Allocation Targets of Public and Corporate Pension Plans

I found this interesting post on the AllAboutAlpha.com website that I access through my CAIA membership.    The author refers to two surveys on pension funds from Pyramis, a part of FMR Management, and JP Morgan.  In previous posts sourced from Pensions & Investments, pension funds are planning to allocate more assets to alternative investments.  The Pyramis study breaks down the pensions into public and corporate plans.  US public plans are allocating 13% while US corporate plans are allocating 5%.  Both figures are well below other western nations.  Canada and countries from the Nordic Region are planning a 20% allocation.

The JP Morgan survey looks at public pension funds, corporate pension funds and endowments/foundations.  Hedge funds, private equity and real estate are the major alternative investments.  Corporate pensions have a higher allocation in hedge funds (4.6% to 4.2%) while real estate (4.6% to 3.5%) and private equity (8.1% to 3.3%) are more popular with public pensions.

Investment Ideas in Real Estate Markets

As a member of the Chartered Alternative Investment Analyst (CAIA) Association, I am fortunate enough to attend various learning events.  Last week, I listened to four investment professionals about their views on the Real Estate Markets.  Real estate may be termed the original alternative asset.  They were Rod Hinze, Founder and Portfolio Manager of Keypoint Capital Management;  Richard Adler, Managing Director and Co-founder of European Investors Inc;  Michael Stratta, Investment Analyst of Aviva Investors and Scott Yetta (sic) of Cerberus RMBS Opportunity Fund at Cerberus Capital Management.  They have different viewpoints on the markets.  Hinze manages an equity long/short hedge fund.  Adler invests in REITs and directly in real estate.  Stratta manages funds of funds and private equity funds.  Cerberus has launched a fund that invests in structure finance.

Keypoint's portfolio is market neutral.  It seeks absolute return by investing in real estate related securities.  Hinze was long on several subsectors such as student housing, data centers and movie theaters.  He was short on big box retailers, toxic debt structures in mortgage REITs and the standard overvalued securities.  Last year, the real estate appeared correlated to the equity markets.  But if the subsectors were analyzed, there was much variation.  Class A malls and self-storage were up and banks were down.  Keypoint's beta or correlation to the markets ranges from 0.1 to 0.2.

On the private equity side, Stratta is seeing a continuation of a trend for better liquidity terms for investors.  The preference is for an open-ended fund with quarterly availability for redemptions.  The classic closed-end fund with a ten year lockup is losing its popularity as more investors are looking for yield and dividends; not for appreciation.  Stratta covers the Americas and has investments in Brazil (Sao Paolo and Rio de Janeiro).  He is already looking at opportunities in what he terms the next emerging markets:  Panama, Peru, the Dominican Republic and Colombia.  Canada is divided into two parts:  Vancouver and everywhere else.  Asian banks control most of the real estate transactions in Vancouver.  Other banks cannot crack the market.

European Investors Inc's regional allocations are:  overweight in Asia, underweight the US and standard weighting for Europe.  Adler invests in REITs and real estate.  They have a portfolio of $1.5 billion in direct investments.  He spoke extensively about the increased volatility and correlation to financial stocks of REITs.  Due to the new ETFs on REIT indices, electronic arbitrage trading is causing large market moves in the same manner as the equity markets.  Regarding investment ideas, he is positive on Thailand, the Philippines, Turkey, Israel and Brazil because the general or macro conditions are favorable.  Mortgage REITs, such as Annaly Capital Management, have a 15% interest rate.  He expects that to retreat to the upper single digits - which is sustainable over the long term.  There is a also a new REIT asset class with the single family house rental as the underlying.  These homes may be a straight lease or lease to buy.  In five years, there are projected to be two to three million homes in this category.  The expected returns for this investment is 8%.  The first deal in this REIT was in April 2011 in a deal co-sponsored by Fannie Mae and Credit Suisse.

The final speaker from Cerberus Capital had recently launched a $1 billion hedge fund focused on Residential Mortgage Back Securities (RMBS).  For a fund manager, he gave a surprising amount of detail to non-investors.  He split his investment universe into agency and non-agency securities which are a $10 trillion market.  Agency securities are created by government sponsored entities such as Ginnie Mae, Fannie Mae and Freddie Mac.  Their main risk is pre-payment of loans and mortgages.  Non-agency securities have credit and interest rate risks.  The fund managers analyze RMBS based on a number of factors:

• Yield is analyzed based on the behavior of the borrowers.  Of the universe of borrowers within an RMBS, they look at how many will pre-pay (i.e. re-finance), pay late, get loan modifications or default.   Scott is seeing value in borrowers with hybrid loans such as the 5/1 homeowner loan where the first five years are fixed rate and then the rate floats.  The most interesting borrowers are two to three years into the floating rate period.  They are pre-paying their loans by re-financing into fixed rate loans at historically low rates.  Many of these loans may be found in a mezzanine tranche.
• The recovery value of houses liquidations is viewed on a state by state basis because of differing state foreclosure laws.  A house in California can be foreclosed without going through court approval;  not so in New York and Florida.  The shorter the period, the higher the rate.
• Built in expectations that there will be another 10% drop in real estate
• Investors need conservative assumptions on the above three factors as a cushion for credit risk.  2011 returns were down because of two macro events:  the Eurozone crisis and the delay in the selling of Maiden Lane II, a huge loan portfolio of the Federal Reserve Bank of New York.  In the third and fourth quarters, funds hedged against a drop in RMBS - anticipating that Maiden Lane II would cause an oversupply of this product.  They hedged using residential indices such as the ABX and Prime Index, commercial index (CMBX) and high yield/investment grade indices.  Paying for the loss protection caused real estate hedge funds to underperform the market.
• Documentation and loan servicers are understaffed and large institutions are selling their units
• Government policy directly affects agency securities.  Cerberus has some insight into the federal government by having Dan Quayle and Jack Snow as staff and by owning GMAC.

Thank you, CAIA, for organizing this great event.

Global Macro: A Star Performer In Times of Market Stress

In the December 2011 issue of the Hedge Fund Journal, Mark van der Zwan, portfolio manager, and Radha Thillainatesan, investment analyst, of the Morgan Stanley Alternative Investment Partners Fund of Hedge Funds wrote a research paper on the Global Macro strategy. During times of stress (current credit crisis, technology bubble and Russian default of 1998), it has one of the top two returns for hedge fund strategies. Global macros returned 4.7% and 15.5% (as defined by the HFRI Macro Index) for the credit crisis and technology bubble while the Standard & Poor's 500 returned -51% and -44.7% respectively. No numbers were given for the Russian default. Correlation of returns also drop during these times. In the credit crisis, the statistic is -17%.

Obviously, investors should use global macro funds to diversify their assets from the standard equity and fixed income funds. In the current volatile markets, investors should think about the high volatility of returns for the strategy, the wide variety of macro strategies and the subsequent wide variety of returns. As macro strategies lose their investing edge, managers are specializing in their investment strategies either through asset class (commodities, currencies, etc.), technical trading signals or length of holding (as measured within the same trading day). This causes the wide range of strategies and returns. With proper research, the global macro portfolio can be diversified and perform well during market crises.

The article can be accessed here.

I would like to thank the Chartered Alternative Investment Association (CAIA) for providing a free subscription to the Hedge Fund Journal.

Risk Management: Some Basics

Dr. Philippe Jorion of the University of California at Irvine and Managing Director of Pacific Alternative Asset Management Company (PAAMCO) wrote a main portion of the risk management overview for the CAIA Level II curriculum.  There are market, credit, liquidity, regulatory and counterparty risks.

Market risk is the risk of loss in financial market prices.  It is also called systematic risk.  To calculate market risk, all the assets in the portfolio should be used to find the possible profits and losses by using market data.  The most well-known model is value at risk (VaR).  This allows for tracking of any drift in investing style, hidden risks and of new fund managers, markets and assets.

Credit risk is the risk that a counterparty to a contract does not fulfill its obligation by not paying the amount or not delivering the asset owed.

Liquidity risk occurs when an investor cannot sell assets.  There are two types:  funding and asset.  Funding liquidity risk happens when investors redeem their capital from a fund, when loans from the prime broker are not renewed or during margin calls.  In these situations, the fund may be forced to sell assets to raise capital.  Asset liquidity risk is the risk of losses due to the price impact of forced asset sales.  These risks can be mitigated by matching the investment horizon of an investor's assets and liabilities, putting in place a lock-up period when an investor cannot redeem their capital, having a notice period before redeeming capital, creating gates to limit withdrawals to a percentage of capital and suspending redemptions altogether.

Regulatory risk is the risk that government or regulatory agencies may change the financial rules such as imposing short stock trades during the credit crisis of 2008.

Counterparty risk is almost the same as credit risk except it includes the counterparties of your counterparty.

We will be examining other topics from Dr. Jorion's writings in later posts.  The source for this article can be found here.

A Different Way of Looking at the Current Investing Environment

Members of CAIA were invited to an event sponsored by the New York Hedge Fund Roundtable last week.  Mark Yusko, CEO and Chief Investment Officer of Morgan Creek Capital Management (with $10 billion in assets under management), presented on how to invest in the current low return environment that he called the 0-3-5 problem.  Cash is at 0%.  Bond yields are at 3% and stocks are expected to return 5%.  In order to attain returns in the high single digits that investors such as pension funds and university endowments need, he proposes that investors move to a skill based portfolio.  There were a multitude of themes presented.  They centered around the lack of returns in the developed world and the rise of the emerging markets.

The best portfolios will not have alternative investments as a separate asset class.  They will ignore these classifications and integrate them.  A traditional portfolio may be 50% US equity, 15% international equity, 30% fixed income and 15% in hedge funds.  The updated concept will ask where the hedge funds invest.  In this example, let's say the funds invest in US equity.  Then the asset allocation of the portfolio will look like this:

• US equity 65%
• International equity 15%
• Fixed income 30%

Adding assets with uncorrelated returns such as hedge funds "can boost expected returns, while reducing portfolio volatility."  Private equity returns for funds operating during a recession are higher.  Yusko encourages investors to take advantage while funds are having difficulty with fund raising.

That being said.  Investing in US markets will be difficult.  The US is in danger of mirroring Japan on government debt, low interest rates and low growth in GDP.  Investors should concentrate in Brazil, Russia, India and China (BRIC) with an overweighted allocation in Asia.  Over the last 10 years, this has returned 250% cumulatively.  The Standard & Poor's 500 and NASDAQ have negative returns.  Credit Suisse, the World Bank and PricewaterhouseCoopers have predicted that China will surpass the US as the world's largest economy by 2020.  The emerging markets have the same forces that propelled the US to become the largest economy in the 20th century:  population growth and low debt in local companies.

Commodity prices will rise as the emerging markets nations develop.  As China and India industrialize, oil demand will rise.  The best way to play this is to invest in oil services stocks or indices such as OIH (Oil Services Holders Trust Index) or OIX (CBOE Oil Index).  Gold prices will continue to reflect the rise in US government debt as a percentage of GDP.  Other commodities with rising prices are platinum, palladium, corn and wheat.

Yusko also commented on various risk factors in the current environment.  They were:

• Inflation - There will be none unless there is growth in the money supply.  The Federal Reserve Bank is putting money into the financial system but the banks are keeping it on their balance sheets.
• Valuation - Stock valuations have been above the historical average since the 1990s.  The market will be reverting to the mean.
• Monetary - The Fed's Quantitative Easing 2 Program will end on June 30th.  US equity markets will be discounting by 20% for that event before the date.
• Growth - Rise in unemployment may signal low growth in Gross Domestic Product.
• Wealth - Housing prices continue to fall in the US and developed nations (i.e. Western Europe).
• Demographic - The US is an aging nation that will spend and grow less.
• Government - Deficit levels are not sustainable.
• Default - Municipal bonds, especially in California, Illinois, New Jersey and New York are in danger of defaulting.
• Sovereign - There may be another debt crisis in Europe because banks own the bad debt of Portugal, Ireland, Greece and Spain.
• China - The renminbi was re-pegged to the US dollar in July 2008.  This caused the dollar to strengthen and commodity prices to collapse.
• Devaluation of the dollar - Largest risk for US investors

One old rule still applies - diversify your portfolio.  In addition to the ideas above, he listed other possible assets:

• International Real Estate
• Absolute Return Strategies as a substitute for bonds
• Distressed debt in US and Europe

Thanks for the roundtable for setting up the presentation and Mark Yusko for presenting their views.

Managed Futures: An Asset Class?

Hedgeworld alerted me to an article regarding the question:  Is Managed Futures an Asset Class?  In an earlier post, I had mentioned that it was according to the curriculum for the CAIA program.  The article defines an asset class as "...investment opportunities that behave and are treated in a similar manner."  The four characteristics are:    common regulatory guidelines, large amounts of assets under management, singular performance when compared to other asset classes and common risk/return profile within the asset class.  The first three answers are definitely yes.  The fourth is a maybe.   Even though the performance of managed futures sub-strategies are not correlated,  they all have position level detail, separately managed accounts and liquidity.  The article then goes on to rebut three counterarguments:

• Not all managed futures strategies react to market events in the same way
• Managed futures' underlying assets include stock indices, currencies and bonds and not only commodities
• Performance is not easily replicated within managed futures space

Distressed Debt Strategy: Chapter 11 Bankruptcy Process

In a prior post, I had mentioned that, during the bankruptcy process, an investor can take control by holding 33% of the debt.  How can the investor have control with a large yet minority postion?  The answer is in the Chapter 11 process.  It gives the company breathing space for its debts and the ability to reorganize its capital structure.  This gives the company a second chance to become a profitable concern.

The company initiates the process by filing Chapter 11 petition with the court.  Upon receiving the filing, the court freezes debt and collection actions.  The company, now called the "debtor in possession" maintains its business operations and submits a reorganization plan to the court.  This plan may be "prepackaged" or may be created within 120 days of filing.  The company has to get the debt owners to accept the plan 60 days afterwards.  Obviously, if the debt holders are paid in full, the plan will be approved.  Otherwise, the plan is accepted if 50% of debt owners and if holders of 67% of the total amount of debt approve it.  This is when an investor with 33% of the debt holds a power position.  Since the investor is able to block any approval of the reorganization plan, this forces the company to negotiate with them.  After this original period has passed and no plan has been accepted, anyone can submit their own plan.  If the company agrees with the new plan, the court may approve it.  If none of the plans are acceptable to the company and debt owners, the court can force a cramdown plan.  Basically, the court tells everyone what the plan is.

Reorganization of the company usually means reimbursing debt, converting debt into equity and wiping out the current equity holders.  Within the company's bond structure, senior secured debt is paid back first.  Subordinated debt receive less than face value and other debt is converted to equity.

The source for the bankruptcy process summary is Mark Anson, The Handbook of Alternative Assets, pgs 483 - 487.  The book forms the core of the CAIA curriculum.

Managed Futures

I received an article regarding managed futures from Albourne Village named "Decoding the Myths of Managed Futures".  In several hedge fund indexes, managed futures are listed as a strategy.  Within the CAIA program, they are a separate category.  The report talks about its recent growth and elaborates on some controversies:

• Opaqueness regarding their "black box" trading strategy
• Non-correlation to equity returns
• Investing in non-commodity instruments
• Volatility
• Homogeneity of funds

Some Investing Ideas in China, Russia and the Emerging and Frontier Markets

Being a member of the CAIA New York Chapter affords me access to their events.  This week I went to a panel presentation called "Perspectives on Emerging and Frontier Market Opportunities in 2011".  The three portfolio managers that spoke were Caglar Somek of the Caravel Fund International, Eric Fine of Van Eck G-175 Strategies and Xiao Song of Contrarian Emerging Markets Fund.   The event was moderated by Michael Weinberg, CFA and Global Head of Equities at FRM Americas.

Caglar is your classic fundamental equity manager with a concentrated portfolio of 40 to 50 stocks in the emerging and frontier markets.  Emerging markets is defined as the BRIC countries (Brazil, Russia, India and China), Emerging Europe, Turkey, Israel, East Asia and Latin America.  Frontier markets would be Africa, with the exception of South Africa, the Middle East and parts of Asia such as Vietnam, Laos and Bangladesh.      He seeks countries with a lower market capitalization to GDP ratio.  In these markets, Caglar wants to have liquidity and equity investments have that characteristic.  He also knows that the political risk is higher.

Eric runs a macro fund with a longer term investing horizon.  Like Caglar, he wants the more liquid securities.  Other factors that he looks at are the country's solvency and foreign exchange rates.  The latter is the key to reading inflation.  These fundamentals lead him to attractive securities.  One interesting fact that he shared with the audience is a country's economy is stable if the Central Bank can raise interest rates during a recession.  His main themes for the present are liquidity, emerging market foreign exchange and short the Euro.

Xiao runs emerging market and distressed debt funds.  He searches for good assets that have a bad capital structure.  These debt assets should be liquid with a limited downside.  The upside has to be greater than investing in the distressed debt of US companies.  Otherwise, why take the added risk of going into an emerging market.  He is seeing more investors coming into the emerging markets and competing with him for investments.

There were two countries that the PM's were questioned about - Russia and China.  Caglar stated that there was too much political risk in Russia for him to invest in any companies.  Eric mentioned specifically the Mikhail Khodorkovsky case where he was found guilty of oil theft and money laundering.  For more details about the trial, two articles can be found the Huffington Post and the Economist.  His fund was staying away from Russia.  If he had to invest, he would trade foreign exchange and invest in a government sponsored company such as Gazprom or Sberbank.

They had divergent views on China and the now famous bubble view by Jim Chanos.  The article can be found here.  Caglar and Xiao believe there are bubbles in the Chinese economy.  Xiao thinks that there is a real estate bubble in cities like Shanghai and Beijing.  The price of real estate is comparable to New York and Chicago.  Who can afford those apartments?  Only 1% of the population make enough money.  Also, all mortgages are floating rate.  Since the Central Bank has raised rates to tamp down inflation, the mortgage payments will increase - just like in the US.  Eric is more sanguine about China's real estate.  The house is a savings vehicle and not used for speculation.  Real estate is bought with a sizable down payment.  He has confidence in the policy makers of the Chinese government.  Even if real estate is a bubble, the banks can be re-capitalized by a government that has $2 trillion in reserves.  Caglar sees 10% real inflation in China and a bubble in hard assets.  He would be short equity and bonds.

One of the panelists spoke about the Chinese Reverse Merger Fraud.  A Chinese company takes over a US shell company.  This allows the Chinese company to be traded on the NYSE or NASDAQ.  Investors, believing that the company is subject to the SEC regulations, buy the stock based on false financial statements.  The sources for this development can be accessed the Business Insider and China Briefing.

Thanks to CAIA for hosting a great panel.

GIPS: Global Standard for Reporting Fund Manager Returns

The CFA (Chartered Financial Analyst) Institute created and published the Global Investment Performance Standards (GIPS) for investment management firmsin the September/October 1987 issue of the Financial Analysts Journal.  They would apply to investment advisers, certain brokers, mutual funds and consultants.  The objectives of GIPS reporting are to:

• Create a minimum standard method for calculating and presenting investment returns for global comparisons
• Ensure data are fair, accurate, consistent and timely
• Promote fair competition and eliminate barriers to entry
• Aid global self-regulation
• Acknowledge caveats for GIPS:  account selection, survivorship and measurement period biases

To achieve this, firms must follow these requirements:

• Consistent data integrity
• Uniform methods of calculation
• Complete and accurate composite construction
• Disclosure of any non-compliant history
• Reporting of long term performance is required

Additional information:

• Returns are calculated on a firm-wide basis.  They must be for at least five years and build up to ten years.  Obviously, if a firm is not five years old, then data from the inception needs to be reported.
• Performance must be presented with composite returns that have common objectives or strategies
• Managers should inform investors of any benchmark indices used for performance comparisons

Please note that compliance is purely voluntary.  GIPS promotes transparency, international comparability and best practices.  Full details may be found at http://www.gipsstandards.org/.

Event Driven Strategy - Merger Arbitrage and More

The event driven strategy invests in a wider range of situations than merger arbitrage.  Merger arbitrage managers are concentrated on mergers and acquisitions.  Event driven managers may invest in firms that are:

• In the middle of a reorganization
• Spinning off a division
• In bankruptcy
• Starting a share buyback program
• Distributing a special dividend
• Specific news announcements such as earnings restatements
• Significant market events

Again, the manager is trying to exploit mispricings of the company's securities due to these one-time events.  Another term for this strategy is special situations.  Some sources state that merger arbitrage is a substrategy of event driven.  I can see the logic behind this.  However, for these articles, I am using the definition promulgated by the Chartered Alternative Investment Analyst program (at www.caia.org) and has these as separate strategies.