For professional money managers, the challenge of beating the market is ever-present. But for the stewards of pension funds, foundations and endowments, these are particularly trying times. Congress is debating major legislation that would mandate higher funding levels and tighter accounting standards for pension funds; legislators are also considering proposals to cap foundations’ fund management expenditures. While keeping one eye on potential regulatory changes, fund managers must try to maintain strong investment returns during a time of relatively high market valuations and economic uncertainty.
With those challenges in mind, Institutional Investor invited four of the most interesting minds in the pension, foundation and endowment worlds to our Manhattan offices last month: Donald Foley, senior vice president, treasurer and tax director, ITT Industries; Laurance (Laurie) Hoagland Jr., chief investment officer, the William and Flora Hewlett Foundation; Linda Strumpf, chief investment officer, the Ford Foundation; and William Quinn, president, American Beacon Advisors, the unit that manages American Airlines’ pension fund. All are winners of II’s annual awards for excellence in investment management, and all have provocative things to say about the festering retirement crisis, the murkiness of markets -- and much more.
Bill Quinn graciously agreed to serve as both moderator and participant in a candid discussion of the issues and challenges facing the custodians of trillions of dollars in pension, foundation and endowment assets. Joining the panelists were Assistant Managing Editor Barbara Rudolph and Senior Writer Loch Adamson. Here are highlights.
Quinn: Let’s start with a big question in the pension, foundation and endowment worlds: How can we achieve the kinds of returns that we need? The markets are not being so helpful.
Hoagland: We’ve tried to position our portfolio so that we have exposure to the markets, so whatever the markets will naturally give us, we will be able to harvest. The difficult part beyond that is, how do we get the return up to our magic number of 8 percent? The boring little mantra I have is that all of our people are out looking for investments that we think will give us high single-digit returns, maybe low double-digit returns, and where the downside is, hopefully, a small positive number and, at worst, a small negative number. The kind of things that fit that are real estate, absolute return, private equity -- high-yielding assets.
Quinn: Do you set a threshold return or expect a certain return on private equity?
Hoagland: Well, for me, private equity long term needs to have a return premium of 3 to 5 percentage points over the public markets.
Quinn: Do you think that’s still achievable?
Hoagland: I hope so.
Quinn: Linda, what are your views?
Strumpf: Generating a 5 percent real rate of return after expenses is going to be a challenge over the next couple of years. There’s so much capital floating around the world looking for a home. We’re somewhat different from Laurie in that we have not put a lot of money into the real asset category. We look at the places where we are going to get incremental returns over that of the market, like private equity. We think that we can get into the good [private equity] funds because we’ve been doing this a long time, and that gives you an advantage.
Quinn: Donald?
Foley: We’ve got an interesting problem. After the split-up of the old ITT, we assumed most if not all of the liabilities associated with the company. We’ve now got four times the number of inactive participants relative to the active population that’s actually generating the cash flows, the contribution sources. So our charge, basically, is to make sure that we’re generating sufficient returns to meet a 9 percent threshold. We’ve been fairly lucky over the past several years in achieving that, through an emphasis on active management. We’re really dealing with a fine set of managers, largely sticking with them through thick and thin. They’ve thrown off returns that have allowed us to basically exceed our 9 percent threshold.
Hoagland: Can you say some more about the hedging of your liabilities?
Foley: It turned out after the 2000, 2001 time frame that there was a great correlation between fixed income and the structure of our liability. What we’ve been able to do, in effect, is through swap positions play that yield curve, realize some returns, taking advantage of the volatility in the fixed-income market. We use it without disturbing the underlying base of managers that we’ve got managing our fixed income portfolio, so it’s an overlay to that. We’re not out there actively trying to catch every movement in the market. We’re looking for the broader trends over a period of time.
Quinn: Our goal has been a 9 percent return. We have achieved a lot of our gains over the past ten years by having an asset-liability match. We have very-long-duration bonds for setting our liabilities, and we started that program back in 1980, when interest rates were 16 percent. Recently, we’ve been reducing our fixed-income exposure. We’re looking at increasing private equity, we’re looking at real assets, we’re looking at a couple of different strategies in the energy area that will do especially well in a high-energy-cost market. That’s almost a natural liability hedge, but it’s also a hedge against getting lower contributions from our parent company. So if oil does go to $70, $80 a barrel and stays there, then the pension fund will generate sufficient returns to more than offset the lost contributions.
How are people increasing the private equity exposure in their portfolios?
Foley: We’re casting a wider net. A disproportionate share of our private equity funds has been devoted largely to the communications areas -- to the media, to entertainment, to some technology ventures. Private equity is attracting an awful lot of capital, and it makes it more difficult for people to distinguish themselves in that area.
Strumpf: It looks like if you invest in a bunch of private equity funds, they’re either competing with each other for some of these big deals or they are in consortium with each other, so when you think you’re diversifying, you end up owning the same company three different times. I pick up a paper -- in every deal it looks like either two of our managers are competing with each other and just inflating the price we’re paying, or they’re in cooperation with each other. So you end up with this sort of double whammy.
Quinn: We’ve been going down in the size of our private equity managers. We’re really almost avoiding the megaguys and staying with one or two and not five or six of them. And then we’re trying to find the next level of managers that are in the midmarket, in the smaller market of private equity.
Hoagland: In private equity we’ve had historically a pretty venture-centric portfolio, so now we are adding more buyout managers and international.
Strumpf: One of the risks in private equity right now is that they’re competing for deals with hedge funds that can get their 20 percent carry right away. They don’t have to wait for a deal to happen, and they can just outbid everybody. Whether they can run a company or not is another question.
Quinn: On the subject of active versus passive asset management, I think we may have an unusual group here in that everybody is an advocate of active management.
Hoagland: When I came on board [at the Hewlett Foundation], we had some passive, and what we’ve done is basically keep the traditional active management that we had in both equities and bonds. Then what used to be passively managed is now largely overlaid with, hopefully, alpha from an absolute-return portfolio. Now pretty much all of our assets are subject to some kind of active management, whether it’s traditional or absolute-return hedge funds.
Quinn: Don, I know one of your fortes is a focus on active management.
Foley: Yes, we’ve proven to our satisfaction that active managers have been very successful for us in the past.
Hoagland: Congratulations, considering the many people who have ended up with the opposite conclusion.
Foley: It’s a lot more intensive work to find good managers, but we think that effort is worth it. We could probably see ourselves adopting passive strategies in combination with some of these derivative plays that we’re talking about. We’re just studying that and haven’t come to any particular conclusions about inserting that into the portfolio.
Strumpf: I think the hard part about active management has been, because of the consultants and the way the business went in the ‘80s and ‘90s, as a money manager you couldn’t get out of your box. People gave money managers very specific tolerances in terms of how much risk they could take around that benchmark. So to survive in the business, if you were a large institutional money manager, you had to play that game. You had to fit in a box, and you had to have very low tracking error to some benchmark. Now managers are more willing to run more-concentrated portfolios and take more risk, but it’s a very significant business risk to do that.
Quinn: We’ve had active management 100 percent since 1980, when I started running the funds, and it goes back before that. I think the key was defining the expectation. During the 19821998 run it was very hard for active managers. We always explained to our trustees that we are going to do better in down markets. We’re going to do better in markets that are probably up 0 percent to 15 percent, but when the markets are up 25 percent, 30 percent, we’re going to trail, though we’ll be up 18 percent to 20 percent in absolute terms. I think given the lower return environment we’re all talking about, we’re back in a mode where active management should be able to add value pretty consistently.
Strumpf: Are you getting less constrained managers?
Quinn: We use all-cap managers, and we want them to have the ability to be small when small is cheap and large when large is cheap. Our managers tend to have more leeway. Generally, they’re not benchmark huggers, so we’ve been fortunate from that standpoint.
Hoagland: We’re trying to avoid overdiversification among managers, trying to have more managers who are willing to have more concentration.
Strumpf: I have a question about a new asset class. Have you all started doing bank loans with your fixed-income managers? Everybody is coming to us and saying, “We have to invest in bank loans.”
Quinn: Are these distressed bank loans?
Strumpf: Hopefully not! No, these are just bank loans; they are the three-month reset to LIBOR. Everybody is running around saying that interest rates are going up, therefore these are better than high-yield securities because they are more senior in the debt structure. It’s one of these things that has become fashionable, and I guess we’re all old enough to know that when everybody is selling you something, it’s usually because Wall Street is making money at it.
Quinn: I think we’ve seen some of it creep into our high-yield portfolios. Let me shift gears. How bad is the pension crisis? Are we seeing the end of defined benefit plans?
Foley: Well, it’s a very serious environment. DB plans are under a great deal of pressure right now, not only to perform but also to defend their position against the regular business. It’s our observation that the Bush administration is trying to protect its interest with regard to the Pension Benefit Guaranty Corp. and wants to have more security associated with the promises being made by a company, so they don’t wind up with the taxpayer. We don’t see DBs going by the by. We look at DB plans as probably being the best benefit we can provide our employees.
Quinn: We’re heavily unionized. Our pilots, flight attendants and mechanics are all for preserving a DB plan, and we are fighting hard to keep one. Our concern is, the focus has gotten so short-term. Some of these benefits are payable over 40 years. We’ve got to look at this in the long term and fund it appropriately.
We touched on hedge funds a little bit. Laurie, how do they fit in your program?
Hoagland: Well, when we started in hedge funds in the early ‘90s at Stanford -- if you look back at the results of those funds, they were just incredibly attractive on a risk-return basis for their low volatility and very solid returns. Now the way the money is coming in, it has sort of flattened those arbitrage opportunities. The biggest concern I have is that the multistrategy hedge fund that used to have several arbitrage-type strategies now has a relatively small amount, and they have bigger amounts in what they refer to as event arbitrage. But whatever they call it, it’s really stock picking. So you’re drifting back to active management rather than the systematic returns you would get out of arbitrage in earlier days. As we develop our portfolio of absolute-return funds, that’s one of the big issues we’re concerned about.
Institutional Investor: With hedge fund managers moving more into private equitytype deals, are people playing fast and loose with valuations?
Strumpf: Managers have been banking performance. Investors, particularly in a hedge fund of funds, want to see a consistent 1 percent-a-month return. Clearly, what some of them are doing is banking performance, so that it looks a lot smoother than it is. And what about hedge funds that have different fee structures depending on how much you lock up your money? If you want annual liquidity, you have to pay a higher fee, and if you really lock up, you get a lower fee. I don’t understand conceptually how a person can be running a hedge fund with different time horizons and different lockups and different fee structures. It seems to me that someone has to suffer in all of this. If something goes wrong, the guy that has annual liquidity is going to say, “Fine, I’ll take my money.” Then you’re the one that’s stuck with this thing that’s falling apart.
Quinn: What about the issue of leverage in hedge funds?
Strumpf: As return opportunities in hedge funds look like they’re diminishing, I think people are just substituting leverage. I know in the endowment and foundation worlds, there are an awful lot of people playing in this area who really don’t know what they are looking at. They are doing it because their boards are telling them, “Well, Stanford is doing it, and Harvard is doing it, so we better do it.” Most of [these foundation and endowment people] tell me, “Well, we’re in hedge funds, but our hedge funds don’t use leverage,” and I look at them like they’re insane. And now you’ve got the public funds throwing money into hedge funds. I think in some states and localities, people know what they are doing. But we’ve seen these little townships saying that they’re going to have a 15 percent allocation to hedge funds. They are either highly dependent on what they think is a good consultant or they’re dependent on a fund of funds. But there are now thousands of funds of funds. They’re not all 200-IQ people, either.
II: Are the economics of the fund-of-funds business sustainable?
Strumpf: There will always be a set of investors that are not going to have the expertise to do it, and therefore, I think, the business isn’t going to go away. What I’m hearing from hedge funds, though, is that they can’t wait to throw the funds of funds out. They needed them at the beginning, but. . . . I caution a lot of my friends that are using funds of funds. I say to them, “You better start developing relationships with your managers directly, because I would guess that within the next five years, most of the funds of funds will get thrown out of these things.”
Hoagland: I think there’s an irony in the fund-of-funds fees. The newer hedge funds tend to have higher fees than the well-established ones with track records. The same thing is true in funds of funds. The early ones who started, most of them just have flat fees, and the newer ones with no track records who are now trying to muscle in are charging fees and carry.
Quinn: I see sitting on some endowment boards that you’ve got one consultant who just believes in hedge funds, and they’re doing it. The endowment can be a million dollars, or it can be a billion dollars, and it is the same strategy being used. And therefore the boards don’t understand it. Do you see that happening in your world as well?
Strumpf: Definitely. I’ve been on this kick for years. I think that trustees and committees are wonderful, but I think they have to know their limitations. You just have to say, “We’re not competing with Harvard and Yale. There’s no reason to. Why are we playing this game of who’s in the top quartile? It’s nonsensical.” I’ve tried whenever possible to get our board away from that. We have our benchmark, we have our 5 percent real rate of return, and evaluate us on that. If you think I’m stupid, fire me. But don’t make me do what everyone else is doing.
Quinn: On a different subject, what are people’s views on long-term bond rates, say, over next three to five years?
Hoagland: To me, a really core issue is this: What’s going to happen with respect to this massive amount of liquidity that we’ve seen? Historically, the markets have been driven by cycles of liquidity, and things get run up during the bull market and then the Fed or somebody comes and takes the punch bowl away. So the question is, are we going to see that cycle again, or are we in a different environment where there’s a secular increase in liquidity that will cushion whatever cyclical phenomenon is going on? If that’s true, then the good news is, we don’t have a big bath coming in the next three years. On the other hand, then long-term-return expectations are going to stay low, and bond yields are probably going to stay pretty low.
Quinn: Which way are you betting at this stage of the game?
Hoagland: I think there’s more than a 50-50 chance that we’ll all have a relatively benign outcome in the short term, but that will leave us all in an even bigger bind trying to get 8 percent or 9 percent returns long term. And there’s a small chance that we’ll have an ugly environment for a while.
Quinn: Don, any thoughts?
Foley: I guess we’re positioning ourselves for a rising yield environment over the next three to five years. Our bias is basically to be lighter in fixed income and heavier in the equity, hedge funds and private equity situations. Our feeling is that there’s probably an asset bubble out there that will be pricked.
Strumpf: I guess the answer to the question about long-term rates is in Beijing, not here in New York. You look where all the money is coming from, and it’s coming from the Asian central banks.
Hoagland: Another dimension to all this is the petrodollar. Will countries spend their petrodollars locally or reinvest them in the U.S.? There’s a lot of uncertainty about that.
Quinn: It’s been a big surprise that the energy prices haven’t created more of a negative. Really, it’s been almost a nonevent.
One thing we didn’t talk about is equity valuations. Are you worried about them being too high?
Strumpf: We worry about small caps having outperformed large caps in value and growth. But I think in broad terms the market is about fairly valued.
Hoagland: I think this liquidity issue and the huge amount of investment funds have resulted in the revaluation of essentially every asset class. They’re rich by historic standards, but that may become the new standard. If there are going to be high saving rates in a lot of places around the world -- probably not the U.S. -- that would sustain that flow of investment funds, maybe things will stay on a higher level.
Strumpf: Real estate is expensive.
Hoagland: I don’t know if you’ve had this experience, where the real estate guy comes in and he says, “You won’t believe what’s going on in real estate and how crazy everything is; everything is just wildly overvalued.” And then a couple of hours later, the energy guy comes in and says the same thing. And it happens across all the asset classes.
Quinn: Nobody is saying there’s anything cheap out there. There is nothing cheap out there.
Strumpf: The only sort of table pounders you get are the people who buy quality growth stocks. I think that’s probably right. There are stocks that are down a lot and where the companies are solid and people are just not paying premium for higher growth. Actually, we’ve taken some money away from our value manager and hired a new growth manager.
Hoagland: The other thing that may be a reasonable value is Japan. We have been building our position there for several years, and there’s a possibility this could be a fairly long-term turnaround in Japan. It’s also a chicken way to play China.
II: Thank you all very much.
Meet II’s distinguished panelists:
DONALD FOLEY
Senior vice president, ITT Industries
Donald Foley, 54, joined ITT Industries in 1996 as treasurer and vice president. With a BA in economics from Union College and an MBA in finance from New York University, he had worked as an assistant treasurer at International Paper Co., helping to orchestrate the company’s global expansion. At ITT he played a key role in reducing debt and was appointed senior vice president and tax director, as well as treasurer, in February 2003. Supervising the company’s $4.5 billion pension fund, Foley has bet heavily on alternative investments while steering clear of real estate. He is also a staunch believer in active management: Not one cent of ITT’s assets is passively managed.
LAURANCE HOAGLAND JR.
Chief investment officer, William and Flora Hewlett Foundation
Laurance (Laurie) Hoagland Jr. joined the William and Flora Hewlett Foundation as chief investment officer in 2001, after managing Stanford University’s endowment for nine years. (Hoagland earned a BA in economics at Stanford, a BA in philosophy, politics and economics from Oxford University and an MBA from Harvard Business School.) From the moment Hoagland, now 68, arrived at Hewlett, he began to overhaul the organization’s portfolio, then heavily invested in shares of Hewlett-Packard Co. and spin-off Agilent Technologies, transforming the endowment into one with multiple asset classes. He slashed U.S. equity exposure, moved aggressively into international markets, made allocations to hedge funds and sought out unusual direct investments in private equity and real estate funds throughout Europe and Asia. Hewlett now ranks as the seventh-largest foundation in the U.S., with $6.9 billion under management.
WILLIAM QUINN
President, American Beacon Advisors
Despite the notorious troubles of the U.S. airline industry, William Quinn, 57, is flying high at American Airlines’ $7.7 billion pension fund, delivering strong performance over the past five years.
He favors a heavy helping of long-duration bonds, keeps a modest percentage of total assets in U.S. equities and has no exposure to hedge funds. He’s not comfortable with the risks associated with that trendy asset class.
A graduate of Fordham University and a certified public accountant, Quinn joined Sky Chefs, American Airlines’ former catering subsidiary, in 1974. Four years later he became comptroller. In 1987, when American set up AMR Investments (now American Beacon Advisors) to manage its retirement plans, Quinn was tapped to become the founding president. ABA manages about $20 billion in nonAmerican Airlines assets in addition to the company’s retirement fund.
LINDA STRUMPF
Chief investment officer, Ford Foundation
Since joining the Ford Foundation 24 years ago, Linda Strumpf -- who was named chief investment officer in December 1992 -- has overseen extraordinary growth in the organization’s assets. The foundation had $6.2 billion in its coffers when she became CIO; over the past 14 years it has given away more than $7.5 billion and has still grown substantially, to $11.5 billion. Strumpf, 58, and her team of 18 investment professionals manage about half of those assets in-house. The onetime buy-side technology analyst and portfolio manager has a knack for private equity: Ford has profited mightily over the years from early stakes in Amazon.com, EBay, Google and Yahoo!
