Many, if not most, investors were adversely affected by the recent global financial crisis, the aftermath of which has called into question long-held tenets of investing, particularly for those investors managing perpetual portfolios, along with the rules of engagement for conducting business.
Welcome to the so-called new normal.
Pension funds, endowments and foundations invest with a view toward perpetuity, all else being equal. Perpetual investing is challenged by the new normal of the higher level and changing complexion of volatility resulting from cyclic changes and systemic events. Consequently, achieving target returns has been constrained by traditional asset management. Dismissing the conditions of the past few years as an aberration will place the investor back in the position they were in just prior to 2008. The events of 2008 can recur if enough investors try to repeat their performance of years prior to 2008 through poor risk/return selections in order to close a perceived gap from the highs.
Astute investment managers of perpetual portfolios, and the investment committees that oversee them, are increasingly recognizing the need to balance the trade-offs between pursuing a variable liquidity premium presumed to be embedded in the intrinsic value of illiquid or longer-dated assets and managing through volatility to optimize return targets against periodic and variable cash outflows and inflows. At the risk of being somewhat trite, the aphorism of “buy cheap, sell rich” has never been more challenged in the face of heightened volatility. For pensions, endowments and foundations, that challenge is compounded by the outflows and inflows of their portfolios. Drawing cash to fund obligations might not coincide with selling rich and investing cash contributions might not coincide with buying cheap.
Long-term investors need to adjust their expectations back in line with long-term returns, moving back to asset selection through value. Value investing is predicated upon capturing price discrepancies in a more determinant, measurable manner using intrinsic value as a fulcrum. This in itself facilitates the management of risk with more clarity and certitude of achieving targeted returns with less risk of realized drawdowns and underperformance of benchmarks along the way. This is the essence of alpha, and the investor wins by not losing.
There is an inherent natural advantage that resides with such portfolios where longer-term value investing provides for greater opportunity to reach return targets than short-term oriented strategies, which as it turns out, are more speculative than initially perceived. Prospecting for emerging opportunities carries serious baggage and requires a connectivity that portfolios and investment offices of all sizes have found difficult to fully manage. Why is value the long-term winner? It is easier to work with the favored probability. The odds are in the investor's favor, and the long run favors the odds. It lets the “inevitable,” that is the convergence to intrinsic value, carry the load.
In our experience, the investment objectives of the perpetual portfolios managed by pension funds, endowments and foundations can be better reached through the combination of traditional long investment strategies and hedge fund strategies that can enhance returns and/or dampen volatility.
Different types of value strategies can be used to achieve both. Hedge funds can bring diversification of risk categories in value investing. It is more effective if hedge funds are additive to an overall discipline of value investing, rather than increasing exposure to a risk class through leverage or beta.
One should recognize that most managers may ultimately win with traditional assets as inputs for their generation of returns. As sensational as it may look, over-the-top structuring or financial engineering or assuming excess liquidity risks usually devolves into poorly managed risk allocation.
The results seen in 2008 certainly bring this point forward. Portfolio and risk management skills make the difference in the long term. They do not require extravagant processes or far-fetched asset reconfigurations. Standard asset classes, comprising the fabric of disciplined value oriented strategies, hedged and unhedged, can be utilized effectively to achieve the investor's targeted returns.
A market-neutral fixed-income strategy can complement a portfolio seeking consistent, sustainable alpha for the long term. Short-run strategies are less sufficient in generating such returns. It is beneficial to add a steady process based upon long-term value to the mix.
Allocating capital to hedge risks using conventional liquid products has proven to be advantageous for perpetual investment portfolios. Funds with higher Sharpe ratios can take the guesswork out of timing payouts and cushion the portfolio from volatility with a steady payout process. Today's conditions enable managers to find value through liquidity premiums scattered through markets. Cash can be used as an option to protect on the downside and to capture opportunities in the aftermath of carnage. Finding value in all phases of the market's cycles requires flexibility. With a discipline of timing, value investing outperforms classic asset mix investing, which creates exposure with questionable levels of risk.
Disciplined, rules-based value investing outperforms and is demonstrated in the long term. Investors should not succumb to the pressures of committee politics, momentary relative performance to peers, or other short-term thinking chasing a process that is weighted heavily upon recent returns.
Investors may be better served using value strategies as their trigger for entry and exit, or find managers that do. The long-term advantage inherent in perpetual investing works in the investor's favor. Check the numbers and you will agree.
Thomas T. Kutzen is founder, president and chief investment officer of AlphaBridge Capital Management LLC in Greenwich, Conn.; John M. Pagli Jr. is the managing director and global head of strategic business development of AlphaBridge.