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Eight top pension, endowment and foundation officials assembled in New York City on the morning of May 15 to share their thoughts on how complex and challenging their jobs have become. The previous evening these experts, who hail from Los Angeles, Washington and a number of points in between, had been honored for investment excellence at Institutional Investor’s annual U.S. Investment Management Awards dinner. Although they work within institutions of varying sizes and missions, the winning eight recognize that, no matter how hard they grapple with difficult investment questions, there will always be unknown factors thrown in their paths.

“The longer you’re in this business and the more you learn, the more you realize what you don’t know,” says Donald Lindsey, CIO at George Washington University in the District of Columbia.

The executives discussed their risk management concerns, compared their very different fund governance structures and debated whether there will be a resurgence of economic growth in the U.S. and other developed countries or if emerging markets will take over the world. Weighing in on the side of U.S. strength, Lawrence Schloss, CIO of the New York City Employees’ Retirement System, declared, “I think the technological impact on everything is grossly underestimated, particularly productivity and capital formation and growth.” Joining Lindsey and Schloss were Douglas Brown, CIO of Chicago-based Exelon Corp.; Conrad Freund, COO of the LA84 Foundation in Los Angeles; Sean Gissal, CIO of Milwaukee’s Marquette University; Joshua Gotbaum, director of the Washington-based Pension Benefit Guaranty Corp.; Robert Manilla, CIO of the Kresge Foundation in Troy, Michigan; and Lee Partridge, CIO of Houston’s Salient Partners, which manages $8.5 billion in assets for the San Diego County Employees Retirement Association.

Institutional Investor Editor Michael Peltz and Senior Writer Frances Denmark moderated the discussion, excerpts from which follow.

Institutional Investor: There are many forces today challenging the quest for investment returns.

Greece is facing the real possibility of an exit from the euro; Italy and Spain aren’t far behind. The U.S. has its own credit problems, job growth is tepid at best, and a contentious election season is under way.

Add to that the unrest in the Middle East and slowing growth in China. With so much negative news, is a 5 percent real return an achievable target?

Donald Lindsey: I’m actually very optimistic. In spite of the overriding macroeconomic problems that we’re experiencing, particularly in the developed world, corporate profitability is at an all-time high. Productivity is extremely strong. If you look at the very long-term return on global equity, it’s around 10 percent. Now, that’s not delivered evenly year after year, as we all have found out. In fact, you can go for rolling 15-year periods and longer where the real rate of return has been negative. But we are undergoing a third industrial revolution, involving digital technology, that is in the early stages; these productivity gains are going to be a fantastic tailwind for corporations.

Douglas Brown: I would agree. I’m optimistic in the long run. I think, however, the next couple of years it’s going to be pretty challenging to meet investment targets, whether it’s a 5 percent real return or an 8 percent pension return target, given the situation around the world, whether it’s the sovereign situation in Europe, the slower growth in China, the fiscal situation in the U.S. or incredibly low rates. At some point, rates have to return to a more normalized level, which will be disrupted from where they are today.

Robert Manilla: I agree with both of those comments. It’s a question of duration. If we look at our ten-, 15-, 20-year returns, we’ve met our 5 percent real rate of return. I think that’s an achievable target. First, there are a lot of risks out there that are still tied to global growth, so you should be spending some of your energy looking for things that are uncorrelated to that global growth. Second, find assets that provide and have a structure that allows you to recapture some liquidity. We look around the world and, with the retrenchment of banking, we think there’s actually a vacuum out there to fill some of the roles that banks used to play. Being a secured lender against hard assets is an interesting spot. Those are really important lessons we took away from what happened in ’08–’09.

Lawrence Schloss: I think you all are right. What makes it really interesting for us is, we have a large pool of assets. So portfolio changes are made around the edges; you expand your edges from 10 percent to 20 percent to 25 percent. Then you come back when you think things are not doing very well. But I totally agree that, long run, there is nothing but growth, because there’s no looking back. I think the technological impact on everything is grossly underestimated, particularly productivity and capital formation and growth. People tend very much to live in the moment, and the moment everyone is looking back to is ’08–’09, and that didn’t feel very good. Much the same way, we’re talking about risk, risk, risk. Well, you know, risk has been around for thousands of years. It’s just when it goes wrong, then you focus back on risk.

You have government regulation pushing banks around, correctly, and there’s not as much regular lending as there ought to be, and there’s not as much illiquidity — there’s actually too high an illiquidity premium. So for people like us to think long term, there’s a great opportunity for what I’ll call easy stuff, like senior loans, private placements, secured lending in Europe. Things that used to trade at basis points are now 100 to 150 basis points over because everyone has to let go of what is the easiest stuff to own. We can get some very, very fat premiums for not a lot of risk.

To get a 5 percent real return, will investors have to take on greater risk than in the past?

Schloss: One of the problems for large funds is they’re told, “Once you have your asset allocation, stick to it and revisit it every three years.” That’s forever. I think one of the things our boards in particular learned is we don’t need to do that again. If you can avoid the losses, everything kind of takes care of itself. One of the things about avoiding the losses is to get out of the way. If you see something bad happening, it’s referred to now as risk on/risk off. I wouldn’t quite put it that dramatically; it’s not a switch. But if you’re worried about the euro in Europe, you might cut back. If you get the bigger things right and avoid the things that could crush you, you’re going to be close to making the return you need.

Once you allocate the money, you’re dependent on the manager. One of the frustrations I’ve had was when I asked all of our managers to manage up to 10 or 15 percent cash. Virtually every manager said, “We don’t want to do that. We only know how to be long only, if we’re equity managers. That’s your job. You’re supposed to figure that out. You’re supposed to call us up and say, ‘Take the money back.’ ” I thought that was a terrible answer, but that’s what everyone said. So I also think there’s a certain amount of responsibility that’s not quite aligned with the actual owners of the money.

Manilla: We set up our governance structure so we could do things internally. Because, generally speaking, our managers are relatively illiquid. Even if we didn’t like something, it might take us a quarter to get the capital back, and that could be too late. So we were very cognizant of the fact that most of the hedging and adjusting we’re doing in our portfolio is around our manager allocations, without having to actually take capital back.

Lindsey: I think there’s a misperception of liquidity. A lot of people think they have to have cash on hand. Cash is helpful, but I see liquidity as the amount of time it takes for an asset to come back to intrinsic value after it goes well below intrinsic value because of a huge sell-off in the market. So if I own shares of IBM or Intel and the market is down 20 percent and the fundamentals haven’t changed on IBM or Intel, that stock is not going to stay down 20 percent for multiple quarters. But if I own an illiquid mortgage-backed security with embedded derivatives, maybe that market does disappear for several quarters and getting an actual bid close to intrinsic value will be very difficult. I think in today’s environment you really have to think about liquidity not in the sense of how much something will go down but how long it will take to recover to intrinsic value.

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