2013 was a great year to add value by using risk to assign asset allocation, according to chief investment officer of Windham Capital, Lucas Turton, whose fund added 300 basis points above benchmark last year by dynamically allocating according to risk.

 

Windham Capital Management’s style is to focus on measuring and understanding risk to then make dynamic top down asset allocation decisions.

“We use risk in assigning asset allocation, 2013 was a good year to do that, it worked for us, we generated alpha,” says chief investment officer Lucas Turton.

Depending on risk, and the health of markets, rather than economic or bottom up analysis means the allocation of assets is often contrarian.

The fund began last year aggressively allocated despite the fiscal cliff and government shut down in the US.

“This is because markets weren’t responding to this situation, but the news had investors cautious. It was contrarian to be aggressive,” he says.

In March and April interest rates were beginning to behave and real estate was converging on bonds, which was identified as more of a regime shift, so a reduction in risk ensued.

“We are not basing our investment decisions on the Fed or geopolitical activity but when markets are susceptible,” Turton says.

About half the time last year, the Windham portfolio was contrarian, and the other half it was in line with markets.

“In the middle of year there was greater consensus markets were becoming more risky. And we reduced risk twice in the middle of the year.”

However what remained contrarian was the degree to which the portfolio reduced risk, with a 30 per cent decrease in growth assets.

“The magnitude was contrarian,” Turton says.

The fund has constraints of about 30 per cent either side of a benchmark allocation, allowing significant shifts and value to be added through better asset allocation.

The benchmark portfolio is a globally diversified passively managed mix of global equities, fixed income, commodities and real estate.

Windham, which was founded by MIT professor Mark Kritzman, uses proprietary measures to look at the global market risk environment, recognise when it changes and position portfolios to take advantage of the conditions.

“What we’ve been trying to determine is where any view matters too much to investors. We don’t think valuations such as P:E ratios impact returns, something that looks inexpensive can become cheaper. We want to look at risk.”

So far this year Turton believes there has been a modest uptick in measures of risk, but that generally markets are calm.

“It has risen this year and is approaching the level of April last year but it’s nowhere near 2011. We have seen a sell-off in an orderly fashion where correlations were low, it’s a traditional pull back after very strong market,” he says.

The outlook in the near term is that risk is low, so Windham is allocating to a diverse set of risky assets, with commodities and US REITs both big diversifiers in the portfolio, and allocations to foreign assets increasing.

“Clients are concerned with alpha and downside protection. We believe short term returns are difficult to predict but risk is somewhat predicable and can add value,” Turton says. “We are correctly anticipating the direction of risk.”

This paper by the French National Center for Scientific Research (CNRS) investigates the main determinants of pension funds investment in private equity funds, and particularly in venture capital and leverage buyouts in the US and Canada over the 1996-2011 period. The results show some important differences between pension funds allocating to private equity and more traditional assets.

The first ones are bigger, mainly diversified private funds. They do not consider the age of their members when deciding this type of allocation and they present a higher discount rate. Furthermore, they specially take into account their private equity returns in comparison to management costs. It also shows that pension funds investing in private equity do not distinguish between venture capital and leverage buyouts.

 

To access the paper, click here

The determinants of pension funds allocation to private equity

Investor allocations to alternatives will increase over the next three years as the focus on outcome-oriented investments heightens, according to respondents in the annual conexust1f.flywheelstaging.com /Casey Quirk Global Fiduciary CIO sentiment survey.

The second annual survey, which included respondents from 56 asset owners with combined assets of $3 trillion, showed an accelerating trend to moving to outcome-oriented approach, as funds focused on meeting objectives.

For different respondents these objectives were different – for corporate funds it was meeting liabilities, for charities it is beating inflation and cash needs, for sovereign wealth funds growth and capital preservation and for public funds it is funding gaps leading to increased risk tolerance for growth-oriented funds and alternatives allocations

But Jeff Levi, director at Casey, Quirk and Associates, says constructing portfolios around these outcomes are more complex with alternatives allowing better management of risk exposures and low correlation.

“They are a valuable tool in executing these objectives,” he says.

Overall the survey showed the projected asset allocation changes in the next three years will see an aggregate average increase of 3.2 per cent to real assets, real estate and infrastructure, 1.8 per cent increase in illiquid alternatives (non-real assets), and 1.6 per cent increase in hedge funds. The losers will be fixed income and domestic equity.

Levi says there is increased demand for an unconstrained approach to investments in the “traditional boxes” not just within alternatives allocations.

“What have been boxed as hedge funds in the past is less relevant, they are a structure not an allocation. In the past long only allocations were style box driven, for example large cap value, and hedge funds were outside that style box. Now there is increased demand for unconstrained in the traditional boxes,” he says.

“They are re-thinking the portfolio around the risk factors, opposed to building around broad categories of type. The old way of thinking about objectives proved to be ineffective.”

As an example of the change taking place, Levi says managing fixed income against Barclays Aggregate Index is inappropriate as it has “nothing to do with the return streams the investors are looking to achieve”. As a result investors are looking more absolute return and floating rate benchmarks. Unconstrained fixed income is a hot topic.

 

Another clear trend is that investors plan to continue to aggressively invest in their internal investment headcount.

Investors were asked to comment on their plans for the three-year period from 2013 to 2016, and 37 per cent of respondents said they will increase their head count in finance, accounting and reporting, followed by manager research (26 per cent said they would increase), in-house portfolio management team (34 per cent), asset and strategy allocation (34 per cent), risk management (28 per cent) and technology (28 per cent).

Within manager research emphasis was being put on increasing in house expertise on alternatives as funds forgo fund of funds and gain comfort in investing directly.

Cost remained the main reason for insourcing, 40 per cent of respondents said they had plans to insource more non-cash assets, with 53 per cent citing cost as the main reason.

The average cost of internal resources of the respondents was 7.1 basis points, compared with 46.3 basis points externally. This means it is about six and a half times more expensive to outsource.

All asset classes were being considered as potential in-source management, but domestic equities were the most likely, followed by illiquid alternatives and non-domestic equity.

 

P17_LAOS_Results_InvestmentConsultantUsage_Page_18

 

For investment managers, and consultants, the results show some clear changes that need to take place in servicing these institutions, in particular segmentation becomes critical as there is no one -size fits all for the investor community.

“Buyers with in-house teams want different skills and investments and engagement model,” says Levi. “This also has implications for staffing. Fund managers need people who are consultative and have know-how to have a conversation with the CIO. You need those who are investment savvy, those with the tools to conduct analysis and have a customised views. And you need to wrap all of it in a strong investment brand, have innovative insights and thought leadership with a marketing presence. It is about flexibility, a conversation with one buyer is very different from another.”

In addition funds managers will be competing with the buy-side, as institutional investors look to their peer group for ideas and information exchange, rather than traditionally looking to the funds management community.

Similarly the investment consulting fraternity is undergoing a change, as institutional investors bring more manager research capabilities inhouse.

For the period 2008-2012, 31 per cent of respondents increased headcount in manager research, for 2013-2016, 36 per cent are increasing headcount in due diligence and selecting managers.

“In the UK and in US public plans it is mandated to have a consultant, but there are questions about the role of consultants and how they are used if the internal team size is increasing,” Levi says.

This re-adjustment of the consultants role is amplified by the fact managers are playing a larger role in unconstrained mandates and giving advice.

Change is afoot for all participants in the institutional investment chain.

 

 

Investors were challenged to think differently about their portfolios by the latest academic thinking from Stanford University at a one-day investment roundtable in California last week.

Chief investment officers from US public and corporate pension funds, endowments and foundations convened at Menlo Park, the home of Stanford University, for a one-day investment think-tank.

Three finance professors from Stanford presented their latest papers on active management, private equity and financial regulation, which were debated and workshopped by the investors in order to enable their application to the investors’ portfolios.

The roundtable sought to fuse the latest academic thinking with investment best practice to give investors an edge in their decision making.

This highly interactive discussion was jointly facilitated by conexust1f.flywheelstaging.com and Professor Stephen Kotkin from Princeton University, and supported by BNY Mellon and Lexington Partners.

 Return to event coverage

Investment think-tank discussion points

1.  Active management: measuring manager skill

The Nobel Prize awards in economic science in 2013 underscored the continuing debate about efficient versus irrational markets, and active versus passive portfolio management.

Professor Jonathan Berk’s research offers a rigorous approach to these issues, including delegated money management, asset pricing, valuations of firms’ growth potential, firms’ capital structure decision, and the interactions between labor markets and financial markets. He also studies the question of individual rationality in experimental settings.

The paper for this conference, which presupposes knowledge of another paper to be read, uses the value that a mutual fund extracts from capital markets as the measure of skill.

The paper finds that the average mutual fund has used this skill to generate about $2 million a year. The paper documents large cross-sectional differences in skill that persist for as long as 10 years.

It further documents that investors recognize this skill and reward it by investing more capital with better funds. Better funds earn higher aggregate fees, and there is a strong positive correlation between current compensation and future performance.

Professor Jonathan Berk, the A.P. Giannini Professor of Finance at the Stanford Graduate School of Business, has coauthored two finance textbooks: Fundamentals in Finance; and Corporate Finance, which remains the most successful first edition textbook ever published in financial economics, and is a standard text in nearly all top MBA programs around the world.

His research has won numerous awards, including the TIAA-CREF Paul A. Samuelson Award, the Smith Breeden Prize, Best Paper of the Year in the Review of Financial Studies, and the FAME Research Prize.

His article, “A Critique of Size-Related Anomalies”, was selected as one of the two best papers ever published in the Review of Financial Studies, and was also honored as one of the 100 seminal papers published by Oxford University Press.

Berk has received the Graham and Dodd Award of Excellence, the Roger F. Murray Prize, and the Bernstein Fabozzi/Jacobs Levy Award, in recognition of his influence on the practice of finance.

Berk was born and grew up in Johannesburg, South Africa, and received his PhD in finance from Yale University.

 

2. Overweighting and underperformance: evidence from limited partner private equity investments

This paper, “Local Overweighting and Underperformance: Evidence from Limited Partner Private Equity Investments”, coauthored with Yael Hochberg, examines the home-state bias in institutional investors’ private equity allocations.

This effect is particularly pronounced for public pension funds, where limited partners allocate around 10 per cent more of their private equity portfolios to home-state investments than would be predicted by the investment behavior of out-of-state investors.

Public pension funds’ in-state investments achieve performance that is lower by 2 to 4 percentage points than both their own equivalent out-of-state investments and equivalent investments in their state managed by out-of-state investors.

Professor Joshua Rauh, Professor of Finance at Stanford Graduate School of Business and a Senior Fellow at the Hoover Institution, has attracted national media coverage for his studies of state and local pension systems in the United States. He has won numerous awards for his research papers.

“Investment and Financing Constraints: Evidence from the Funding of Corporate Pension Plans” was awarded the 2006 Brattle Prize for the outstanding research paper on corporate finance published in the Journal of Finance.

“Public Pension Promises: How Big Are They and What Are they Worth?” coauthored with Robert Novy-Marx, won the Smith Breeden Prize for the outstanding research paper on capital markets published in the Journal of Finance.

“Earnings Manipulation, Pension Assumptions and Managerial Investment Decisions”, coauthored with Daniel Bergstresser and Mihir Desai, won the Barclays Global Investor Best Symposium Paper from the European Finance Association and appeared in the Quarterly Journal of Economics.

Professor Rauh received his PhD from the Massachusetts Institute of Technology.

 

3. The banker’s new clothes: what’s wrong with banking and what to do about it

The past few years have shown that risks in banking can impose significant costs on the economy. Many claim, however, that a safer banking system would require sacrificing lending and economic growth. Professor Anat Admati’s work reveals that the narratives used by bankers, politicians, and regulators to rationalise the lack of reform are invalid.

Professor Admati argues it is possible to have a safer and healthier banking system without sacrificing any of the benefits of the system, and at essentially no cost to society. Banks are as fragile as they are not because they must be, but because they want to be – and they get away with it. Whereas this situation benefits bankers, it distorts the economy and exposes the public to unnecessary risks.

Weak regulation and ineffective enforcement allowed the buildup of risks that ushered in the financial crisis of 2007-2009. Much can be done to create a better system and prevent crises. Yet the lessons from the recent crisis have not been learned.

Professor Anat Admati is the George G.C. Parker Professor of Finance and Economics at the Graduate School of Business, Stanford University.

She has written extensively on information dissemination in financial markets, trading mechanisms, portfolio management, financial contracting and, most recently, on corporate governance and banking.

Since 2010, she has been active in the policy debate on financial regulation, particularly capital regulation, writing research and policy papers and commentary. She is a co-author of the book, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It.

Professor Admati received her BS from the Hebrew University in Jerusalem and her MA, MPhil and PhD from Yale University.

She is the recipient of a Sloan Research Fellowship, a Batterymarch Fellowship, and multiple research grants.

She is a fellow of the Econometric Society, and has served as a board member of the American Finance Association and on multiple editorial boards.

She also serves on the FDIC Systemic Resolution Advisory Committee.

 

 

Delegates

Anat Admati, professor of finance and Economics, Stanford University

Eric Baggesen, senior investment officer for asset allocation and risk management, California Public Employees’ Retirement System (CalPERS)

Jonathan Berk, professor of finance, Stanford University

Mary Cahill, chief investment officer, Emory University

David Cooper, chief investment officer, Indiana Public Retirement System (PERF)

John Donaghey, head of North American institutional distribution, BNY Mellon Investment Management

Hershel Harper, chief investment officer, South Carolina Retirement Systems

MaDoe Htun, chief investment officer, William Penn Foundation

Jennifer W. Kheng, principal, Lexington Partners

Stephen Kotkin, professor, Princeton University

William Lee, VP, pension & foundation investments, chief investment officer, Kaiser Permanente

Jamie Lewin, head of manager research and performance analytics; chief investment officer, BNY Mellon Investment Management; Lockwood Advisors, a BNY Mellon co.

David Long, senior vice president and chief investment officer, Healthcare of Ontario Pension Plan

Farouki Majeed, chief investment officer, Ohio School Employees Retirement Systems (OHSERS)

Tom Newby, partner, Lexington Partners

Joshua Rauh, professor, Stanford University

Stan Rupnik, chief investment officer & interim executive director, Illinois Teachers’ Retirement System

John Skjervem, chief investment officer, Oregon State Treasury

Colin Tate, chief executive, Conexus Financial

Amanda White, editor of conexust1f.flywheelstaging.com

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Return to event coverage

New research finds institutional investors favour investing in private equity general partners that are located in the same state as their organisation. This is intuitive as local knowledge and contacts attract investments. However research from Stanford University finds this bias is coming at a large cost – about $1.2 billion a year – particularly for public pension funds.

 

Professor of finance at Stanford, Joshua Rauh, and co-author Yael Hochberg, are the first academics to produce a paper that examines the geographical bias in LP private equity investments.

“Institutional investor asset allocations to alternative asset classes have increased over the past few years but few papers explore institutional investors’ choice within alternative asset classes, and how that affects performance.”

Rauh’s research, outlined in the paper Local overweighting and underperformance: evidence from limited partner private equity investments, looks at the extent and cost of a particular strategy, showing a clear preference for home state private equity investments among institutional investors.

It finds, clearly, that limited partners (LPs) in a state overweight with general partners (GPs) in that same state.

This is true of all types of investors, including endowments and foundations and public and corporate pension funds, but is particularly true of public pension funds.

Rauh presented to delegates at the conexust1f.flywheelstaging.com investment think tank, made up of chief investment officers of public and corporate funds as well as foundations and endowments.

He showed that for all investors in the universe that he examined there was an 8.1 per cent excess overweight allocation to their home state.

This was determined by looking at how an investor, for example a California LP, invested in California relative to the entire population of US LP investors, and also compared to non-California LPs only.

While the overweighting was true for all types of investors, in public pension funds the overweight was more exaggerated with a 9.8 per cent home-state overweighting, he says.

 

Underperformance

In its own right this might not be a particularly unusual finding, but what is important for public pension fund investors is that the overweighting to home state also corresponds with underperformance.

The research looked at how home-state investments perform relative to out of state investments, examining whether they can make use of the local connections and networks and better access and information.

All funds measured had an IRR that was 2.86 per cent worse in their home state, but public funds had 3.74 per cent worse.

Endowments and foundations, the research finds, do not underperform in their in-state investments.

“Most hypotheses predict public pension funds overweight with a view to gaining excess positive performance on in-state investments because of detail on deals, superior information on in-state investments, rationed out of state access. But better information and better access is not translating to better performance,” Rauh says.

The political argument is that public funds are supporting businesses in their local communities and the chief investment officers from public funds echoed this view – that reasons other than performance often drove the investments in local investments.

Eric Baggessen, senior investment officer and head of asset allocation, CalPERS says how systems have “come in to being” is important because it means their governance will be different which in turn affects their investment allocations.

“For example in California given the government mechanisms underlying it, it is hard to separate it from the political environment. It would be like having negative gravity.”

He suggested Rauh add in governance considerations to the data or questions. But Rauh said the authors had added in board composition data but didn’t find anything.

Baggessen says it is impossible to take a state public fund and have it not affected by politics.

“They don’t exist in a political vacuum,” he says. “We have 13 board members; six are elected by unions and the other are from legislature appointees. It is hard to imagine they would get on board without a sense of political connection.”

Similarly Farouki Majeed, chief investment officer of the Ohio Public Schools Retirement System and former employee of CalPERS, says the results are not surprising.

“My experience in Minnesota, California and Ohio public funds is that there is board directed allocations to in-state funds,” he says. “Boards are not concerned if they underperform, what’s important is that money is allocated to the state, jobs are created, and enterprises are supported.”

Mary Cahill, chief investment officer of the Emory University endowment agreed.

“These investors are not saying we’ll live with underperformance but performance is not the main objective.”

Rauh conceded that home bias and underperformance may not be sub-optimal because these investments might support the local economy, and have positive externalities from local economic development.

This study did not measure the benefits of in-state investments, and Rauh said a future academic study could examine what are the benefits of in-state investments.

 

Data

Rauh’s research looked at 19,000 LP/GP private equity fund investments by institutions over 1980 to 2009 drawing on data from Thomson Reuters’ Venture Economics, Preqin, VentureOne, and Capital IQ.

Broken down by type, 30 per cent of the investments were in buyout, 30 per cent in venture capital, 13 per cent in real estate, and 27 per cent in other (including distressed debt, mezzanine, fund of funds, secondaries).

“We looked at the share of all investments made in that state. For example Minnesota has 0.79 per cent of sample investments made in that state. So Minnesota LPs should invest 0.79 per cent in that state, like all other US funds. But they don’t, it’s 9.7 per cent of investments made by Minnesota LPs into Minnesota GPs. They are overweighting by a lot.

“This has implications for risk management,” Rauh says. “Risk management suggests that the optimal investment portfolio should underweight your own state. The state’s basket is already in the local economy, so they should diversify outside of that.”

The states LPs which are overweighting the most relative to the entire LP universe measured by Rauh are: Massachusetts (overweight by 32.4 per cent), Ohio (31.9 per cent), Illinois (24.3 per cent), Pennsylvania (16 per cent), and Minnesota (14.1 per cent).

Professor of history at Princeton and co-host of the roundtable, Stephen Kotkin, asked whether LPs were investing in their home state deliberately.

“The hypothesis is that you know people better and can judge them, so you would expect a correlation between locality and the result. But you’re showing the result isn’t there?” he asked.

“The positive result is more than missing. There’s actually underperformance,” Rauh says.

 

 

Cost

If each public pension LP performed as well as in-state as it does out-of-state, the LPs would reap $1.25 billion extra annually, Rauh estimates.

He uses Massachusetts, which is the state overweighting the most relative to the entire LP universe, as an example.

Massachusetts LPs investing in Massachusetts GPs had a net IRR of -7.5 per cent. Out of state LPs investing in Massachusetts GPs had an IRR of 1.93, and Massachusetts LPs investing out of state GP had an IRR of 1.4.

“This is an underperformance of around 9 per cent per year which when multiplied over the size of the $5.9 billion Massachusetts private equity program is a big cost,” he says.

The delegates also discussed why there is a difference between the performance of LPs out of state and LPs in state investing in a particular state.

BNY Mellon’s head of manager research and performance analytics Jamie Lewin, asked why LPs out of state doing a better job of choosing GPs in state.

Majeed posited that it was adverse selection and because there are allocations across the state, there are more investments so more managers (including the bad ones).

Other issues for discussion were raised by the chief investment officer delegates including the staff model and delegation within public pension funds (Stan Rupnik, Illinois Teachers’ Retirement System) and the role of size with regard to investments and GP capacity (David Cooper, Indiana Public Retirement System).

 

Breakdown of type of LP – overweight to home-state GPs

Public pension – mean excess in state 16.5 per cent

Private sector 7.8 per cent

Endowment 8.1 per cent

Foundation 9.6 per cent

 

In 1840 equity funded more than 50 per cent of bank assets in the US, now it’s around 7 per cent. Banks as lenders would never lend to a business with such little equity, so why is it ok for them? And why don’t institutional investors have more of a voice about the extent of debt and leverage in the system? Professor at Stanford, Anat Admati, addresses the problem.

The banking system is fragile and dangerous, it distorts the economy and is dysfunctional; there is way too much leverage which is unnecessary and unproductive, and there are forces within that are self-destructing. Needless to say it’s a mess.

This is the dim picture painted for delegates at the conexust1f.flywheelstaging.com investment think tank by Anat Admati, professor of finance and economics at Stanford Graduate School of Business.

“It’s a system that’s essential to the economy but not supporting it, it’s not aligned,” she says.

“It’s fragile because there is an extraordinary amount of leverage and a reliance on a large amount of short-term debt. It lives on borrowed money and has liquidity problems. It consists of many layers of fragile institutions with an incredible amount of inter-connectedness and contagion mechanisms,” she says. “There is flawed and ineffective regulation, which makes it worse – off balance sheet commitments, shadow banking, OTC derivatives, risk weights, and the opaqueness of the system are all not helping.”

Admati, who in presenting to the institutional investors was straight off the plane from a Davos presentation, says because the system is so highly leveraged there are conflicts of interests between borrowers and lenders.

“There are very few people who benefit from this unhealthy system,” she says. “There are a few, mostly the managers of the banks that benefit, the rest are hurt from it and it has to be absorbed by the economy somehow.”

She says bankers love to borrow and resist leverage reductions but for society excessive leverage is expensive.

“We are shooting ourselves in the foot creating a fragile system by subsidising debt,” she says recommending regulators act now by mandating banks have between 20 and 30 per cent of total assets.

Basel III capital requirements of 4.5 to 7 per cent, but she says that these requirements are based on flawed analyses of trade-offs.

“Regulators have authority but lack political will,” she says. “This is a huge missed opportunity for reform. Financial stability doesn’t have a constituency in this world, institutional investors should have more voice.”

In 1840 equity funded more than 50 per cent of bank assets in the US. In the 1980s it was 25 per cent, and now around 7 per cent of US bank’s funding is equity.

She uses JP Morgan Chase’s balance sheet as an example. At the end of 2011 it had an equity market value of $126 billion, and equity book value of $184 billion and less than $700 billion in loans. Other debt, which is mostly short term, was valued at $1.8 trillion.

“People don’t appreciate the outrageousness of this.

“Banks as lenders would never lend to a business with such little equity, so why is it ok for them?” she says.

Admati, who was sitting on a panel in Davos with hedge fund manager Paul Singer and representatives from HSBC and Barclays, says it is hard to find people who say something about the banks.

But her recommendations for decreasing leverage, and increasing equity will have immediate benefits, she says.

It will reduce the likelihood of default, protect the economy from spill over effects and it shifts the downside risk from the taxpayer to the shareholders or also benefit from the upside.

“The big challenge to bank failure is that whereas banks live globally, they die locally.” ” she says.

Admati says that banks as corporations don’t need to borrow to fund.

“Central banks don’t understand banks are corporations that can fund with equity, they are blind to the impact of leverage on the system,” she says. “Political-will won’t change the system. The government wants banks to fund them, it’s all money politics, which is a general political problem in this country. The public has to demand a better system.”