumber is in ragged disarray, the forests still sell at a huge premium to what they used to sell at.

And you pour money into private equity. By the way, you don’t need private equity to be cheap to justify the boom; you only need debt to be artificially cheap to justify the boom. It was much more debt-driven than it was opportunity-driven. The opportunities were perfectly ordinary, in fact, subordinary, but the debt was wonderful, and the money you could make with that kind of debt at that kind of price is spectacular, even if you have no alpha at all, and on average they have very little.

And that gets to the heart of the problem: There isn’t enough talent to go around to have everyone look like Yale. There aren’t enough talented hedge fund managers or private equity managers or venture capital managers or real estate managers. And there isn’t enough alpha to make it interesting. So they’re going to pump money into illiquid and undertalented areas and they will have, from time to time, considerable pain.

This is the paradox. In the end, of course, they are more efficient portfolios. So you have got to end up 10 years from now, 20 years from now, if you’re a large pool of money — including sovereign (wealth) funds, several of which would like to look like Yale and are in the process (of doing so) — you’ve got to end up with a broadly diversified portfolio. You’ve got to get there through a minefield where there’s much too much money short term chasing after limited opportunities and limited talent. So it’s chaos and confusion.

What we’re doing in response to the current market dislocation is saying, we didn’t have enough talent to deal with all these arcane problems that this rather sophisticated fixed-income bubble has thrown up. We would like going forward to have the talent to exploit any inefficiency, any dislocation in any market anywhere in the world and so let us get out there and hire talent in diffused areas. Not easy but a lot of fun, and we’re actively doing that at GMO. [email protected] Any good talent, let me know.

Mr. Chernoff: The issue of diversification came up repeatedly during this past question. So far, has diversification paid off?

Mr. Goetzmann: I can't argue with the extent of diversification we see as a trend, even if it’s slightly misguided by the notion that one could imitate the performance of this handful of endowments. The key to the claim, though, that you could diversify into illiquid categories, is the notion that your endowment has got a very long life, that you could exploit the liquidity premium by not having to draw on your resources. That tells you that the liability side is actually a really important gauge to whether or not you could afford to extend into investing in forests or private equity or venture capital.

The real ultimate measure of whether or not this has been a good thing is going to take a long time to play out. Again, it comes back to how well the assets have matched the demands of the liability side for these institutions.

The hedging of inflation risk is really important. Real estate is, in the long term, a great inflation hedge. Short term, if you bought into a commercial real estate portfolio six months ago, you’re probably feeling kind of sick right now because of the short-term trends in the commercial real estate market. Long story short, it’s too early to tell whether it’s hurt or helped institutions, but my guess is any kind of extended diversification is going to reduce risks.

Mr. Nankof: It’s pretty clear if you look at performance across asset classes. A number of comments and data have been provided on the disappointing performance of the U.S. equity market, which takes up — save the top 15 to 20 endowments, pension funds we’ve been talking about — a dominant share of the portfolio risk; even if it’s only 50% to 60% of the assets, if you look at it in risk allocation terms, it’s well in excess of 90% of the risk. Investors have started to look at their portfolios in this way, and it’s a healthy thing.

The expectations or the hopes for diversifying and what they will add either to return or to risk reduction are much more modest than the 500 basis points that Jeremy alluded to that some investors have been able to realize who have been early movers.

But I would somewhat object to the point made by Will that some of these markets are less liquid. We have clients investing in emerging market debt for 20 years. Last time I checked, that’s probably a lot more liquid than some AAA U.S.-issued securities, mortgage-backed securities. I don’t think there’s much of a market trading those securities these days. Emerging market equities also (are) quite liquid.

We would agree that hedge funds are not an asset class; they’re a vehicle to get exposure to a wide range of things. But there’s no question that diversification has paid off and will continue to pay off over the long term. Hopefully, U.S. institutions in general will continue to realize that and more appropriately allocate their risk as opposed to just looking at assets across a wide array of asset class types.

Mr. Leibowitz: Joe is absolutely right that if you look at just about any institutional portfolio, including the highly diversified endowments, an overwhelming percentage — 90% or often more — of the risk is associated with just the co-movement in home equity markets.

A corollary of that is that most of them tend to have roughly the same ex ante volatility. So even when you diversify your short-term risk and short-term volatility, which has been, I think, masked in some ways by what has been extraordinary returns in these diversifying investments over the past several years … the risk level on the basis of any kind of standard return covariance matrix is still 90% associated with equities even when you’re diversified. (That’s) because of the ways in which diversification has taken place and the fact a lot of these diversifying assets do have pretty significant correlations themselves with U.S. equities, and because not only has equity been used to fund this but so has fixed income, which is perhaps the least correlated. So you really haven’t changed a lot of the short-term risk characteristics of most institutional funds.

One other thing, which I think is important, is that in a period of stress your correlations will tighten. They may not all go to one like the usual saying goes, but they will tighten. When they tighten, it’s going to be the diversified portfolios that are hurt the most — not the standard 60/40 portfolio — because you need something to correlate with.

So there is some time bomb sitting out there, which is not an argument against diversification, but it is an argument for thinking that diversification helps you short term on the one hand and another argument that says that … willy-nilly diversification is not necessarily a good thing.

For example, the issue of hedging against inflation, something which may be a good hedge against inflation may be a lousy investment at a given point in time. TIPS (Treasury inflation-protected securities) these days, (with) negative real rates … (are) just too expensive.

One has to be careful as to the nature of the diversifying asset or the hedging asset and the pricing and return that it offers going forward. In an arena where there are these fashionability bubbles that we’re talking about, that’s going to happen more and more. These issues have to be handled with more and more delicacy as we go forward.

Mr. Gundlach: Diversification, not only is it often done willy-nilly, I’ll go one step further.

Diversification is one of these words that has this great positive kind of thrust behind it like “alpha,” like “up.” Diversification often is used at an investment committee level as a Trojan horse for justifying a badly timed investment into a beta that has been successful over the past several years. I think that that happens more often than not.

Mr. Chernoff: Managers have raised billions of dollars in (credit opportunity) funds, TCW among them. What are the risks, what are the opportunities in this area?

Mr. Gundlach: In a so-called distressed fund or distressed market, the risk is that what you think is low, turns out to not be low. I started this discussion mentioning subprime. There is no distressed opportunity in the lower reaches of subprime. If you take a look at that index that got so much attention back in the first quarter of ’07 — the ABX index — it was an international crisis when a BBB minus index got to 70 in March of ’07. I know that because I was in Europe, and every time I picked up a newspaper they talked about subprime and the ABX index at 70. There are a lot of people that thought that that was distressed and cheap.

Then it dropped to 50. It started to disappear from the newspapers because it was an old story without the same kind of splash. But then it went to 30, and then it went to 20, and then it went to 10, and now it’s at five offer, no bid. Because the distressed part of subprime — the true bottom layer of subordination— is worth zero.

So it’s just a question of how much interest you’re going to get until it gets shut off through loss allocation. The danger here in distressed investing is people apply regression-based or historically based valuation ideas to determine what distressed is.

However, having said all that, we at TCW have raised billions of dollars — particularly my own fund, which closed July of last year, which is a long time ago now — for distressed opportunities in MBS.

We’ve come to the conclusion that the best opportunities are those that are the safest for a variety of reasons that all coalesce together. But instead of trying to be cute and think that something at pennies on the dollar is a great opportunity that has exposure at the first or second and even third loss position, you’re better off in the most senior part of the market where there is at least no case for a total wipeout.

… If those investments are not going to pay off profitably with very high risk-adjusted levels of returns, then you are looking at a very, very massive depressionary scenario in the United States.

Somebody mentioned the Alt-A market is another shoe that might drop. The Alt-A market is enormous. It’s in the $1 trillion category. About 85% of it started out life as AAA at the senior part of the capital structure and 15% lives below it.

That market … people bought it because they thought there was no risk. After all, it said AAA on it, and there was no historical precedent for that AAA being called into question. Those people that own it own it naively and need to retrade it. In many, many cases, a lot of it is locked up in structured finance vehicles that will default and need to be liquidated. Some of that is happening now. Others are owned relative to guidelines that don’t allow them (the securities) to be owned. Others are just not willing to live with the volatility that they’ve ended up living with. So this market has been sort of periodically for sale.

But when I talk about the opportunity there … if it’s not an opportunity, then certainly parts of your portfolio are headed to the gallows. It’s because when Alt-A gets cheap at the AAA level where we invested some of our fund that closed last July … You could default 60% of the mortgages underneath those pools and assume a 70% loss to the loan upon liquidation of the property, which means an 80% loss vs. the original believed value of the property, and still, at the absolute darkest moments, walk away with yields in the teens. If those mortgages default at a higher rate than that and/or have a higher severity than that, every major bank in the United States is bankrupt, period. That may be the case. We need to hope it’s not the case.

Since Jeremy mentioned his letter on GMO.com, I write about this frequently, and there’s lots of detail on this topic at TCW.com in my chief investment officer letters, including one about a month ago talking about the high probability that this market would soften up again, which has already happened.

But the way to think about it in terms of an opportunity — in the distressed mortgage market anyway — is, if those investments don’t pay off at the cheap levels, you’re still probably talking about small positive returns if you really paint the death case. Whereas most investments aren’t priced with that sort of cushion because they’re not so badly owned and so dislocated and so technically challenged in the market.

So that’s the concept. I would suggest that some of these other categories — people talk about bank debt and other sorts of corporate loans. Certainly, historical default rates would make investments in some of those categories today not work out. If you saw default rates that approximate what you saw in the early ’90s or in the earlier part of this decade, those investments wouldn’t work out. From a distressed perspective they probably need to cheapen further.

Mr. Leibowitz: I’m just in awe. I don’t think I have anything to add.

Mr. Grantham: I agree, pretty much too. The prime mortgages last month were defaulting at a higher rate both percentage-wise and in absolute numbers than subprime defaults.

Mr. Gundlach: That’s because there's more of them.

Mr. Grantham: Yes, of course. But even the percentage from the tiny to the increment — they incremented at 50 or whatever percent and subprime incremented at a lower rate —

Mr. Gundlach: Does anyone here know what the default rate is right now on what still remains of the ’06 vintage of subprime? Does anyone have a guess at what the default rate is right now?

Mr. Leibowitz: It’s not that bad.

Mr. Gundlach: No, it’s outrageous … almost 40% are in foreclosure of the ’06 vintage of subprime. It’s unbelievable. And the ’07 will be as bad, but it’s a little bit down the seasoning curve.

If you take the total securitized subprime market right now, which includes all the vintages put together, it’s 28%: 60%-plus are in foreclosure, and in our world today, 60%-plus you could just send it to the graveyard at 60 days delinquent. Twenty-eight percent of them are that bad off.

Alt-A is 12%. Prime is about 2%, but as Jeremy correctly points out, it’s accelerating on a percentage basis in a very alarming way. Subprime was 20 basis points delinquent forever. And last August, with all of the publicity around this topic, it had the effect of ringing a bell that basically took some of the moral negativity away and people said it’s OK to default. So prime is going up 20 to 30 basis points per month right now. Very, very scary.

Mr. Leibowitz: What is the prospect, given that level of deluge, that there will be a political response that will basically create some form of standstill?

Mr. Gundlach: That’s a very good question. My view is that whatever is done politically will probably not really hit the sweet spot of the problem. It will not really solve the problem.

You talk about all these solutions that are out there. We hear about them. “Write off the principal” and there was the “don’t let them reset,” but there are big rights and contracts and different interests that live at the security level. It seems to me that it’s only possible to do modifications and major things to loans that are still owned by the lender. Once they go into the securitized market, there’s just too many constituencies. Eighty percent of many of these categories have been securitized, so it’s very difficult.

It’s a very, very interesting question. I think the way to approach it is just keep your mind open because nobody knows.

Mr. Chernoff: Of course, a lot of quantitative equity strategies have also been hit by the fallout from the subprime crisis. Marty, what is the longer-term impact on quantitative strategies?

Mr. Leibowitz: People who run the quantitative strategies are obviously very acutely aware of what transpired starting last August. Many studies have been done on that, including Andy (Lo)’s. They are strongly trying to address ways of trying to get around that kind of correlation with each other and with some of the underlying credit availability.

One of the things that’s really quite remarkable, which has caught people off guard, is that their excess return correlations typically were not that high in the earlier part of ’07 but the correlations soared when things started going badly.

I guess that’s not too surprising, but when you think of it soaring from the 20s to the 80s, what you find is that you could be generally low correlation under normal times and yet under the times when it matters you could find yourself in a particularly bad form of soup. Everyone I know is addressing this very seriously, (they) are trying to find ways of essentially protecting that tail and that tail correlation from (becoming) the same problem again in the future.

Quantitative strategies are very resilient. They are malleable and I think that it’s too early to sound a (death knell). I don’t think the bell tolls for them. I think they’ve heard a warning bell, but I think they’re responding to it.

Mr. Grantham: I agree with all of that. However, I do think the good old days when you could show up armed with three ideas — value, momentum and discipline — and expect to get paid an annuity have gone. You’re faced with some tougher decisions about the interface of quant and qualitative judgment, about when an asset class or sector has gone simply too far and you have to override. The problem quants have with these concepts are profound. I like to describe them often as stepping off the cliff with considerable discipline. Somehow they have to find a technique for identifying the cliff edge. The data just doesn’t go back long enough.

They have a model that deals perfectly with the last 10 years, seven years, 15 years, 20 years. Completely new things like this current credit crisis are always happening to do different things that the model simply doesn’t know about. How can you expect it to know if it isn’t in the model? And, therefore, you have to be more flexible. That’s the area we’re entering.

Mr. Gundlach: That would seem obvious to me. I don’t understand how so many people get involved in investment strategies that take the past, run it through a regression model with bells and whistles on it, and then say, “This is great. This is going to dictate the future.” It would seem that at a very basic level, intelligent people would reject that idea.

Mr. Grantham: I can tell you one semi-reasonable reason they might do that: It is because for 30 years, it trashed the active managers. That’s a pretty good reason.

Mr. Gundlach: Yes, I know.

Mr. Grantham: That will catch most clients most of the time. It trashed them for very good reasons and that is to have more discipline, more diversification and more attention to transaction costs than the typical stock picker. They are huge reasons, but they’re not enough for the new world where everybody has caught up.

It’s like an arms race and we just had a machine gun for 30 years and it was great. Now, the enemy has tanks and we better damn well develop some bazookas or whatever they were.

Mr. Goetzmann: On this question, I would be critical of academia. A lot of these ideas for models have come out of academic minds and been brought to the Street. As Jeremy says, they have paid off handsomely for a stretch of time. What we’ve learned in this last series of events is that there are many more funds than models and … as the reliance on the handful of models that you could trace almost culturally to a few universities have —

Mr. Grantham: Ooh, that hurt.

Mr. Goetzmann: — have attracted cash, the spreads have —

Mr. Grantham: We were doing that decades before French and Fama showed up. When French and Fama first came out with book and momentum, I was embarrassed for them. Since the practitioners — the Windsor funds of the worlds, the Batterymarches of the world — had been actually using it in place as a money-making idea for 20 years before they wrote their seminal paper giving a new definition to the word “seminal”: seedy.

Mr. Goetzmann: When people piled into your strategy, it must not have been a pleasant experience.

Mr. Grantham: They dribbled in. One of the nice things that the French and Famas did, and Bill Sharpe (did), was promoting the idea that we lived in an efficient world.

Most smart people stayed away from the investment business. What is the point of going into the investment business if the market is efficient? So for 20 years, we owed them a lot. They kept the talent away, and then gradually the truth came out that we live in a behavioral jungle and the Goldman Sachses and everybody else got in line outside MIT to snap up PhDs and particle physicists, as we do.

Mr. Chernoff: Joe, do you want in on this one?

Mr. Nankof: I’m ready to jump in. We’re not quite ready to write off quantitative management … If you were, you might have to reconsider whether fundamental equity management has any merit either, because when we select quantitative managers we’re often looking for managers who think about the fundamentals and merely capture in a systematic way sensible views and signals on stocks.

In fact, if you look at the experience of 2007, to say it was purely a quantitative equity manager failure just for that period of time, would be missing a lot of what happened. Because if you look at deep-value fundamental players, they got killed, worse than quant because they had higher tracking error. If you look at it, it was a value-growth spread, because we know that quantitative managers in most cases have a value component to their strategy.

So now we’re writing off value like we did in the late ’90s where everyone — and Jeremy might remember that time — everyone was writing off value. We’re saying, we’re in a new paradigm, value doesn’t work. If it’s one thing we’ve learned over time is, the minute everyone is ready to write off a strategy, that’s probably about the best time to think about investing in that strategy with the best players in that market.

Mr. Gundlach: But you said you’re not writing it off, so not everyone is writing it off.

Mr. Grantham: Let me just qualify that. It’s a huge difference. In ’99, value was extraordinarily cheap, as cheap as it got in the Nifty Fifty era, which I never thought I would live to see again.

Last summer, value was expensive, despite one or two determined value managers saying to the contrary. On all the data that we have, value is simply stretched. It had had seven brilliant years in a row. That will usually get the job done, and it had got the job done. So value is extremely exposed, unlike the great ’99 opportunity.

Mr. Chernoff: Joe, what have investors learned about absolute-return and hedge fund strategies during this credit debacle?

Mr. Nankof: First, they’re not absolute-return strategies.

There is no absolute-return strategy in the way most investors naively had thought, which is these are strategies (that) can produce positive returns in any market environment. We have done a lot of work trying to help our clients understand when they do get into strategies like hedge funds, that they’re not absent of betas or market risks. In fact, they’re littered with market risks … That’s the way in many cases that hedge fund managers are making money.

If you believe that you’re getting into strategies which can survive a market like we’ve just come through and produce a positive return, you probably adjusted your expectations going forward … because it’s hard to find diversified hedge fund portfolios that have produced positive returns.

There are selective strategies. Macro strategies have actually in many cases done quite well in the last nine months. They’ve learned that they need to be more careful about understanding the market risks that are imbedded in these strategies. Obviously, the structure of the portfolios, the leverage that’s imbedded in the portfolios, and the asset-liability match or mismatch.

Mr. Chernoff: Will, you teach about hedge funds. Have you had to rewrite the curriculum?

Mr. Goetzmann: We’re in the constant process of learning about this structure of investing. The one thing you could say about hedge funds is that, despite my earlier comments, they do a lot of different things under this broad brand that we placed on them. So I think that what we learned about high correlations and betas, risk exposures among a core group of funds — I’m actually pretty optimistic about the long-term prospects of creative minds in that domain finding new investment strategies and frontiers in the capital markets to generate returns. Those opportunities will continue to be out there. I also think that when you have the kinds of dislocations that we’ve got, we’re going to see people like Jeff understanding how to take advantage of this disequilibrium and generate profits.

Mr. Gundlach: Absolute-return strategies really only work if you don’t mark them to market — in which case, just about everything is a good absolute-return strategy.

It’s funny, someone mentioned TIPS earlier … Forget about today’s pricing, which I agree is overvalued. But let’s say they were paying three or four (percentage points) over inflation, which is kind of how they came out, and actually got cheaper upon issuance to 4 (percentage points) over. A lot of people said this is a no-lose, this is an absolute-return strategy, I’m going to get inflation plus four. If it’s a 10-year bond, I know after 10 years I’m going to get CPI plus four; ergo, this has sort of an infinite Sharpe ratio because it is absolutely going to deliver this.

What they fail to understand is that doesn’t mean it has no volatility. In fact, one of the most amazing facts is if you actually do the work and you compare the TIPS return series and use its index as the CPI. Calculate that number and then calculate the broad bond market, the Lehman aggregate return series, and compare it to CPI; the Lehman aggregate has a higher information ratio than the TIPS index. Not by much.

Mr. Grantham: Only goes to show you how little use the information ratio can be.

Mr. Gundlach: I’m not going to agree with that. I’m not going to disagree with it, because it’s a different topic. But my point is that it’s remarkable that the thing that’s supposed to give you the infinite kind of risk-adjusted return vs. inflation — when you do it mark to market — you get an inferior return vs. that index.

Timber keeps coming up. I remember years ago that the rap on timber was, “Hey, the trees grow 8% a year.” There’s just something about that that’s hard to argue with. They’re growing 8% a year, but that doesn’t mean that they have an 8% return year in and year out. Again, it’s the mismatch between some sort of a concept of long-term return and (having) to mark them to market. Absolute return strategies — it sounds good, but to me they’re out there on a short-term basis.

Mr. Chernoff: Marty, if you were running a pension fund, what tactical shifts would you make to your portfolio this summer?

Mr. Leibowitz: If I were running a pension fund, I wouldn’t make tactical shifts. I would try to make strategic shifts based upon what was a carefully considered view of my liabilities … and my assessments of what are structural changes in various asset classes.

Mr. Grantham: I would attempt to work out what the long-term value was. I believe that at the asset-class level, there are huge inefficiencies like the tech bubble of 2000, the Japanese bubble, and so on. I would attempt on a multiyear basis to move away from the badly overpriced bonds towards the incredibly cheap ones emerging six years ago. REITs in 2000 yielding 9.1(%), TIPS at 4.3(%), and just be prepared to wait years and years to settle for my 4.3% real return until it became 1.5(%) or whatever and rotate away again.

Everything that I have ever looked at suggests that that increases your return and lowers your risk, even if you measure it as traditional volatility, so you get a higher Sharpe ratio. Half the bright world of endowment funds do it and quite a few of the best ones do not. I think the best ones are making a mistake not doing it.

Mr. Nankof: We’re not big on tactical moves either, so we would agree with Marty on that one.

We would agree with the criticism of willy-nilly diversification because the amount of upfront education that we believe is required for committees, boards, to make the proper decision with regard to diversification is enormous. We spend a good part of our time doing that. It’s really a constant evolution of adding diversification.

To echo an important point Marty made about the liabilities, we continue to encourage pension funds to look at the liability and understand the tracking error — the volatility of their assets around the liability. We’ve had (numerous) discussions with committees over the last several years where they have guaranteed us rates were going to go up, and they were not willing to put any interest-rate risk in the portfolio … Now we’re hitting new bottoms with regard to interest rates.

We believe that they should really take seriously the interest-rate risk that’s embedded in their liabilities and the volatility of equities, which make up a lion’s share of their portfolio risk … and do as much as they can to either justify it, A, or, B, more closely manage it and maybe hedge some of it.

So those are some of the things — continued diversification and pay attention to liabilities.

Mr. Goetzmann: I have to agree with everything that people have said before. If you’re a pension fund and you’re thinking about reacting decisively to current events in the market, don’t. Shifts in policy in reaction to current events have a real potential risk of whipsaw.

I would say that things that people should continue to work on and be aware of, and we’ve mentioned these before: How have interest rates and inflation environments affected the liability side? Understand your liabilities. A second thing is that in a downdraft in markets — where things like fraud and lack of real skill are being revealed — the human side of the investment process has to be paid a lot of attention. The quantitative top downside, where your decisions have already largely been made, may be is less important. But I would say those are the two things one might focus on.

Mr. Chernoff: Jeffrey, the last word.

Mr. Gundlach: Maybe what Will means when he says people should not react is a cynical view. They always react the wrong way and sell when they’re low and I agree with that. So in a sense I disagree but it’s really an agreement point.

What people should be doing is buying low. When we talk about Sharpe ratio, information ratio, it’s all buy low, sell high at the end of the day. What pension plans and endowments should be doing is trying to think about developing a strategy that facilitates their “buy low” of two areas that will probably, coming out of some of these problems, have robust returns.

One is real estate. Institutions for years have had real estate allocations underinvested and real estate is weak. I’m not saying buy it today. I’m saying put together the means to implement the strategy over a multiquarter, maybe even multiyear viewpoint.

The second area they should be funding up for goes to Jeremy's point, which is emerging markets.

Emerging markets probably are going to be challenged still through this period. But coming out of it, I completely agree with him when he (says) it’s a better bubble story than the other bubble stories and will be more profitable than the other bubble stories. The beauty of it is you have time to implement it because right now they’re going down.

Mr. Chernoff: I would like to thank everyone for a fascinating discussion.