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Finding Opportunities and Avoiding Trouble in Today's Market

In our annual Roundtable, eight award-winning investors discuss China, hedge funds, investing in a low interest rate world and how to pick asset managers.

Question: What do you get when you cross the chief investment officer of a $120 billion public pension fund with the CIO of a $380 million college endowment, or when you mix the investment chief for three county retirement systems with total assets of $6 billion together with the CFO of a $420 million spend-down foundation?

Answer: The Institutional Investor Roundtable, an annual event at which award-winning investors from across the financial industry share ideas, affinities and differences in a forthright discussion and collegial atmosphere.

The group of mission-based investors who gathered on the morning of May 17 at the Union League Club in New  York was notable in both its diversity and its commitment. The lively conversation ranged from the vagaries of manager selection to the onerous nature of peer group comparisons.

George Moss began investing for the LSU Foundation while still in business school at Louisiana State University in Baton Rouge. The foundation is a private entity legally separated from the school and required to be self-sufficient. "Our biggest challenge is our return target," says Moss, who teaches a course on derivatives at his alma mater. At Baltimore-based Johns Hopkins University, CIO Kathryn Crecelius manages close to $5 billion in assets, including the $3.4 billion endowment, pension and operating funds. Compliance issues are one of her biggest headaches.

"We have to report to the Fed and the IRS on offshore accounts," she explains. "We're now grappling with the implications of Dodd-Frank, even though I don't believe that legislation originally contemplated touching endowments and foundations."

Whereas Moss is the sole investment professional at LSU, Kathleen Lutito has a staff of 19 to manage $18 billion in defined benefit and defined contribution assets for telecommunications company CenturyLink (formerly Qwest Communications International) in Denver. Lutito, who has been strategizing about how to manage the Federal Reserve's interest rate interventions and their future ramifications, says, "I think it's a real challenge to match the longer-term nature of investment strategy with the short-term regulations and funding rules that we struggle with most."


The Faces at the Table

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Ronald Meyers, pension and investment administrator at Boise-based Idaho Power Co., is most worried about the effects of low interest rates on his $475 million defined benefit plan. He believes that institutions' return assumptions have to be scaled back. "Your fixed income is just not going to do what it has in the past, so you've got more contributions to make," he complains. He is seconded by Laurnz (Larry) Swartz, CIO for three separate Fairfax County, Virginia, retirement systems. Swartz, who oversees about $6 billion for three boards and 25 trustees, asserts, "I think if you look at capital markets assumptions, the issue is more with low interest rates than it is with the ability to earn 7.5 percent."

Thomas (Britt) Harris is CIO of the Austin-based Teacher Retirement System of  Texas, which at $120 billion is the fifth-largest public pension in the U.S. "We have a very substantial risk management effort that tries to spot bubbles and looks at economic mapping," explains Harris, who manages $45 billion in-house with a staff of 120.

Susan Racher's mandate at the Miami-based  Wallace H. Coulter Foundation could not be more different from those of her fellow award winners. Funded in 1999 from the estate of a hematology diagnostics innovator, the Coulter Foundation funds biomedical research and other humanitarian endeavors. When the Coulter Foundation appointed Racher, its founder's former banker at Bank of America Corp., as chief financial officer, it put her in charge of $420 million in donor assets to spend down. The limited-life foundation, through her efforts, developed 18 partnerships with early-stage health care venture capital firms. "There's not a lot of risk modeling on what you do when you have an uneven expectation of cash outflow," she notes.

Rounding out the discussion was Linda Strumpf, retired CIO of both the Ford Foundation and the Leona M. and Harry B. Helmsley Charitable Trust. Strumpf provided the group with diversification through her roles on four different investment committees, two of which she chairs. They range in size from the $80 million Alvin Ailey American Dance Theater to MetLife Funds' variable annuity business, at about $180 billion. "I would highlight the difficulty of organizations with small staffs having to analyze the many, many more new asset classes that didn't exist when some of us started in the business," Strumpf observes. "It was a relatively simple life then."

After a gala awards dinner the previous evening, the eight top investors sat down with Senior  Writer Frances Denmark and Editor Michael Peltz for breakfast and a peer-to-peer conversation.

Institutional Investor: In the wake of the financial crisis, bond buying by the Federal Reserve has kept interest rates artificially low for five years. How has quantitative easing affected your investment strategy, and what are you doing to position your portfolios for when the Fed reverses course and rates start going up? Swartz: The biggest challenge for us right now is how to position ourselves in advance of the increase in rates. It's a particular challenge for us because we run our market exposures on a risk balance basis, which means I have a lot more fixed-income exposure, a lot of real rate exposure but also nominal rate exposure. Lutito: We've embraced an LDI [liability-driven investing] concept, but with historically low interest rates, it's a real tough balance. Meyers: Definitely the biggest thing that we're facing is the low interest rates. It pushed up the required contributions, so there's pressure on contributions. The low interest rates also put pressure on return assumptions. Crecelius: I would definitely agree, particularly for our pension plans, that the low interest rates are problematic and worrisome. Our two plans are about 10 percent of our assets, but I definitely spend more than 10 percent of my time worrying about them. Harris: It's important to realize that for the first time in maybe all of history, we're at the end of four cycles at the same time. One of them is the credit cycle. Thirty years ago interest rates were high and debt was low. Now we're at the end of a credit cycle where debt is high but interest rates are low. We're also at the end of a political cycle. If you go back to the '80s and asked the general citizen, "What is the problem: Is it government, or is it business?" the answer was "Government is the problem, and business is the solution." If you go to the general man or woman on the street today, it's often the opposite. In addition, we're at the end of a demographic cycle. The world has never experienced a time when the marginal growth in the population came from its oldest cohort. We are in uncharted waters. Last, we're at the end of the era of finance. Those in this room who came out of college at a time when the era of finance was just beginning, we have had a wind at our back for 30 years. But that era is ending. When it comes to fixed income, what, specifically, do you do? Racher: I'm a little nervous about my fixed-income portfolio, but I stress-test the hell out of it and constantly take a look at how fast the rates have to rise before I'm in trouble. I still think high yield has some ways to go, and I think emerging [markets] debt is still attractive from a coupon standpoint. So I'm not as depressed as everybody here. I may be wrong, and, of course, I'm spending down, so some of the pressure is off. Crecelius: We put our fixed income in a Barclays Aggregate and hold our breath. We've slightly overweighted equity, and we do have some multistrategy hedge funds, so we're able to take advantage of distressed debt when that cycle is in favor. Otherwise we just admit that for that component of our return, we're going to take a hit, and we try to make up for it in a prudent way in our equity investments. Meyers: We have to have some bonds. Pensioners need money every month, and you have to have some liquidity. You have something without a lot of volatility, you're going to earn very little on it, and you're going to keep it to a smaller asset. We do have some money in absolute-return funds, but they aren't as easy to get into. There are some out there, especially in funds of funds, and we've used some of those. The third thing that we're looking at that I know a lot of corporations use is dynamic allocation. As rates start to ratchet up, we're going to start locking some of that in, capturing a bit higher returns. Lutito: From a pension plan standpoint, it's a double-edged sword because if you own bonds to hedge your liability you're in fear of rising interest rates. But if you're not 100 percent hedged, from a funded status you'll still be better off because your liabilities will fall more than your assets. We're currently around 40 to 45 percent hedged on the liability. Meyers:  We had that discussion a little — well, it was tongue-in-cheek — but we said maybe one of the best things we could do is take our bonds, put them all in long corporates and hope we get killed. Lutito: Unless you're fully hedged, that interest rate rising is going to help you from a funded status point for pension plans.

Meyers: That doesn't necessarily help you when you get in front of the investment committee and you explain to them, "We just lost 40 percent of the money in the bonds, but that's okay because the liabilities went down." One's real money, and the other is just an actuarial calculation that they don't grasp.

How do peer group comparisons affect your ability to invest? Strumpf: Corporate pensions are, and certainly the endowment and foundation world became, very peer-group-oriented. I felt that was one of the most subversive things to happen in our business because we were all paid to do the job we were hired to do, which was to make sure the Ford Foundation or whoever we worked for could pay its bills, not have liquidity problems, do the right thing. Then somebody comes in and says, "Yes, but you weren't as good as X, Y or Z." Incentive plans were developed where it was not just, "Did you generate the 7 percent or 8 percent required?" It was also "You did, but you rank in the bottom quartile or the second quartile." It was this competitive nature that led people to some extent into problems before the financial crisis. I think there's probably a little bit less of that now. I think some of the boards have learned their lesson in the crisis, that if you follow everybody over the cliff, you all end up over the cliff. Lutito: We all have different situations. In the corporate world we've fought that battle for a while, and I'd say the past five years we definitely have divorced from that to say we shouldn't be compared against peers. We have different liabilities. We have different contribution rates. We have different company structures, different company credit ratings. If you're a highly rated company, you issue bonds and put them in your pension plan. If you're not, you probably won't. Same with the public plans. I think they have a very different structure too, and foundations and endowments definitely have different spending needs, different contributions. Strumpf: Also different credit ratings. That was the other problem during the crisis. The three or four universities that had problems were triple-A and could do billion-dollar bond deals, while Podunk University couldn't do them but they ended up with the same portfolio. Did this ever make sense? The answer is no. But the Podunk investment committee said, "Why can't we have an Ivy League portfolio?" Lutito: To your point, I think it's very important how we measure success. Each institution needs to define how to measure success because when you set the bar, people will reach for it, and if the bar is what other institutions are doing, it could cause unintended consequences. Racher: In all those rankings they left out a very crucial variable, and that was risk. They were thinking of one variable — return — and when you see these rankings, it drives me crazy, whether they're private surveys or others where they don't talk about risk. Swartz: I continually reiterate that when the stock market is booming, we're going to underperform. Every time I come in with the quarterly report and we're below the median public fund, I'm asked what happened. I have to continually remind the trustees we don't spend relative dollars. Harris: You're going to have to get more out of your diversification. You're going to have to use your competitive advantages. You have to know what they are and use them in a better way. Everybody in this room is a large investor compared with 99 percent of the world. We have the advantages of being long term, and we have massive amounts of excess liquidity, and we are not inappropriately levered. We've got all kinds of advantages, but it's absolutely essential that we use them well going forward. Racher: I can offer a somewhat contrarian opinion. At the risk of sounding too Pollyanna-ish, I think we're still in rehab from 2008 and still revving up. I'd like to take issue with some of the things Britt mentioned in terms of the outlook. In Paradox of  Wealth, William Bernstein wrote that when everybody thinks the end is near, there are four things that drive economic well-being. Those include the rule of law and property rights, innovation and science, capital markets, and modern communications and transportation. All those things are not only going on here but around the world: Latin America, where countries are finally getting it; Africa, where microeconomics is flourishing. In Asia the middle classes are growing. We see it on the technology side here. The universities are powerhouses of innovation, and the government and the states are finally figuring out how to harness it. So I'm very optimistic about the future and about what this country is going to look like.

Moss: I don't think your view is all that contrarian, so I'll take a very contrarian view. Given what you just said and given how important it is, if we're thinking about places like the Middle East and Northern Africa — frontier markets, emerging markets — and if we're looking at unloved parts of say, venture capital, like health care, then the question is, do you really want to be diversified? That's the real question, I think. Should we have any fixed income in our portfolio when we're investing in equity? Should we be investing in the U.S. at all? Should we have a very different, almost not very diversified, portfolio focused on where we think the opportunities are? Maybe you do need diversification. Not every new company in Africa is going to be a success, so you need diversification, maybe at the localized level but not necessarily at the top level.

What do you think of China, both as a competitor to the U.S. and as an investment opportunity? Harris: China has the obvious advantage of 1.3 billion people. But can you imagine a world where the leading economy has a citizenry that's operating at less than 50 percent of the global standard of living? China has done a fantastic job of getting from gate A to gate B, but if they don't improve their rule of law, deal with their copyright issues, build up a better financial infrastructure and treat their people more humanely, they're not going much further. So I'm pulling for them to do all that. I think it'd be a better world if they did. But to think that their rate of growth is going to be what it was in the past is way too optimistic. Racher: China lacks one thing that the U.S. has: diversity. As long as we keep our immigration policy rational and enable young, smart people to come here and create and stay, then we will continue to have an edge, because that's how innovation and creative ideas occur, from unique points of view. Harris: We are in what some people have called the American Empire right now. If you have to date the start of it, it would probably be the fall of the Berlin Wall in 1989. After  World  War II we transitioned from the British Empire to a competition between an American or Soviet Empire. That has now been settled. We're now in the American Empire, and every empire lasts for centuries, not decades. We're only 20 or 30 years into the American Empire. Moss: Do you think technology might speed up that process? Harris: Technology could speed it up, but we're the fastest-growing technology center in the world. We have the most resources. We have the highest levels of innovation. On average, we have the hardest-working people. We have the greatest academic institutions. We have the best rule of law and the greatest military. People today tend to vastly underestimate the importance of the military, both in terms of our ability to keep the world a safe place and to increase global trade, a secondary role that is served by our military, particularly the Navy. What is the current thinking about hedge funds and their role in your portfolios? Strumpf: I think the lesson of a lot of hedge funds after '08-'09 was that they had too much risk; now they have de-risked their portfolios. You look at a lot of these guys' track records since then and they've been uninspiring because they had all of their own money in it, and when they personally lost 20 or 25 percent, it focused their minds. If you de-risk your portfolio, how do you then generate the returns endowments and foundations require? How can you look at the historical track of a hedge fund? Crecelius: Managers are getting larger, and they have more products. Managers you've found on the private [equity] side who you like and thought you would be growing with suddenly turn into a disappointment because they're not doing what you think is optimal. It's good for them, though. They're bringing in more fees and more investors. They are more focused on the growth of their business, as opposed to purely investing. I think something similar has happened in the hedge fund world. I think that that has been pushed by consultants and by plan sponsors who are looking for low volatility and more stability. Ironically, they could probably achieve the same results themselves in a 70-30 manner [70 percent equity, 30 percent fixed income] given the issues that we've all discussed with fixed income right now. Harris: To Linda's point, I think hedge funds went into the decline because they were overlevered relative to normal and they got their heads handed to them. They started losing clients like mad. People said, "I thought this was absolute return," and they pulled in their risk and did not reestablish it. Once you get behind the curve, you start chasing to catch up. The risk management systems were not what we were hoping for as an industry. Racher: A lot of the hedge funds established their great performance in the period of the dot-com bubble, when there was such a bifurcation of returns around the marketplace. It was not a market meltdown. It was very sector-related. One of the things that scared me about hedge funds is that if your optimization model said you should be 100 percent hedge funds because it's the best thing since sliced bread, we all know that that doesn't work that way. Strumpf: It's funny. I've seen reputable consultants have an assumed rate of return for hedge funds. Moss: Did you say "reputable"? Strumpf: And they are usually a higher rate of return than the equity market. There's no way on earth that you can possibly expect over a long period of time to have a higher absolute return than the equity markets and almost no beta and low volatility. They haven't invented that yet. Swartz: In all fairness to the consultants, though, I think they do that because they're trying to figure out how to deal with the decision makers, at least on the public fund side. Otherwise it's too complicated to explain. It's too big of an educational hurdle. Strumpf: So if you sell them a free lunch — a higher rate of return than equities, low correlation and low volatility — where do I sign up? Lutito: When we went through our merger, we did have to reiterate this to everyone and say, "If you look at my asset allocation, you're not going to see hedge funds in there." I have probably 10 percent of the portfolio in hedge funds, but it's embedded in the other asset classes and they're used as tools to change the risk-return characteristics of those asset classes. Swartz: We do that too. We get the market exposure synthetically and deploy the capital. We take the active risk that the long-only manager brings to the table and deploy that where we're going to get a better information ratio. We had hedge funds before I ever used the words "hedge fund." Racher: The reason I use funds of hedge funds is because the business model is the thing that concerns me the most about [single-manager] hedge funds. The business model is that you are in an LLC or an offshore entity. You're an investor in this entity, not in the underlying [partnership], with lockups and fee structures. I look at the exposures, but then, I also look at them as hedge funds because I don't have the same control and decision-making ability. Lutito: The economics of a hedge fund are very attractive [for the manager], but as an investor you have to be careful you get what you pay for net of all the fees.

Harris: One thing that I realized about four years ago was that there is no legal definition of a hedge fund. This thing we're talking about doesn't exist in any legal sense.

Does the fee structure distinguish hedge funds as an asset class? Harris: You ask, "Where did 2 and 20 come from?" There's lore — I don't know if it's true or not — that it came from John Maynard Keynes in the '30s. When he came up with this new type of fund, he asked, "What should I charge?" He apparently had studied pirates. The traditional charge for pirates, because they would be conscripted by their employers to go out and plunder the seas, was a 2 percent management fee and 20 percent of the loot. That is the only explanation I've ever heard. I like that story, so I'm sticking to it. Meyers: On that same theme, corporations were always beaten back because they didn't adopt hedge funds as quickly as endowments and foundations did. Part of that is that corporations were dealing with the more nefarious side of hedge fund managers. The hedge fund managers were calling my CFO, and they were pestering him. They were going to short us. They were making our lives miserable. Then they'd call me up and say, "How do you want to invest your money?" Lutito: Must have been like pirates.

Meyers: Yes, we had to deal with the pirates, and we were a lot less likely to invest with them.

How do you identify managers that will outperform their peers? What qualities do you look for? Harris: I believe the toughest job that any of us face is picking a manager that's going to outperform in the future. That's much more difficult than picking a stock. It's much more difficult than setting a strategy, and I think it's even more difficult than allocating assets tactically. Strumpf: With the changes on Wall Street, the changes in regulations, in any sort of nontraditional asset class it's really about how difficult manager selection is. You're no longer picking up the beta of an asset class. Of course, we all have top-quartile managers — whatever happens to the other three quarters? I don't know, but they still exist somewhere. We don't know them. Moss: For me it's skin in the game. They're not just compensated on an incentive fee basis, but they have their own money — and not just some of their own money, a meaningful amount of their own money — invested alongside. You have to have that. Second, I look at their investment process before I ever get to performance and volatility, however you measure it. Swartz:  You have to evaluate whether they've just been lucky or skillful. No statistic is going to give you that because no one's been around long enough for statistics to be significant. So, track record and your assessment of their expertise in the decision-making process. Lutito: I think it's always process and people and then performance, but it depends on the asset class. If you're talking about large-cap equities, that's tough. If you think you're going to pick one manager that's going to outperform large-cap equities, I think it's a no-win game. Moss: That's why we index that. Lutito: We try to diversify what they're doing because we've kept maybe one stock picker. You do a little bit of a cap bias in there or a value bias. Using a multimanager approach with different levers, you have a higher probability of outperforming the benchmark net of fees. Meyers: One of the questions that I've developed over a lot of years when we're doing manager searches and due diligence is very simple. I ask, "What are the attributes of a good investment, and how do you go about finding those?"  That — I actually shouldn't tell you this — is the secret of my success. That's been one of our ways to focus in on their discipline: a good, repeatable process. Crecelius: I like managers who know who they are and what they are and what they do and don't do. We want somebody who's going to focus on their area of expertise so that we can hire other managers. I like people who are thoughtful, who really understand what drives their process and their success and when they're not successful spend time thinking about what went wrong and make adjustments if need be. I also think that we try and focus on eliminating the losers. We look at, and analyze very closely, track records and want to know what drove success in the past. We are willing to fund first-time funds and have done so, but those people need to have a demonstrated record of experience. Strumpf: It's that combination of brilliance and humility that I'm looking for. I think it varies tremendously from one asset class to another. When you're thinking about fixed income, you need a huge amount of computer horsepower. Fixed-income managers are in a different world than private equity or small-cap equity. I would also say intellectual honesty about what they do well and the process is a very important part of the equation. My long experience tells me that if somebody is overly dedicated to a process, particularly value managers, they get trapped in what they're doing, and markets evolve. Now, in a volatile market things are completely different. What looks like value may not be value, so while you want a process that makes sense to you, you want somebody who doesn't get so locked into their genius. It's the one-man show where there's one guy who's the decision maker. There's no one there with any power to dissuade him. Harris: Brilliance and humility is the key. We start by trying to minimize the flaws. The biggest problem, according to the data, is we all tend to sell poorly. The managers that we sell actually start doing much better after they are sold. It?s human nature. It's a part of the agency issue. It's a problem. We try to be realistic about what the problems are going to be and try to pick managers in a way that will at least diminish some of those flaws. You also need stability in the people. I don't personally know of any organization that didn't have a stable, settled decision-making structure that performed well. It takes a while to get to know each other, so they need to have that. They care about excellence in everything that they do. Racher: There's not an awful lot to add. Let me try to be creative:  We look for people who look like George Clooney. I'm kidding, kidding. Lutito: Tall, dark and handsome. Racher: In addition to a very lengthy due diligence process that we go through, I use a lot of instinct about whether people believe what they say, whether they treat their people well, whether they accept conflict and disagreement and do not drink the same Kool-Aid over and over again because they're powerful. I look at their risk control and how they describe their failures, because people do learn from their failures.

I don't think hiring is as hard as firing. People tend to fire at the wrong time and for the wrong reasons. I have the doghouse, and then I have the other doghouse, and then I have the cooling-off period. Then I fire them, because if I reacted to my own human nature, I'd be firing too early. I will say that with that process, I'll keep two out of three managers that I would have fired and will be happy that I did because everybody, even good people, have ins and outs. That's a real challenge with active managers.

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