The Rise of Absolute Return Investing

The Rise of Absolute Return Investing

Originally published in the May 2008 issue

The nature of pension fund investing changed following the dot-com bubble and subsequent rise of hedge funds. The end of the world’s longest equity bull run in 2000 gave investors reason to question the use of market indices as their benchmarks. The tradition of buying and holding securities is no longer the only way to manage assets.

Hedge funds suggested an alternative: absolute returns. Today, some pension plans report their returns in cash only to emphasise the end of index influence. However, hedge funds offer more than a change in metrics. They encourage institutional investors to seek the best strategies for making money wherever possible. Now equity managers don’t just hold stocks they like, they also profit by shorting stocks they believe will depreciate. Almost 60% of DB plans are using or seriously considering 13030 funds that facilitate long/short investing.

Long/short equity strategies are rapidly being adopted by pension funds because of their value in differentiating market exposure (beta) and manager skill (alpha).

The future of retirement asset management will see this distillation become almost universal. Weaker active managers will no longer be able to charge for what the market or asset class has achieved. Providing beta exposure will become a basic service.

Conversely, true alpha managers will earn even greater sums than today. And the battle for their talent, and ultimately sustainable alpha, will be won by those with the deepest pockets. Retirement providers will pay for these services because they align reward and performance more accurately than traditional active management.

However, in the minds of some investment consultants, sustainable alpha from any one source doesn’t exist. Competition prevents any single competitor from being able to employ a profitable trade or technique for long before rivals copy it. This efficient-market theory means that alpha from any source survives only a short time. Multiple alpha strategies anticipate this dilemma by accepting upfront that no single source of revenue will always be sufficient. Instead, opportunities for alpha have to be perpetually hunted across classes and around the world since they disappear almost as quickly as they appear.

Asset managers who can convince clients to permit such flexibility will succeed. In the future, mandates will reflect this new flexibility: Retirement fund clients will permit latitude in return for greater openness, especially on how risks in the strategies are managed.

The pursuit of alpha will not shrink interest in market returns. The first purpose of accessing new asset classes and markets is to earn a premium from being in these markets. The $140 billion that poured into commodities indices in the last five years is evidence of this appetite. For better or worse, most of that money has only sought beta returns.

As greater wealth and the rising costs of provision feed pension funds’ hunger for higher returns, new investable markets will have to be created. A virtual circle of supply and demand for assets in frontier markets will be just one feature of the financial landscape in the years to come.

Pension funds will no longer rely on investment managers who follow a market benchmark because regulators are looking at scheme-specific funding, and in such an environment, there is little sense in referring to market returns. In the future, beta will be the major source of return for retirement funds but not a measure of their performance.

Derivatives to the fore

The use of both over-the-counter (OTC) and exchanged-traded derivatives is already proliferating far faster than traditional securities markets. Since 2001, the notional value of outstanding derivatives has more than trebled, growing at a rate roughly three times greater than equity and bond markets. Between 2002 and 2005, the market in interest rate and currency swaps grew by 25%.

From index futures to bespoke interest-rate swaptions, derivatives are being used to improve portfolio management. At the start of the century, most retirement plans would have balked at the suggestion of most derivatives, with the exception of currency and market futures. Plans were generally content to rely on long only equities, bonds and real estate as derivatives were associated with trading rather than long-term investing. In the years to come, some retirement providers will execute their strategies with portfolios that are entirely synthetic. Ironically, it has been the demands of pensions regulators for higher funding as much as the growth of hedge funds that caused the change. The old myth that derivatives only increase risk has been laid to rest.

The same survey revealed that LDI funds will be the most popular route for managing longevity risk, with 58% of plans in Europe and North America intending to use them. Hedging the risk of an aging population is the greatest demand of any mature plan today. However, LDI funds will need to evolve considerably to meet such demands. Currently they mitigate sensitivity to changes in interest rates and inflation, but not longevity. That must change as a result of demand.

Coping with old age

Longevity risk has been described by one leading consultant as “the gorilla in the room.”1 The State Street survey of institutional investors referenced found it was the second greatest type of risk on the minds of European respondents following investment risk. Yet because longevity is so difficult to predict, a simple, cost-effective solution doesn’t exist, even in the derivatives markets. To give some sense of the breadth of estimates, in 2003 the UK’s Pensions Commission made low, high and median assumptions for the longevity of a British male aged 65. The spread of outcomes ranged from 74 to 93 years of age. Some DB schemes have solved the longevity risk problem by linking normal retirement age to longevity. Professor Steve Haberman of City University London believes that longevity swaps will come into being if natural beneficiaries of longevity such as pharmaceutical firms and old-age care providers can be brought to one side of the table and their interests securitised. So far, attempts by investment banks to develop a market for trading longevity have failed due to insufficient buyers. One holistic solution for longevity and all other sponsor-held risks is for insurance companies to acquire the liabilities and assets of plans: so-called ‘buy-outs’. This can liberate companies from their occupational pension plan responsibilities. But insurers typically want to see assets worth 130% of liabilities on IAS 19 standards (part of the International Accounting Standards that pertains to accounting for employee benefits) before considering this type of transaction. Some sponsors may believe this is a price worth paying, in which case pensions management will move further from a trust to an insurance-based model.

For swap providers and asset managers, little changes apart from the legal definition of the customer. The techniques outlined using bond-like derivatives remain the same. Thus far buy-outs, like cures for longevity risk, have been rare. Most large pension funds have preferred to adapt to managing risks under the new regulations themselves, or at least waiting until funding levels improve before considering buy-outs. That is likely to change. Over the next 10 years, DB assets will move out of the hands of company sponsors and fiduciaries and into the hands of insurance companies, banks or similar managers of capital. But these new groups themselves will rely on specialist asset managers to execute risk mitigation. This is evident from the list of advisors to new buy-out specialists in the UK retirement market. Such risk-sharing is not a characteristic of the World Bank model but may be in the future. Pooling risk collectively is ultimately a more effective means of addressing longevity risk than are individual accounts. DB fiduciaries are already working on better managing long-dated liabilities, and those responsible for DC must do the same. Otherwise, many countries will find that they have implemented a DC system that fails to account for rising longevity and instead ultimately provides inadequate benefits.

Smarter investing for retirement

What unites modern investors, whether in 10-year mandates or momentum trading strategies, is a search for better returns. Pension plans have broken out of the compartmentalisation of returns by asset class, overseen by incomplete risk management. The lesson that applies to physical and synthetic investing post-hedge funds is that market returns as a comparator are irrelevant. In their stead, liabilities are the new benchmark. Assets are there to ensure liabilities are met and so fiduciaries and sponsors increasingly see the world in terms of risk. Almost half the respondents to a State Street survey of institutional investors said they now spend 21-40% of their time on managing risk rather than investment return. Securities markets are already reacting to such changes in behaviour by creating more assets to suit long-term liability needs. Longevity swaps are one type of instrument that would address the final risk of plans. If risk comes first, excess return cannot be ignored. Many plans still need to make their assets work harder to reach secure funding levels. Efficiency is vital in the search: More and more fiduciaries are becoming familiar with absolute risk measures such as Value-at-Risk (VAR), semi-standard deviation and Sharpe ratios. Their demands on suppliers will become higher and analysis of investment products more vigorous. Pension plans and their advisors have learned from the purveyors of absolute-return strategies. They have adopted the same valuation metrics, and as clients, will both understand more and expect more. Finally, in the world of investment return, the distinction between exposure to assets – in the form of beta – and exposure to strategies – in the form of alpha – will grow stronger.

Ironically, the tougher requirements from national pension regulators have ensured that DB plans work harder and more imaginatively in investments. But the greater danger is that nascent DC schemes don’t emulate occupational DB plans. Even if the savings accounts are individualised, DC schemes should try to find ways to include sophisticated absolute return strategies. Otherwise, they risk providing members with second-rate investment choices. This would be a great step backwards in funding retirement globally and can be avoided by paying attention to the governance structures of DC.

This article appeared as part of a report issued by State Street ‘The Pensions Industry: Bridging the Gap’