Following is an excerpt from the round table. The edited transcript of the complete discussion can be found at pionline.com/roundtable.
Mr. Chernoff: 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 ... 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 ...
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 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 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: 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.