Report suggests alternative investment allocations could be impacted by new pension accounting rules

You don’t have to be a licensed accountant to figure out that many pension funds are being squeezed from both sides.  Assets are down and lower future return assumptions mean the present value of those assets is down even further.  And pension liabilities are up due largely the same thing: low discount rates leading to higher present value of future liabilities.   These phenomena have conspired to create what Michael Moran and Abby Joseph Cohen at Goldman Sachs called “challenges and changes” for pensions in 2011.  Anyone who manages the overall health of their pension fund, or anyone who thinks they can help the managers of those funds get out of their pickle, should definitely read this report.  What follows is a quick taste of what you’ll find in the report.

Despite the hysteria surrounding pension under-funding over the past decade, the report ^[2] begins by showing that the average funded status was actually over 100% in both 2007 and 2008 – for US pensions at least.  However, the market calamity of 2008 means that average funded status is now around 82% with the median approximately 75%.  As if that weren’t bad enough, pension funds are beginning to acknowledge that their traditional return assumptions will have to be revised downward even further than they have been already.  The chart below from the report shows that average expected return assumptions have fallen around 1% since 2002.

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Of course, a tiny drop in the expected future annual return will have a dramatic impact on the present value of the fund’s assets, and thus on its long-term funding gap.  The report contains several examples of public pension funds (totaling over $550 billion) that have recently dropped return assumptions.  In 2003, says Goldman, 95 of the pension funds of S&P 50 firms used a return forecast of 9% or higher.  By 2009, that number plummeted to 3.  You can imagine how these recalibrations alone would open up a funding gap the size of the San Andreas Fault.

One way of dealing with this is to decouple fund returns from market returns.  Or, as Goldman says,

“This means that plan sponsors have a greater incentive to have assets with characteristics similar to the characteristics of the plan’s liabilities.”

This means a shift into less volatile assets such as fixed income and alternative investments.  We’ve chronicled the shift out of long-only equities several times over the past few years, so regular readers will find the chart below showing a drop in equities and corresponding increase in fixed income and alternative to be vaguely familiar:

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But while this was clearly the trend up to and including 2008, check out what happened in 2009:  Equity allocations bounced back a little, fixed income allocations dropped like a rock and, through it all, “other” jumped by over 50%. This indicates that, although Goldman classified non-fixed income assets as “risky” for the purposes of the report (and hedge funds as even riskier “Level 3″ assets), allocators seem to be increasing hedge fund allocations as part of their “de-risking” strategy. Go figure!

It’s easy to assume, like we did, that much of the precipitous drop in long-only equity allocations was a passive effect of falling markets.  But the chart below from the Goldman report shows that it wasn’t just “actual” equity allocations that were falling, it was the “target” allocations themselves.

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Okay, you don’t have to be an accountant to understand the challenges facing pension fund portfolio managers, don’t worry.  But you might actually need a CPA to figure out the implications of these challenges for the plan sponsors such as the S&P 500 companies who likely now regret ever starting a pension plan.  It turns out that pending accounting changes could impact the future of pension plans far more than either the return assumptions or the discount rates applied to liabilities.

The report explains how pending changes to international accounting rules (i.e. the International Financial Reporting Standards  or “IFRS”) could make their way to US plans.  One such change would do away with the ubiquitous return assumptions that got plans into a bind in the first place.  These changes, says Goldman, will remove the incentive to see the world through rose-coloured glasses and pave the way for pension funds to abandon what many believe is an overly-optimistic perspective.  If this were to occur, Goldman Sachs says a “powerful incentive for some plans to maintain exposure to equities would be removed” and we would see an acceleration in the aforementioned move out of the asset class.

The pending proposals would have pension plans recognize profit and loss on pension funds in the period they occur.  But to avoid the resulting excessive volatility, that profit or loss would be recognized as other comprehensive income and would therefore not directly impact the company’s bottom line every year.

Again, not directly.  But if the running balance in that “other comprehensive income” account is negative (i.e. if the fund was under-funded), then the company would have to recognize an “interest charge” for the balance – as if it was borrowing the money from outside. If, on the other hand, the balance was positive (i.e. if the fund was in surplus) then the company would recognize interest income from its pension fund.

This sounds like a win for sponsors since many are currently amortizing the full value of recent losses.  Using the new standards, they would no longer have to amortize those losses and would only have to recognize the “interest” on the resulting funding gap.  But as Goldman points out, without the benefit of being able to recognize 8.5% returns, regardless of actual returns, many plans would actually be worse off in the short term.  (The firm includes a simple example of how the accounting would work.)

Had the IFRS proposal been instituted in the US in 2009, 34 S&P 500 companies would have seen a hit to net income in excess of $100 million.  Even more-so, two of them would have seen a hit of more than$1 billion.  We’d venture to guess that most of these companies would likely lobby against such a proposal.

The bottom line is that pension fund portfolios aren’t managed in isolation.  Asset allocation can increase or decrease funding gap and the accounting treatment of that gap can, in turn, drive the asset allocation decisions made by US pension funds.  Advocates of alternative investments would be well advised to keep an eye on this evolving story. As always, the impact hinges on whether you believe alternative investments are “risky” or they are part of an overall “de-risking” strategy.

Hedge fund manager-diversification vs. hedge fund strategy-diversification

Pundits often like to say that long term investing success is usually the result of sector selection, not security selection.  Perhaps that’s why so many mutual fund managers are accused of being closet indexers.  But hedge funds are different.

As Girish Reddy, Peter Brady and Kartik Patel pointed out in the Winter 2007 edition of the Journal of Alternative Investments (“Are Funds of Funds Really Multi-manager Funds with Extra Fees? ^[2]“) there is a relatively tight dispersion of returns among managers using the same traditional strategy, e.g. equities, fixed income, etc., and a relatively wide dispersion of returns across those traditional strategies.  Conversely, they found a relatively wide dispersion of returns among managers using the same alternative strategy, e.g. long/short equity, market neutral, and a relatively small dispersion of returns across those different alternative strategies.

The trio concluded that multi-manager hedge funds – which can rotate between strategies, but not across managers other than a select few in-house managers – may miss-out on these opportunities.  Funds of funds, which can rotate across both strategies and managers, are better able to exploit opportunities across both dimensions according to the trio of authors.

Which begs the question: What about a fund of funds that is constrained from rotating among strategies altogether? Assuming Reddy, Brady and Kartik are correct that the opportunity for hedge funds of funds lies in manager selection, not strategy selection, then one might expect a sector-specific fund of funds to perform nearly as well as an unconstrained fund of funds.

But a recent paper ^[3] by Na Dai and Hany Shawky of the University at Albany finds this intuition may be off.  The duo finds funds of funds that diversify across both strategies and managers are able to generate higher alphas.  The chart below, created with data in Table 2 of the paper, shows that funds of funds with more numbers of “focuses” (TASS) and which are “diversified” (CISDM) produce higher Fung & Hsieh Alphas:

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But they also found that the benefits of strategy diversification applied mainly to large funds of funds.

 ^[5]
Finally, Dai and Shawky confirm the intuition that more diversified funds of funds had lower failure rates; anyone who invested in a Madoff feeder fund they believed was a “diversified” fund of funds doesn’t need any further evidence. While traditional long-only investments may be all about beta, alternative investments are all about alpha or idiosyncratic manager risk.  So any portfolio of hedge funds that is able to rotate among managers is sure to offer alpha opportunities.  But it also appears that the ability to rotate among different hedge fund strategies remains an important source of out-performance.

“Serious doubts” raised about hedging potential of long-only commodities

Regular readers of this website know that managed futures strategies have almost always provided a stellar downside protection when the equity markets fall out of bed.  While many managed futures funds trade in physical commodity futures, many others trade in futures based on financial instruments.  Still, many (including, admittedly, us) sometimes treat managed futures as a hedged version of long-only commodity investing, like comparing a market neutral equity fund to a long-only equity fund.

But an article in the Winter 2011 edition of the Journal of Alternative Investments provides some helpful clarity on this topic.  In “Protection Potential of Commodity Hedge Funds,” Pierre Jeanneret and Stefan Scholz of Man Investments team up with Pierre Monnin of Swiss National Bank to create an index comprised solely of hedge funds that trade in commodities. (Available for free by registering at CAIA.org ^[2], then clicking here ^[3].)  What they found both confirms intuition and challenges our thinking on the downside protection of commodities.

Firstly, they reaffirm the notion that commodity hedge funds have outperformed long-only commodities over the past decade.  They create a new index of all types of hedge funds (not CTAs) that report to invest in commodities via futures, equities, options, fixed income, etc.  This “peer” group contained 92 funds.  As you can see from the chart below, they creamed long-only commodities indexes such as the S&P/GSCI.

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You can see that the trio’s proprietary “commodity hedge fund” index had some serious downside protection during the financial crisis.  As a result, it has basically regained all of it’s (modest) loss since 2008.

So did the managers of these hedge funds reverse their exposure at exactly the right time?  Not really.  In fact, the chart below from the article shows that the 24-month rolling correlation between the commodity hedge fund index and various long-only indexes remained largely unchanged during the financial crisis.

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So what gives?  How did these commodity hedge funds beat their long-only brethren so handily during the crisis?  The answer is that they took some serious volatility off the table.

Recall that beta is a factor of benchmark correlation (above) and volatility relative to that benchmark.  By dramatically reducing volatility during the credit crisis by, for example, moving quickly into cash, the commodity hedge funds managed to reduce their beta very quickly during 2008  - note that this actually began in early 2008, even before the full brunt of the financial crisis hit.

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Other charts in the article by Jeanneret, Monnin and Scholz show that this was indeed true.  Amazingly, the annualized standard deviation of their new commodity hedge fund index (on a rolling 24-month basis) remained at historical averages of around 10% during 2008, while the annualized standard deviation of the various long-only commodities indexes spiked to around 30% in late 2008 – and remains there today.

The bottom line is that the ability for commodity-focus hedge funds to take money off the table seems to have been a significant advantage.  The chart below created with data from Exhibit 1 of the article makes the point.  Notice how a high volatility seems to buy you a low return when it comes to long-only commodity index investing. CAPM be damned!

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The article concludes with an interesting discussion about the true ability of long-only commodity investments compared to hedge inflation.  While commodities are generally thought of as a hedge againstinflation, Jeanneret, Monnin and Scholz show that over the past decade this has only been true when “inflation surprises are positive,” or when inflation comes in lower than was anticipated.  Put another way, long-only commodity investments can hedge expected inflation, but are relatively powerless against inflation surprises.  The trio is quick to point out that the past decade has been a period of low inflation and so their results need to be taken with a grain of salt.  Nonetheless, they write, the results “…raise some serious doubts about the hedging potential of long only commodity investments…”