Abstract:

The paper investigates how ageing will affect asset prices. A small model is used to show that economic and demographic factors drive asset, and in particular house, prices. These factors are estimated in a panel regression framework encompassing BIS real house price data from 22 advanced economies between 1970 and 2009. The estimates show that demographic factors affect real house prices significantly. Combining the results with UN population projections suggests that ageing will lower real house prices substantially over the next forty years. The headwind is around 80 basis points per annum in the United States and much stronger in Europe and Japan. Based on the analysis, global asset prices are likely to face substantial headwinds from ageing. Download full paper here.

The NSAHO has implemented some investing ideas that have been around for a while, Jordan said, adding that this theory of risk budgeting and liability driven investing can actually be put into practice—regardless of limited internal resources.

“DB pension plans,” he emphasized, “can be saved by those who are committed to saving them.”

The Good

Beginning with the best of the trio, “good” leverage reduces uncompensated policy risk. This is done through hedging interest and inflation rate risk. Jordan explained that their strategy uses bond forwards and repos to leverage additional bond exposure beyond what would be possible if they only used physical assets. They have 65% fixed income exposure while only using 25% of their physical assets.

Jordan points out “Sixty-five percent may not be the perfect allocation, but I don’t know what the perfect allocation is”. He continued “Don’t miss good looking for perfect. If we had hedged more than 65%, we may have found ourselves overhedged because of the sensitivities that exist in other asset classes.”

Jordan argues that the 40% unfunded part of his bond strategy not only reduces risk, but may also increase expected returns. The expected return enhancement results if the yield curve in the future is upward sloping on average. With an upward sloping yield curve the expected return from the bonds is higher than the expected cost of financing inherent in the derivatives.

But Jordan stressed that any increase in expected returns is a bonus. The point of the exercise, is just to make the assets better match the liabilities from a risk budgeting perspective.

One more bonus of the strategy is that it may indirectly provide solvency relief, said Jordan. If your actuary agrees that expected returns used in your going concern valuation are increased, your current service cost will decrease, leaving more of your contributions left over for solvency special payments.

The Bad

The “bad” part of leverage that Jordan highlighted was the credit spread charged by mortgage lenders on real estate assets. To minimize credit spreads the NSAHO Pension Plan tries to position leverage in the fund where it is cheapest. They keep mortgage debt as low as possible, and in its place access leverage implicitly with synthetic exposures in other asset classes.

Jordan says he’s heard a few arguments against NSAHO’s approach:

• leverage within the real estate portfolio is necessary to get reasonable diversification; and

• a reasonable amount of leverage can help increase returns.

He explained that these arguments don’t hold water, as his strategy doesn’t reduce total fund leverage, but only shifts it to where the credit spreads are cheapest. The gross exposure to real estate beta doesn’t need to be reduced.

The Benign

That leaves the “benign,” increasing expected compensation from the active risk budget (portable alpha).

Jordan compared the traditional approach versus the portable alpha approach using a large cap US equity example. Traditionally, you invest cash in U.S. equities and get the U.S. market index return plus the value added from active management, he said.

With portable alpha, the exposure to U.S. equities comes from an unfunded derivative instrument. The NSAHO Pension Plan uses the cash that is left unused to invest in hedge funds, with the hedge funds selected to have reasonably low equity beta. The alpha is the hedge fund return less the financing cost that is inherent in the derivatives. Jordan argued that even if you assume a fairly low hedge fund return, with today’s low financing costs you may improve your expected compensation from your active risk budget.

Of course the hedge funds could provide negative returns, but Jordan compared this risk to the chance that an active manager would provide negative alpha. It’s a risk but Jordan argued that the potential impact on the total fund is minimal relative to a fund’s policy or beta risks. And if you wish you can limit the risks related to portable alpha by reducing the amount of your portable alpha exposure.

Taking all of their strategies together, Jordan indicated that they estimated that they had increased their expected real returns by about a third, and reduced their expected funded position risk by about a quarter. This is compared to a typical 60% equities, 40% debt asset mix.

Risks of these leverage strategies can include liquidity risk, counterparty risk, headline risk, career risk and key employee risk. Jordan agreed that such risks need to be managed but remained unfazed. “The 60%/40% alternative to these strategies also has its risks” he concluded.

Among big-name funds, only a handful have shone, however, almost all thanks to a more bearish outlook on the global economy.

The $1.7bn Autonomy Capital saw its global macro flagship fund, which aims to make money by trading on global economic trends and events, return 0.71 per cent in August, bringing its year-to-date return to 21.3 per cent.

The $700m Conquest macro fund, meanwhile, returned 10.96 per cent in August, bringing its year-to-date return to 23.32 per cent, according to an investor in the fund.

In contrast, many of the industry’s largest and most prominent global macro players have struggled.

Brevan Howard, the $28bn hedge fund manager founded by Alan Howard, was flat through August, bringing its year-to-date loss to just under 1 per cent.

Large managers have been particularly careful of directional trades in foreign exchange and bond markets that have seen violent price movements in recent months.

Read the full article.

Investments with little downside, but also limited upside (Value Traps) can gain prominent position sizes because of their limited risk, but end up being poor use of capital. This inefficiency is caused by the basic human instinct of loss aversion. 

Tversky and Kahneman, pioneers in cognitive psychology, found that the disutility of a loss is about 2x greater than the utility of an equal gain. What this means is that the pain of a loss of $100 is about the same as the pleasure of winning $200. This effect explains how emotion takes over when losses occur. Compounding may explain this emotional response because the impact of a portfolio loss is more detrimental than a commensurate gain is beneficial. So, our instinct is partially right to love an asset with downside protection, but the cost of downside protection must be measured. Read the full article.

Introduction

Margin loans to Canadian investors totalled approximately $8 billion in the first half of 2002, and exceeded $10 billion at the start of 2001. This enthusiasm for leveraged investing is due to potential magnification of bull market profits. However, there is considerable risk from greater losses when stock prices fall. The technology sector has provided painful lessons to investors in recent years.

One prominent example is Nortel, which quadrupled in value from fall 1999 to its record highs above $120 in summer 2000. Investors buying on 50% margin approximately doubled their profits before interest charges. But, in the two years following its peak, Nortel plummeted to less than $2 per share by summer 2002. Buying Nortel on 50% margin in 2001 produced losses of almost 200% for investors who held the stock throughout the decline.

While this example highlights the risk inherent in buying a single stock on margin, it does not shed any light on how leverage affects diversified portfolios in the long run. If the stock market continues to have a long-term upward trend, as in the 20th century, leverage may increase investors’ profits.

Our research examines the risks and returns on diversified Canadian equity portfolios when margin is used throughout long periods, such as 10 or 20 years. How much leverage is prudent to use? What are the chances of underperforming a more conservative strat- egy? Should the asset allocations vary across different long-term horizons? This study provides answers to these questions. Read the full article.

What does he find? Ratings do show sensitivity to crisis situations – and that negative reaction to downgrades from the market is much more marked during crisis than it is during calm.

The findings could be interesting for investors – and especially for regulators who might exercise caution when considering how to use credit ratings going forward. The results also hint that credit ratings could exacerbate an already tough situation for companies facing difficult economic conditions.

Abstract:

This paper studies the behavior of Credit Rating Agencies both in times of credit crunch and calm. In particular, I examine whether or not the rating agencies differ in their propensity to downgrade firms during times of financial crisis, and especially, times of credit crunch. Having established that, I study the stock market reaction to rating changes with a focus on downgrades to see whether or not investors react differently to the ratings happening during the times of calm and those influenced by the state of the economy and credit crunches to identify any changes in investors’ behavior. According to the findings, recommendations are made to both investors and regulators; for investors, it necessitates further investigation of the creditworthiness of the downgraded firms and might help finding investment opportunities, and for regulators, cautious approach might be needed in incorporating the credit ratings in the regulatory frameworks to avoid the creation of a vicious circle of bankruptcy and credit crunch in markets in the times of financial crisis. Download the full paper.

These “black swan” events have obviously bolstered risk management practices. But they are also giving rise to new investment strategies, the Wall Street Journal reports.

“Today, there are as many as 20 hedge funds specializing in tail-risk strategies, most of which have formed in the past 18 months, according to Hedge Fund Research Inc. Capula Investment Management LLP of London and Pine River Capital Management LP of Minnetonka, Minn., are among the firms that have started tail-risk hedge funds this year.”

“Some of these specialized funds aim to profit when markets tank. Others are designed to protect against a market plunge but still profit when markets rise. Investors don’t typically put all of their money into these funds—but they are putting in more these days.”

“Retail investors are getting more access to black-swan-oriented strategies, too. Bond-fund giant Pacific Investment Management Co., or Pimco, has recently begun using tail-risk strategies in its Pimco Global Multi-Asset Fund, which launched in October 2008; in its RealRetirement target-date funds; and in its new equity funds launched this year. The firm also has filed a registration statement with regulators to offer exclusive “private placement” investments to well-heeled investors using tail-risk hedging strategies.”

Still, black-swan investing isn’t a slam dunk.

“But black-swan investing has its risks, too. The biggest: When markets are behaving normally, the strategy can miss out on a rising stock market—even as costs add up.”

“That is because the strategy typically involves buying lots of out-of-the-money ‘put’ options on everything from stock indexes and interest rates to currencies. Put options confer the right to sell the underlying instrument if the price falls to a certain level. Because they offer protection, their values soar during market panics, producing big profits for the holders. But if the market doesn’t plunge, the options expire worthless, and the investor must buy new options to replace the old ones.”

“If markets hold steady or rise for long periods, those costs can add up. During the stretch from late 1990 to early 2000 there wasn’t a single bear market, commonly defined as a 20% or greater fall from the peak. An investor using a pure black-swan strategy would have missed out on one of the greatest bull markets in history.”

Former money manager Eric Falkenstein, who blogs at Seeking Alpha, is skeptical about black swan investing:

“In my book Finding Alpha, I argue that people tend to pay for hope, and nothing offers hope better than the lottery-like returns available in potential Black Swans. Hope is a good thing, and motivates a lot of hard work and creativity. But it would be foolish to think that the more improbable, the more speculative, the more derided by economists, the better the risk-adjusted return merely because of this. This tendency to buy into lottery ticket leads to all sorts of really bad investments:

• Higher volatility stocks have lower return than low volatility stocks
• Higher beta stocks have lower returns than low beta stocks
• out-of-the-money options have lower returns–and higher betas–than in-the-money-options
• higher leveraged firms have lower returns than lower leveraged firms
• firms in greater financial distress have lower returns than firms with low financial distress
• Junk bond mutual fund returns are lower than investment grade mutual fund return over the past 22 years
• sports longshots such as 50-1 odds horses, have lower returns than favorites
• lotteries with the highest payouts have the lowest expected returns
• IPOs have lower-than-average stock returns”

To paraphrase Oscar Wilde, the only thing worse then banking on the expected is banking on the expected.

The Top 25 are awarded to those individuals at plan sponsor organizations who are deemed by their peers and an expert panel to be the most influential individuals in the pension industry, in terms of leadership, innovation and impact.

If you know of a deserving individual, nominate them for the Top 25 by September 24. The Top 25 will be honoured at a gala event at The Fairmont Royal York on November 10, 2010. Click here for more information.

Is that a bubble? Not necessarily says hardcore value investor James Montier. “The bond bubble believers love to cite stats along the lines that bonds are witnessing inflows at the same pace as equity funds did during the TMT bubble.” For him, that’s a sterile debate. The real question is whether bonds offer good value.

Some think they do. Money manager Cullen Roche at Pragmatic Capitalism argues: ”When your options are 0% cash, unstable real estate and equity in what appears like a weak economy that 2.6% government bond doesn’t sound so bad.”

Montier doesn’t think so. “I’ve always thought that in essence bond valuation is a rather simple process (at least one level). I generally view bonds as having three components: the real yield, expected inflation and an inflation risk premium.”

Real yields are at 1% and forecast inflation is at 2.5%. To that Montier adds an inflation risk premium of 25 bps to 50bps.

“Using these inputs a ‘fair value’ under normal inflation would be around 4%. Of course, this assumes that the current market 1% real yield is itself a ‘fair price’. This seems like a questionable assumption to me. In the UK we have a longer history of index linked bonds – introduced in 1986. The average yield since the introduction is 2.6%, in the last decade the average real yield has been 1.5%. Given this ‘parameter’ uncertainty it would be reasonable to say that ‘fair value’ for 10 year bonds is somewhere in the range of 4-5%.”

But fair value is not what investors are pricing in, he notes.

“The current 2.5% yield on the US 10 year bond is clearly a long way short of this. So unless you believe that Japan is the correct template for the US (i.e. inflation will be zero for the next decade), government bonds don’t offer an attractive return as a buy and hold proposition.”

Either bond investors are underestimating inflation, or Japanese deflation looms. For Montier, “in essence, the market is implying a 70% probability that the US turns Japanese.”

Not happy news for U.S. policymakers.

Currency management was the topic of the most recent Canadian Investment Review debate.

Is active hedging the answer? Thanos Papasavvas, head of currency management at Investec Asset Management thinks so, for two reasons. The first is that the orderly world of Bretton Woods is gone. Thus, “in the fixed exchange rates world of the 1950s and 1960s, currency investing was neither necessary nor worthwhile. However, over the last 15 to 20 years, it has developed greatly by way of cross-border portfolio exposure management and as a stand-alone way to manage assets.”

On top of that, currency investors have different reasons for their investment decisions. “Many market participants do not try to maximize their returns when trading currencies, meaning currencies may trade away from their fair value for prolonged periods of time.”

But is active management worth the cost?

Jay Moore, managing director at State Street Associates, thinks otherwise. “[W]hile there is a strong argument in favour of direct investment to currency alpha strategies within a diversified portfolio, I would argue that investors should primarily concern themselves with existing currency risk rather than embarking on a quest for new sources of alpha.”

What’s key here is the likely current exposure of pension funds to international securities. “The primary challenge to active overlay programs in Canada is that these programs impose constraints that limit investment opportunities to exposures that are highly concentrated within USD, EUR, GBP and JPY, and which make up roughly 80% of total foreign exposure.”

As a result, pension plans are constrained from seeking alpha, say in emerging markets, because they are heavily benchmarked to the developed world in their asset allocation. “Until benchmarks are moved away from a market-cap weighted (or similar) allocation methodology to international investing, active currency overlay will continue to be handicapped by the concentration of currency exposures,” Moore says.

So, a passive or an active currency allocation? Debate moderator Michael Lewis, a principal at Mercer, concludes that “we have seen that currencies should be part of the investment decision-making process from the strategic allocations through to implementation…. the discussion of hedging or active currency management may ‘paralyze or polarize’ a board of trustees.”

Paralyze or polarize? Not for participants in the debate.

They voted 57% in favour of active currency hedging.