Investment Strategy Webinar. April 17, 2013

Transcription

1 Investment Strategy Webinar April 17, 2013

2 Presenters Dave Keil, CFA, Partner Core Consulting Phone: Lucinda Downing, Senior Research Analyst Global Asset Allocation Team Phone: Satya Kumar, CFA, Partner Core Consulting Phone: Phil Kivarkis, Partner U.S. Director, Investment Policy Services Phone: Matthew Towsey, Senior Consultant Liquid Alternatives Phone:

3 Discussion Topics Opening Remarks Market Views Focus on the Eurozone Breaking Down Barriers to Success Opportunity Investing What s Over the Horizon in Fixed Income? Hedge Fund Replication Strategies Closing Remarks Q&A Session 3

4 Entries in the HEK Blog ( In Case You Missed It Alternative Investments in DC Plans: Comments on this recent trend. Rollovers: Why Keeping Money in the System Matters: Comments on the GAO study on rollovers. Return Free Risk: Implications of the low yield environment on fixed income strategy. Breaking Down Barriers to Success: Six ways to improve your portfolio construction and decision making. Considering the Appropriate Level of Risk for Target Date Funds: Thoughts on a recent DOL memo on target date funds. 4

5 Subscribing to the HEK Blog Go to Enter your address where it says subscribe. Get ~2 s per week with useful info 5

6 Market Views Focus on the Eurozone Lucinda Downing

7 Risk Asset Rally is not Universal Recent emerging equity returns have been negative Developed equity markets have rallied this year despite slow global growth and Eurozone concerns. However, emerging market equities continue to underperform MSCI World MSCI EM Treasuries have held up well, rallying over the last month in the face of expectations of slowing QE Now tentative evidence that US economy is cooling after decent first quarter growth 70 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Treasury yields are back to year-end levels % US 10 Year Treasury 1.2 Jan-12 Jul-12 Jan-13 7

8 Eurozone Update Crisis has retreated since Draghi s summer whatever it takes statement but fundamental problems have yet to be resolved, banking union is way off and OMT remains inoperative Germany s September elections puts Eurozone situation on hold and will delay any policy decision Increasing anti-austerity and anti- German sentiment 8

9 Eurozone Economy has been Worse than Expected Eurozone unemployment is at a record 12% Germany, with 0.7% growth and 5.4% unemployment stands in contrast with peripheral countries PMI Manufacturing Indices below key 50 level Weak Eurozone growth and moderating inflation leaves the door open to new monetary easing measures 30 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Eurozone France Italy Germany Mar-12 Jul-12 Nov-12 Mar-13 9

10 Does Cyprus Matter? Will Italy and Spain Need a Bail-Out? Cyprus is too small and its banking system too unmatched to spread contagion risk. There is still potential for shock deposit levy to undermine confidence in Eurozone banking sector Inconclusive Italian elections in February resulted in political stalemate. If Italian economy does not stabilise, the situation could become serious, given its heavy debt burden, and a bail-out could be required While the immediate threat of a bailout has receded, Spain's banks continue to present a serious threat 10

11 What is the Impact on Eurozone Markets? Eurozone was the best performing developed equity market in 2012 Eurozone equities are expected to underperform other regions Core European bond yields close to all time lows on back of safe-haven demand. Peripheral bond markets have shrugged off Eurozone concerns Euro/USD has weakened, retracing half of its rally since July 2012 low Peripheral bond markets vulnerable as troubles will resurface, but some underpinning by weak economic data We anticipate further weakness on back of weak economy and withdrawal of US QE 11

12 Summary of Medium-Term Market Views Equities Bonds Alternative Asset Classes Gains to slow significantly, but prefer to bonds Non-US markets should outperform on currency hedged basis Neutral growth/value Retain preference for large cap Continue with negative view Negative view on US treasuries Take profits on credit move back to target Cautious on high yield, still prefer loans Local emerging market currency debt preferred to dollar denominated Favor real estate, hedge funds, infrastucture and selected private equity investments 12

13 Breaking Down Barriers to Success Opportunity Investing Satya Kumar

14 Opportunity Allocation: The Concept Asset allocation is the most important factor dictating long-term performance Constraints of a formal asset allocation policy should not impede investors from investing in attractive or innovative opportunities An Opportunity Allocation creates flexibility within the Investment Policy Statement to make investments that may not fit within a traditional asset allocation construct Strategies considered should offer a compelling return enhancement and/or diversification benefits (risk reduction) Optimal for investors with existing well-diversified portfolios that encompass both traditional and alternative classes and who are seeking additional flexibility 14

15 Rationale for Creation of an Opportunity Allocation From time to time, investors may be faced with opportunities that are truly opportunistic in nature Not all investment opportunities fit neatly within clearly-defined asset class lines Commitments to potentially attractive investments may be relatively small and not warrant the creation of a dedicated target allocation at the present time An Opportunity Allocation provides maximum flexibility to access such interesting and attractive opportunities by removing constraints of a formal asset allocation 15

16 Opportunity Allocation: Challenges and Desirable Investor Characteristics Challenges of an Opportunity Allocation include: Complexity Defining Time/Objective Illiquidity Higher Fees Sourcing of Funds Benchmarking A robust governance structure is critical to its success High degree of comfort with various constituents developing and promoting new ideas Nimble, but sound, decision-making process Comfort with ideas that do not fit neatly into traditional investing Willingness to be different than peers at times Willingness and ability to allocate additional time to investigate and monitor new ideas Ability to terminate managers as needed 16

17 Opportunity Allocation: Implementation Design as a maximum allocation as opposed to a target Suggest an allowable range of 0% to no more than 10% Opportunity Allocation policy target should float to be generally in line with the actual allocation to the category over time Source of funds should be liquid public securities and linked to the role of the investment 17

18 Benchmarking the Opportunity Fund The overarching objective of an Opportunity Allocation is to provide return enhancement and/or diversification relative to the opportunity cost of capital Suggest benchmarking the Opportunity Allocation, as a whole, to a blend of liquid returnseeking and risk-mitigating assets (i.e., stocks & bonds) An alternative approach is to use the weighted average of the underlying strategy benchmarks The underlying strategies can span the gamut in terms of risk and return characteristics Utilize category or style-specific benchmarks Performance should be evaluated over a full market cycle, at two levels Portfolio level: Is the overall Opportunity Allocation meeting stated goals Strategy level: Are underlying strategies performing in line with expectations Important to also assess performance from a qualitative standpoint to ensure that stated goals are met 18

19 Evaluating Strategies for the Opportunity Allocation Potential strategies of interest should provide one or more of the following: Superior expected returns relative to the rest of the portfolio High degree of diversification relative to the rest of the portfolio Attributes that the Policy portfolio does not capture Points of consideration when selecting strategies may include: Impact on overall portfolio risk and return characteristics or fit within portfolio Liquidity and lock-ups Complexity Leverage Fees Ultimately, each investor will have their own maximum tolerance in terms of various risks introduced via an opportunistic investment 19

20 Developing a Framework for Opportunity Allocation Investments Given the unique nature of the allocation, there should be a clearly-defined framework to assess potential opportunities, including: Rationale Expected characteristics Portfolio benefits Risks Source of funds Benchmarks Review procedures and exit strategy The nature of the strategies/asset classes that are candidates for this category may vary significantly Hence, the underlying due diligence should be customized to suit the unique attributes of each type of strategy/asset class 20

21 Opportunity Fund Framework Summary Recommend below summary framework be utilized when ideas for the Opportunity Allocation are put-forth Investment Objective New Investment Risks Implementation Strategy Other Factors: What risks are we trying to address or what opportunities are we trying to take advantage of? Identify market risk/opportunity being targeted for more opportunistic-type investments, and/or Identify portfolio benefits that investment provides that long-term strategic asset allocation does not What risks (new or increased) do such investments bring? Identify new sources of risk or increases in types of risk that would result from pursuing such a strategy Identify environments when strategy will not be successful Identify risk mitigating factors What should be the focus of implementation? Identify the precepts that will drive manager/strategy selection Fees Liquidity/Lock-up provisions Transparency Leverage Benchmarking 21

22 HEK Client Use of Opportunity Allocation HEK clients have used the Opportunity Allocation for several years now, though there has been a recent uptick in its adoption Listed below are some examples of how clients have utilized an Opportunity Allocation: Accommodate strategies not easily classified in traditional asset class terms Absolute return, activist, inflation hedging Take advantage of dislocated markets at times of crisis Convertible arbitrage in 2009 Promote a level of confidence with non-traditional strategies Reinsurance funds Take advantage of timely new product offerings or capital raising that are outside of traditional asset class boundaries The investment universe for the Opportunity Allocation will continue to grow as periodic dislocations in segments of the financial markets are nearly certain to arise and new products are continually developed 22

23 What s Over the Horizon in Fixed Income? Phil Kivarkis

24 Long Credit in LDI: A Tragedy of the Commons? April

25 Overview As corporate plans increasingly embrace dynamic Liability Driven Investment (LDI) strategies to de-risk, we believe demand for Long Credit will increase to unprecedented levels We believe that over the long-term, markets will adapt to this increase in demand for Long Credit, but there may be dislocations in both pricing and liquidity over short- and medium-term horizons Credit spreads of these bonds would likely narrow in the event of such a demand/supply squeeze, making hedging strategies more expensive Investors of smart money need to consider several implications in such a complex market environment: Consider buying physical Long Credit when spreads are wide and adjusting duration with derivatives Have adaptable investment strategies and governance processes Monitor the Long Credit market and adjust portfolio if warranted 25

26 Tragedy of the Commons? Tragedy of the Commons Ecologist term for when overuse of a shared resource by individuals deplete the resource to the point of hurting the entire group. Tremendous number of corporate pension plan sponsors developing strategies to de-risk, which almost always include significant increases of the allocations to Long Credit So many plan sponsors planning to buy the same type of asset, will there be an imbalance between supply and demand? Will this create a tragedy of the commons? 26

27 Tremendous Demand Expected Capacity of U.S. Long Credit Market ($bn) 1,400 1,200 1, $1,304 $1,200 $700 $ Conservative Estimate Baseline Estimate 4-7 times of the average annual issuance over In 7 years, corporate plans would consume 48% to 79% of entire supply of the Long Credit market Long Credit Held by Corporate Pension Plans Long Credit Held by Other Investors We estimate the future aggregate demand for Long Credit by corporate DB plans will grow from current $126 billion to $700 billion - $1.2 trillion 27

28 How Could Markets Adapt? Meaningfully low credit spreads could drive more issuance Creation of synthetic Long Credit could reduce demand Long Govt. CDS Long Credit Intermediate Credit Interest Rate Swaps & CDS Significant basis risk hinders the practical merits of this strategy Lump sums could reduce demand Lump sums for terminated vested participants are already factored into our estimates. Unclear whether regulatory hurdles will allow massive flows out of retiree liabilities 28

29 Impact on Plan Assets / Liabilities and Beyond Corporate plans could benefit from, or become a victim of the massive inflows. WATCH OUT! Benefit: existing holdings of Long Credit will benefit Victim: continued buying could become unattractive Tighter credit spreads Higher transaction costs from poor liquidity 29

30 Recommendations We continue to believe in LDI as an effective de-risking solution for corporate defined benefit plans, but investors should be vigilant about watching the market environment Step 1: Reposition Current Portfolio Move early, transition part or all of the Long Government holdings to Long Credit. NO Believe longterm rates will rise? YES Buy Long Credit physical bonds as much as their glide path allows and shorten duration with derivatives. Step 2: Plan for Future Strategy Monitor indicators and evaluate the relative attractiveness of Long Credit Buy Long Credit as early as aggressively as glide path allows Still Attractive Long Credit? Already Expensive Be open to other long duration instruments such as: Long Mortgages Global Long Credit & Long Govt. 30

31 Summary For legitimate reasons, the insatiable appetite for Long Credit could lead pensions into an overgrazed Long Credit market Markets will adapt over the long-term, but there could be a bumpy road to a new equilibrium We suggest corporate pension plans consider the possibility of a different Long Credit Market 31

32 Hedge Fund Replication Strategies Matthew Towsey

33 History Replication borne out of impressive hedge fund performance Roots in academic work regression analysis First products appeared in the mid 2000 s Most products offered by investment banks 33

34 What is Replicated? 1) Single hedge fund return Portfolio turnover 2) Broad hedge fund exposure Commonality of views, groupthink and index inertia Is this return stream appealing? 3) Hedge fund sub strategy exposure Similar to the broad approach Confusion over strategy classification and esoteric exposures In practice, most practitioners choose options 2 or 3 34

35 How is it Done? Regression analysis decomposes returns of a group of funds into a small number of different predictive factors If factors are liquid and investable, and explain a large part of the returns of the group, it may be possible to replicate the index with them Potential advantages Low fees High liquidity Transparency Simplicity Challenges include Intuitively works better for some strategies than others Tend to rebalance only monthly Out of sample performance has mostly been poor 35

36 What Do the Numbers Say? Look at 5 replicators all using a regression based approach with a common live period from at least June Net of fees performance used where available % 10.00% 5.00% 0.00% -5.00% % % % % % Fund A Fund C Fund E Benchmark B Fund B Fund D Benchmark A Benchmark C May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 36

37 What Else Do the Numbers Say? Return and Volatility June Dec 2012 Fund A Fund B Fund C Fund D Fund E Benchmark A Benchmark B Benchmark C Annualized return -2.0% -2.7% 0.9% 1.3% -0.6% 1.7% 2.7% -2.9% Standard Deviation 6.1% 8.2% 6.0% 7.5% 6.9% 7.8% 7.3% 7.3% Correlation Correlation Fund A Fund B Fund C Fund D Fund E S&P 500 Returns DJ US Total Stock Market MSCI World Ex US BC Agg Bond Index BC High Yield Bond Inex DJ UBS Commodity Index

38 Problems? High correlation to traditional investments such as equities Lack of clarity over replicating universe The universe used to create the replication is rarely, if ever, disclosed Choice of benchmark is somewhat arbitrary and can make a huge difference to how successful the product looks High monthly and annual dispersion between replicators Is the average hedge fund (which these products have mainly failed to replicate) a compelling return stream? 38

39 Conclusions Low fees range from 0.5% to 1.5% p.a. Net of fees returns still poor Liquidity most products offer daily liquidity do institutional investors need this? Transparency Hewitt Ennisknupp demands position level transparency from all hedge fund investments Simplicity you get what you pay for - lackluster returns and limited diversification Current offerings are not compelling 39

40 Closing Remarks Dave Keil

41 Question & Answer Questions may be submitted at any time during the web seminar by typing the question in the "Ask a Question" text field and clicking "Submit." Questions will be answered live as time permits during the question and answer session. 41

42 Our next investment strategy update call is scheduled for Wednesday, May 15th, at 10 a.m. CDT. 42