Giving investment managers leeway to move into cash when markets become pricey is the best tail-risk strategy available, believes James Montier, a London-based portfolio manager with GMO LLC.
He contends in a white paper that institutional investors seeking black swan protection now may be looking for returns in all the wrong places.
Mr. Montier called cash “a severely underappreciated tail-risk hedge,” which — in the hands of skilled managers — offers the most organic solution to the thorny issue of when investors should add such protection and at what cost.
Timing is the biggest issue in tail-risk protection, with permanent allocations likely to do more harm than good, he wrote, concluding “a long-term value-based approach ... coupled with a broad mandate (allowing money managers to add cash in overvalued markets) seems to offer the best hope.”
In an interview, Mr. Montier admitted he's a skeptic when it comes to this “topic du jour.” He argues that greed, more than fear, is driving the current surge of interest in tail-risk protection: investors want to keep reaching for returns even in markets where returns are increasingly tough to come by, “when they really should stop ... (and) hold cash as a safe place to be, until things look more attractive,” he said.
Providers of costly tail-risk strategies have an interest in enabling such risk-taking, he noted. The fact that “you can't charge very much” for a cash-focused tail-risk strategy could be one reason it remains an underrated option in investors' arsenal, he added.
Mr. Montier conceded it would take a “pretty radical departure” from the prevailing asset-liability model used by institutional investors to promote cash as a tail-risk strategy. A majority of investors continue to set a strategic asset allocation benchmark and then spend the bulk of their time worrying about manager selection — a questionable ordering of priorities, he argued.
Still, the question of allowing managers to add cash, rather than force them to buy into overextended markets, is getting a lot of interest lately.
Money managers who look to add value for clients by moving into cash when they can't find attractive investments say they're likewise seeing more tolerance now for that strategy among institutional investors.
“In the old days, if you told a consultant you need the flexibility to have more than 5% or 10% cash, very often they would say, "well, I can't include you in this search,' ” said John Arnhold, chairman and CEO of First Eagle Investment Management, New York. “That isn't happening as much” any more, he said.
Scott Simon, chief investment officer of the $3.2 billion Fire & Police Pension Association of Colorado, Greenwood Village, is part of that trend. Mr. Simon said during the past year, his team has loosened the requirement that newly hired managers remain fully invested.
Still, Mr. Simon said the restrictions haven't been removed entirely, with tail-risk hedging and asset allocation continuing to be handled by the plan's investment staff.
David Barnes, an Atlanta-based senior consultant in the global manager investment group of Hewitt EnnisKnupp, expressed some sympathy for Mr. Montier's arguments, as his firm favors placing fewer constraints on managers who are perceived to have skill. Even so, he noted, most clients continue to prefer their equity managers to remain fully invested, making that “the last constraint to be loosened.”
A sampling of institutional investors found some ready to agree with Mr. Montier in theory but cautious in practice.
Michael Trotsky, executive director of the $50 billion Massachusetts Pension Reserves Investment Management system, Bostonsaid Mr. Montier's idea would be attractive if a bevy of managers had shown consistent skill at raising cash at the right time. Finding those managers is the problem, he said.
Kenneth Frier, former CIO of Stanford Management Co., which oversees Palo Alto, Calif.-based Stanford University's more than $14 billion endowment fund, agreed. With most clients asking their managers to remain fully invested and most managers focused more on relative, than absolute, performance, the industry has yet to spawn a broad group of candidates with “a demonstrated ability to go into cash (and back out again) at the right times,” he said.
Mr. Trotsky, who like Mr. Frier counts himself as a fan of Mr. Montier's writings, said he believes in the theory behind dynamic asset allocation, and that capital market valuations have to count when pursuing asset allocation. Still, asset allocation “is one of the most important decisions you can make” and not necessarily something that should be entrusted to the managers overseeing the assets of a broader portfolio, he said.
An executive overseeing one multibillion-dollar U.S. corporate defined benefit plan, who declined to be named, reached the same conclusion more bluntly, writing in an e-mail: “I thought asset allocation was my job?”
Some investors say they're finding ways to give their managers greater flexibility while maintaining the oversight needed to remain in the driver's seat on asset allocation.
The chief investment officer of one Fortune 500 company's retirement plans, who declined to be named, agreed with Mr. Montier's contention that giving managers free rein to raise cash can be an effective tail-risk strategy.
“The caveat is that people like ourselves need to know our managers and their styles really well so we can be confident that ... they aren't fully invested for the right reasons, said the CIO, adding that the pension fund's staff gives managers approval to raise cash and then revisits the situation every three to six months.
