Asset Allocation Trends in Public Pensions

In the October 1, 2012 issue of Pensions & Investments, I noticed an interesting statistic in an article about the funding ratios of public pension plans.  The weighted average asset allocation of the top 100 plans in Pensions & Investments' universe for 2011 is as follows:

• US Equities - 21.6%
• Global Equities - 16.9%
• International Equities - 13.2%
• Fixed Income - 23.9%
• Private Equity - 7.5%
• Real Estate - 6.3%
• Hedge Funds - 2.3%
• Real Return - 1.2%
• Commodities - 0.4%
• Cash/Other - 4.4%

The target allocation for the same year was as follows:

• US Equities - 15.7%
• Global Equities - 23.6%
• International Equities - 9.7%
• Fixed Income - 25.2%
• Private Equity - 7.3%
• Real Estate - 7.6%
• Hedge Funds - 2.8%
• Real Return - 1.6%
• Commodities - 0.6%
• Cash/Other - 2.9%

The weighted average asset allocation 2007 is as follows:

• US Equities - 36.5%
• Global Equities - 6.0%
• International Equities - 17.4%
• Fixed Income - 25.3%
• Private Equity - 5.2%
• Real Estate - 5.7%
• Hedge Funds - 0.9%
• Commodities - 0.2%
• Cash/Other - 2.8%

The biggest losers from 2007 to 2011 were US and International Equities.  Global Equities, Private Equity, Real Estate, Hedge Funds, Real Return and Commodities were net gainers.  Based on the target allocations, we can expect more investment in Global Equities, Real Estate, Hedge Funds, Real Return and Commodities.

The source for this article can be accessed here.

Management Fees and Investor Alignment in Private Equity

In an article in Pensions & Investments, the Blackstone Group announced that it does not count management fees as one of the items that align general partner and investors' (i.e. limited partners) interests.  Instead, the company's investment in its own funds removes that issue - according to Steven Schwarzman, Blackstone founder, chairman and CEO.  During the company's twenty year history, it has invested $6 billion in its funds, alongside their clients.  For example, they committed $826 million in capital for the Blackstone Capital Partners VI LP, a $16 billion fund.

However, Blackstone is one of the few publicly traded private equity firms.  It is in the interest of management, who have large holdings of the stock, to maximize their management fees versus their performance fees.  The reason is that research analysts value these companies based on their management fees and/or assets under management.  Performance fees are too volatile and unpredictable to include in their analysis.  Instead of concentrating on a fund's performance, the company would be gathering assets.  Also, if performance fees are already high, there is less incentive to hit the hurdle.

Charging management fees was originally used to help private equity funds keep the lights on while investing capital.  For larger funds, the fees can be much more than the basic costs.  According to the Institutional Limited Partners Association, management fees should be based on reasonable operating expenses plus reasonable salaries.  In the second quarter of 2012, Blackstone had $373.4 million in fees, $113 million in expenses and $269 million in salaries.  Some institutional investors are pushing back on management fees and receiving fee discounts of 25 basis points if they invest $100 million or more.

The source for this article can be accessed here.

Effects of Pension Risk Transfer on Fund Managers

In the largest pension risk transfer deal of all time, General Motors offloaded $26 billion in pension liabilities to Prudential in exchange for $29 billion in assets.  This plan was executed in two stages.  First, a lump sum settlement was offered to 42,000 retirees which are about 33% of the entire beneficiaries.  For the rest of them, their pensions would be covered by annuities bought from Prudential.  The deal was created with help from Morgan Stanley, State Street and Oliver Wyman.  Other large corporations seeking to follow in General Motors’ footsteps are Alcatel-Lucent, Verizon, Ford and United Technologies.

With the rise of defined contribution plans like 401K’s, corporations have reduced or terminated their defined benefits plans.  Since 1975, the number had dropped from 250,000 to less than 30,000 – and 33% were frozen.  At the same time, pension funds have been reducing their risk profile by reducing their asset allocation to equities, doing buy-in deals (buying annuities to hold on their balance sheet) or buy-outs (doing a General Motors type of deal).  The giant deal is a harbinger of things to come.  In a survey of 500 global companies, Aon Hewitt discovered the following pension planning:

• 35% will offer lump sums to beneficiaries
• 6% will buy annuities to cover their payouts
• 6% will transfer their plan
• 4% will terminate their pension plan

Of the insurance companies involved in pension risk transfer, only Prudential and MetLife are able to take on General Motors-like transactions.  There is capacity to handle approximately $100 billion in pensions and General Motors has taken $26 billion of it.  Besides the big two, other firms that are participating in the business include MassMutual, Principal, American General and Mutual of Omaha.  Non-insurance companies such as JC Flowers and private equity firms are also targeting US companies.

These transactions may change the game in the financial services sector.  Asset managers of pension funds will lose assets to the insurers.  Managers specializing in long duration bond, liability driven investing, ETFs and alternative managers will gain.  So will consultants in risk transfer:  Aon Hewitt, Mercer and Towers Watson.  Corporate pensions currently hold twenty percent of US stocks.  As these assets are sold in exchange for bonds, there will be secular weakness in the stock market.  From a government point of view, the Pension Benefit Guaranty Corporation (PBGC) will be under pressure as only healthy pensions can transfer their risk, leaving underfunded pensions to be insured.

The source for this posting is the September 2012 article of ai-CIO.com.

Multi-strategy Funds Are Disappearing

Multi-strategy hedge funds have had a tough time lately due to poor performance and high redemptions since the credit crisis of 2008.  Several large funds have closed - Arrowhawk Capital Partners ($575 million in AUM), Drake Capital Management ($6 billion in AUM), Deephaven Capital Management ($4.5 billion in AUM) and Stark Investments ($7.2 billion in AUM).  The last and latest, Stark, is still running $1 billion in single investment strategies such as Stark Mortgage Opportunities and Stark ABS Opportunities fund.  Other funds have converted to single strategies successfully.  They include some of the more famous names:  SAC Capital Advisors, Highbridge Capital Management and Maverick Capital Management as well as Black River Asset Management, Halcyon Asset Management, Polygon Global Partners, HBK Capital Management and York Capital Management.  The challenges in the current environment for multi-strategy funds are:

• Difficult to generate excess returns (alpha) in all strategies at the same time
• High employee turnover
• Work culture is not collaborative across strategies.  Multi-strategy funds start in convertible arbitrage or event driven strategies and then add equity long/short and other strategies.  The mindsets needed to be successful in each strategy are different and not conducive to working together.

The source for this article can be accessed here.

Fund of Hedge Funds Continue Losing Market Share

Fund of hedge funds (FOHF) are under pressure due to poor performance in 2011 and their failures of 2008 - ability to give their investors liquidity and superior due diligence.  Many funds' liquidity was negatively affected by their hedge funds' imposition of gates and side pockets for poorly performing assets.  Confidence in FoHF's due diligence capabilities were lost in the Madoff ponzi scheme.

In 2007, 43% of hedge fund assets were invested through FoHFs.  In 2010, it was down to 34% (Statistics are from Hedge Fund Research.) as more investors started making direct investments into funds.  In absolute numbers, assets under management for FoHFs are down from 2010 to 2011 - $646 billion to $620 billion - despite the uptick in hedge fund assets.

Since 2008, private banking clients have divested themselves from hedge funds.  Insurance companies and endowments are investing directly into funds and family offices are using managed accounts and pension consultants instead of FoHF.

According to Peter Laurelli, vice president, research, eVestment Alliance in the article at finalternatives.com, “To an evolving landscape of hedge fund investors, it is increasingly difficult to showcase a clear, superior value provided by funds of funds, specifically using performance comparisons over every possible sub-classification, to other methods of accessing the industry.“Fund of funds’ core strength of single investment diversification to the hedge fund industry is moving towards a niche role as larger allocators to the industry become more comfortable investing directly, or working with consultants who may already be employed for traditional portfolios.”

The source for this article can be accessed here.

Hedge Funds Are Not An Asset Class

Capital Generation Partners (CGP), an investment advisory firm, analyzed portfolio diversification ideas.  They concluded that there are only three asset classes:  debt, cash and equity.  Alternative investments such as hedge funds should not be classified as an asset class.  They should be classified based on their underlying positions.  Hedge funds are merely investment strategies for these assets.  There are four strategies based on two points:  directional versus arbitrage and systematic versus discretionary.  These four strategies and three asset classes combine to create twelve buckets.

Equities
directional & discretionary - equity long/short, long only, real estate, private equity and 130/30 funds
directional & systematic - equity index trackers and quantitative funds
arbitrage & discretionary - equity market neutral and event/risk arbitrage
arbitrage & systematic - equity statistical arbitrage and systematic CTAs

Cash & Commodities
directional & discretionary - global macro, physical commodities and currency (carry) trading
directional & systematic - trend following CTAs, commodity ETFs and money market funds
arbitrage & discretionary - commodity/macro curve trading and volatility arbitrage
arbitrage & systematic - statistical arbitrage and systematic CTAs

Fixed Income
directional & discretionary - fixed income long/short and distressed debt
directional & systematic - bond indices
arbitrage & discretionary - global macro and structured credit
arbitrage & systematic - fixed income arbitrage and systematic CTAs

Proper diversification includes having non-correlated assets in a portfolio.  CGP analyzed returns from 2000 to 2010 for the twelve categories.  Their conclusions were:

• Alternative investments are not real diversifiers of a traditional equity/fixed income portfolio
• Hedge funds should be allocated across the twelve categories and not be treated as a separate asset class
• Fund managers should be closely monitored for style drift
• Correlation map indicates that larger allocations should be made to hedge funds

The correlation heat map from the paper confirms an earlier study by Welton Investment Management.  Global macro and managed futures (Barclays CTA Index in this case) are not correlated to other hedge fund strategies.  In CGP's chart, equity market neutral can be added.

The source for this article can be accessed here.

A Study on Infrastructure Investments

In recent years, a new asset class investing in the infrastructure of a nation has been classified for use in asset allocation models.  What is infrastructure?  It is commonly known as assets in the transportation, telecommunications, electricity and water sectors.  Emerging and developed nations need to build out their infrastructure for different reasons.  The former due to population growth and economic development.  The latter to upgrade and replace existing infrastructure.

Usually, these projects would be financed by local or national governments.  The developed world is still recovering from the credit crisis in 2008 and dealing with the continuing Eurozone situation.  The emerging world, other than China, does not have the financial resources.  They are unlikely to meet global need for infrastructure investments.  This could be as high as US $70 trillion for 2005 to 2030.  Hence, the call for private investors such as pension funds and private equity firms.

Investors may invest directly into infrastructure assets through Public Private Partnerships or project finance structures.  They are exposed to disadvantages such as liquidity risk, very long investment time horizon, political risk, concentration risk, regulatory risk and high capital requirements.  They can buy securities of companies directly or buy funds/indices in sectors related to infrastructure.  The reduces all risks except for political and regulatory.  Market risk is higher in this case.

In the article Risk, Return and Cash Flow Characteristics of Private Equity Investments in Infrastructure in the Alternative Investment Analyst Review, Florian Bitsch, research assistant at the Center for Entrepreneurial and Financial Studies; Axel Buchner, postdoctoral researcher at Technische Universitat Munchen and Christoph Kaserer, professor at Technische Universitat Munchen obtained detailed private equity deal information, including monthly cash flow data, from the Center for Private Equity Research for 363 infrastructure and 11,223 non-infrastructure deals from January 1971 to September 2009.  The deals had to be exited and spanned the alternative energy, transportation, natural resources, energy and telecommunications sectors.


From the data they find:

• Infrastructure investments have shorter time horizons
• Infrastructure investments are twice as big as non-Infrastructure deals
• Infrastructure does not offer more stable cash flows
• Infrastructure investments have higher returns and lower risks.  They have lower default rates and better returns than non-infrastructure deals.
• Brownfield investments of established companies have lower risk and default rates.  They have better returns than greenfield investments.  Private equity and venture capital deals were used as proxies.

The factors affecting fund performance were:

• Excess investment capital does not bid up asset prices for infrastructure deals as it does for non-infrastructure
• Data is inconclusive that infrastructure investments are an effective hedge against inflation
• Infrastructure deals are correlated to the markets
• Infrastructure deals are not correlated to the broader economy, as defined as GDP
• Infrastructure and non-infrastructure deals are negatively affected by interest rate changes
• Fund manager experience has no influence on returns
• Longer dated deals have better returns as poorly performing deals are exited quickly
• A fund requiring additional rounds of financing usually have poor returns
• The size of the deal does not affect infrastructure deal returns
• European infrastructure deals have the best performance
• Transportation is the best performing sector