Participating in the What's next for asset allocations? round table were:
• Nancy Everett, chief executive officer, GM Asset Management, New York
• Rumi Masih, managing director and head of the strategic investment advisory group, JPMorgan Asset Management, New York
• Cynthia F. Steer, chief research strategist and managing director, fixed income, Rogerscasey Inc., Darien, Conn.
• Hartley R. Rogers, chairman, Hamilton Lane, Bala Cynwyd, Pa.
• Michael Travaglini, executive director, Massachusetts Pension Reserves Investment Management Board, Boston
Joel Chernoff, executive editor, moderated the discussion, which was held at P&I's New York offices. An excerpt follows.
Joel Chernoff: Rumi, let's talk about the short-term scenario and then we'll come back to the longer-term. There is significant concern about deflationary pressures. What steps should investors take to position their portfolios?
Rumi Masih: Yes, I think it is a very warranted consideration. However, I don't share the view that we will see deflation in its corrosive form in the form that we witnessed over the Great Depression where CPI was declining 10% year on year.
People refer to deflation, and when I think of deflation, I think of debt. I don't think of deflation as necessarily spotty periods as we saw where prices were falling. And I don't think we are going to get into that corrosive area.
But, however, let's entertain the hypothesis that we do. And one of the reasons we should entertain it is we get so many references to the Depression. One of the biggest theories of the Depression by Irving Fisher was debt deflation. You hear about this all the time: unprecedented levels of debt caused by excess leverage and you also have the specter of deflation. ...
So, supposing it does take place. I would think that no asset class really stands out clearly, in my mind, to ensure yourself against deflation. Equities in this kind of a crisis, interest rates go to zero, you're getting into unconventional easing, how on earth are companies going to get back into a healthy stream of margins? They can't charge for their profits; that's going to get us into this corrosive form of deflation. So, I can't see equities doing really well.
Intermediate- to longer-term bond funds or those equities that deliver dividends as a protection to your purchasing power, I think would be a good idea. Also, those sectors in the equity market, such as consumer staples ...
I don't see (deflation) coming to be a strategic concern going forward ... And even if we did, I think there are only a few asset classes that you could think of in overweighting your asset allocation. I don't think it should really be a consideration for strategic asset allocation in any case.
Mr. Chernoff: But, tactical bets?
Mr. Masih: That's a tough call because I'm much more in the camp of Cynthia (Steer) that we may be laying down the seeds of inflation that we are going to see probably, I don't know what the time frame is, in terms of all of this infusion. We've had three synchronized events. We've got synchronized slowdown, synchronized deleveraging and now synchronized infusion across the world.
From a technical perspective, I think you'd have been brave to make that call and say, let's categorize an investment strategy just for deflation because it is very, very hard to find in terms of what are the asset classes, apart from the ones that I mentioned, that you could actually tier toward insuring yourself against deflation.
Cynthia Steer: I think Rumi has made some great points. On the issue of deflation, the asset class that has most looked at deflation right now has been long Treasuries. It was a superb-performing asset class for 2008. It is probably not going to be the same for 2009.
Deflation, to me, is interesting ... because it is the deleveraging story. How do you reassess values in individual stocks and bonds how do you look at strategically the rerating system, the downgrading of companies and countries, simultaneously. That, to me, is the more real part of the deflationary story.
How do you reassess manager skill because the criteria for the top-performing manager going forward are probably not the criteria we have used for the last two decades. So, how do you rejigger that in terms of their survival skills, in terms of what factors they look for, in terms of what asset classes do you start to rebalance.
To my mind, the interesting thing about deflation is depending on how much you believe in it how do you create the inflationary asset class in the midst of deflation, especially in the broad commodities and the real asset classes where you can buy these. I would put emerging markets in some context in that downdraft. How do you think about buying these in scenarios where you would then lay in programs over time. That, to me, is the more thoughtful work.
Hartley Rogers: Rumi had it right. Equities are not a great place to be in a deflationary environment. That goes for private equity and long-biased hedge funds and all of the alternative asset classes as well. The real risk is what has been said: The Fed actually wins the battle and maybe doesn't even expect to win it, but wins it in spectacular fashion, and we have an inflationary environment, and something happens to the currency. Those are generally good for alternative asset classes. Private equity is long only; it borrows money, which is going to be inflated down in terms of real value that they have to pay back. So that's good for private equity. And long-biased hedge funds ... are going to be in a position to benefit better from that environment.
So I think what Cynthia says is exactly right. You really have to plan for laying some piece of your portfolio to benefit if you have the inflationary environment, which is not the one that most people are seeing on their immediate windscreen today.
Nancy Everett: I'm in the same camp ... Most people find (deflation) a very low probability, although should we get it, it certainly would be a major problem that we would have to deal with.
I think more people are more thoughtful and concerned about ... inflation. ... (Dealing with inflation) might not be pleasant, but I think there is a certain amount of faith in the central banking systems ... that should it be inevitable, it will be dealt with. That kind of outcome is more debated than the deflation discussion.
Ms. Steer: One of the things to remind plan sponsors and anyone who is dealing with portfolios is that the issue of downgradings is very different with inflation and deflation and the amount of nimbleness that managers are going to have to have in maneuvering this (changing environment).
So, to put in my plug again, this also argues for an opportunistic portfolio. ...
And I think this is where the governance issue that Nancy and Rumi brought up is so important right now because I don't think we have enough playing room in many cases. We don't have enough delegated authorities, committees may not meet frequently enough. ...
Although we believe in mean variance, we believe in the long-term assumptions, we are going to have to look at those dispersions in the one-year area of the strategic asset assumptions relative to the long term a lot more frequently. And I'm almost thinking we (need to) do it quarterly. ...
Mr. Masih: Absolutely. The other point ... is that now the Fed, the government, is no longer a referee. They are a player. And they will continue to be a player ... You're making a bet on the ability of the Fed to turn on a dime, which is a question out there. It is a debate. Can they turn on a dime and really suck out the infusion in the system and curtail an inflationary or pricing pressure from happening either through that or through stabilization of (gross domestic product)? They are going to be in, almost like an investor, a flow that we have to kind of take and make a view on. It is not just markets, it is not just investors, it is not just capacity. It is going to be the government and what it does.
So, when you think of inflation, you should think about what is happening in the world, where are the energy sources? Is Iran going to be a net oil importer by the year 2050? If it is, then oil is going to be an issue in terms of where we are going to import oil from. Add on to that financial intermediation. I think financial intermediation is going to be a global corporate governance (issue) that is going to take on a world of its own.
So, to Cynthia's point, what does that beg? That begs that you have to be much more dynamic in terms of your allocation and also monitoring of your allocation and your return. You can't just sit back and say, I have got a 15-year horizon here and these are my returns and I can wait until the cows come home. It's got to be much more frequent.
Ms. Steer: I would like to add one thing. It goes back to my original point in that the zero-to-five-year arena, we can be living with deflation and inflation in the portfolios and they are going to be at odds with each other.
The pragmatic thing, whether we are plan sponsors or consultants, is how do we put in our meeting process some kind of report or some kind of discussion on this now so as we get further out into this shorter-term horizon that our boards are not caught off-line or our junior staff are not caught off-line. How do we do the education now? How do we say that you are going to have this back and forth and, depending on what you own today, it is going to look different in the portfolio.
Mr. Chernoff: Mike, do you want to take a stab at the governance issues involved here?
Michael Travaglini: What I was going to say and this doesn't mean I disagree with anything that Rumi or Cynthia said, but that would be is the nimbleness in my world is not one of the hallmarks of the public DB plan. So, you would be talking about a cultural revolution basically. ...
This nimbleness assumes that you're going to make every tactical decision or change that you make in the short term in the correct way that adds value to the plan ... My point is, some are going to be done that add value to the plan and some will detract ... This is one of the fascinating things about our challenges as institutional investors.
I do think we are going to need to look at our construct and figure out, Are we equipped to handle these types of markets, especially in the short term? I just want to make sure, in my fund, we don't do it at the expense of principles that we know have (been) borne out over time. Because while the next five years are going to be what they are, the State of Massachusetts is still going to be running a DB plan long after I'm gone from there.
Ms. Everett: ... It begs the inevitable question from a public pension fund perspective ... Are they doomed to mediocrity because the governance structure will not allow for this type of creativity and so therefore they are not going to be able to participate and they are not going to get access? I think it is a really important question for the industry to come to terms with.
Mr. Travaglini: And it's a legitimate one. I don't think we are doomed to mediocrity. It's the state's liability, right? So, they kind of do whatever they want with it. In Massachusetts, they have done a good job of setting up the structure where they are trying to make the assets earn gains and limit the state subsidy. The 24-year history, up to now, has ... worked in the state's favor. So, the taxpayers have benefited (from) this structure.
Again, it may sound like I have got the blinders on. I'm not disagreeing with what is being suggested. I think it needs to be done, in our realm, with some understanding by all of the stakeholders directionally what that might mean.
What I always say in my world, we try to minimize the number of decisions we need to get right. Because it is one thing for David Swensen (chief investment officer of Yale University's investments office) to make a strategic allocation decision. If it turns out right or if it turns out wrong, then there is the same 10 people that it sort of matters to. Whereas, in my world, strategic allocations that the staff and the trustees are making that don't turn out to the benefit of the fund creates a whole different public criticism of that decision.