If your investment horizon is effectively “forever,” almost any period of turmoil will seem like a short-term blip, no cause for changing strategy or losing sleep. That is how university, foundation and pension fund chief investment officers see the world. Even when markets are as jittery and volatile as they’ve been since last summer, these CIOs don’t get terribly nervous . Which is not to say that the best of them aren’t paying very close attention.
Institutional Investor brought six of the most prominent of these CIOs together in January in its New York offices to find out how they have been making sense of the markets since the subprime bubble burst. The participants — International Paper Co.’s Robert Hunkeler, the W.K. Kellogg Foundation’s Paul Lawler, the University of Michigan’s Erik Lundberg, Dartmouth College’s David Russ, the Gordon and Betty Moore Foundation’s Alice Ruth (who in March became a managing principal with private equity firm Quadrangle Group and CIO of Quadrangle Asset Management) and the Pennsylvania Public School Employees’ Retirement System’s Alan Van Noord — were all finalists for II’s 2007 Awards for Excellence in Investment Management. Hunkeler and Lundberg, who manage $8.7 billion and $7.1 billion, respectively, were two of the four winners. (The others were William Petersen of the Alfred P. Sloan Foundation and Ronald Schmitz of the Oregon Public Employees Retirement System.)
At the time of their animated and freewheeling conversation, excerpted on these pages, it had been apparent to all of them for the better part of a year at least that the Great Leveraging that had fueled returns for so long was over, and the Great Unwinding had begun. The panelists spoke of the increasing difficulty of finding alpha in the current climate and about the cold eye they were casting as a result on their hedge fund portfolios. They also talked about the growing importance of other alternative asset classes, about commodities and the opportunities they continue to see abroad and about raising cash to fund bargain hunting. Although they acknowledged short-term concerns about the U.S. economy, none thought the sky was falling.
The shotgun marriage of Bear Stearns Cos. and JPMorgan Chase & Co., arranged in March by the Federal Reserve Board, did little to alter that collective view. We checked back in with our six star CIOs post-Bear, and they told us the Fed’s intervention in the markets and the firm’s demise were not worrisome symptoms of a deepening crisis so much as signs that long-simmering problems were finally being addressed.
“I would make the analogy that this is the third chapter in a very long book on our understanding and pricing of risk,” says the Kellogg Foundation’s Lawler. “Perhaps the first chapter was Long-Term Capital Management, and the second chapter was last July and August, when there were challenges in the market. Bear Stearns is just the third chapter. I think it’s going to be a very long book.” International Paper’s Hunkeler agrees: “While I am certainly concerned about what could happen in the near term, I have a degree of confidence that the markets will settle back to a more normal environment before too long. This is not the first time we’ve experienced a crisis. We have had them in the early ’90s, the late ’90s, the early 2000s. This is a big one, too, but it certainly won’t be the last. I don’t think this is what’s going to cause plan sponsors to change their investment direction. There are, however, other, more permanent changes occurring in the area of legislation, regulation and plan design that will likely cause plan sponsors to rethink their asset allocation policies.”
If Bear Stearns didn’t cause any of the six CIOs to revise substantially what they told us in late January, it nonetheless served as proof that the party was now finally, definitely and officially over. And although the CIOs agree that that was a good and necessary thing, some also feel just a twinge of nostalgia for the era that has come to an end.
Lundberg, for instance, who has seen the assets of the University of Michigan endowment nearly triple during the nine years he has been running its investment policy, says, “We’ve had so much leverage the past few years, and now it’s coming off, and it’s not pretty.” He adds a little wistfully, “But it was great when we were putting it on.”
On the pages that follow are highlights of the discussion with the six CIOs conducted by U.S. Editor Jeffrey Kutler, Senior Editor Loch Adamson and Senior Writer Frances Denmark.
Institutional Investor: When you look at what has been going on in the markets over the past several months, what year does it look like to you? Is it 1987, 1973 or, as George Soros suggests, 1929?
Lawler: Maybe I’m a little biased, coming from Michigan, which is in tough economic shape, but I think we are in the beginning of a downward cycle. There is also the issue of secular change. I think that’s what Soros was talking about mostly. The position of the U.S. in the world is changing, and as investors it’s hard to ignore.
Lundberg: We’re slowing from a very high pace that has been going on for such a long time that maybe people took that as the new reality. We could just be going back to normal.
Van Noord: Every economic downturn has its own unique causes. In the most recent downturn, credit was easily extended, packaged and then levered. The first signs of something going wrong came from mortgage resets, negative equity in homes and then foreclosures. This, as the economy faced record crude oil prices, huge budget deficits, a weak dollar and rising unemployment. The Fed has responded by lowering interest rates and adding liquidity to the system. The fiscal stimulus should also help. Given the stimulus that has already been announced, one would expect this downturn to be contained and shallow. The real wild card, however, is the credit crisis and whether or not enough delevering has taken place.
Has all of that turmoil led to any big changes in the way you look at your portfolios? Are you rethinking your strategies in any fundamental way?
Ruth: At the end of 2007, we deliberately raised some cash. This was an effort to buffer the downside and to be opportunistic. Also, as a foundation we have spending needs and didn’t want to get caught selling at the trough of the market. I think eventually, once valuations are sorted out at lower levels, private investors are going to start to see great values, and we’re going to be in a position to take advantage of that.
Lawler: I wonder if things have changed significantly for private equity. Credit is less available, and the leverage that they could use is certainly going to be less. The fee structure of private equity will help the general partners for sure, but I wonder if we limited partners will benefit from those lower prices.
Russ: We’re definitely seeing a reversal of the flow of cash from distributions to potential future capital calls. We also established liquidity in that respect. And our concern is that the capital calls overwhelm any distribution. Our asset allocation is also changing because as public equity markets drop, our exposure to alternatives on a percentage basis grows.
Van Noord: We have instituted a number of changes. We substantially reduced our small-cap domestic equity portfolio and correspondingly moved up our U.S. large-cap exposure. We also established a commodities allocation midway through 2007. We substantially increased our non–U.S. securities as a percentage of our total equity exposure some years ago, in essence eliminating what we call the “home-country bias.” Our current public equity exposure is 31 percent non-U.S. and 27 percent U.S. Over the past months we did increase our fixed income from 16 percent of the portfolio to 21 percent. A lot of that started last summer with the distressed mortgages and the distressed bank loans. We put quite a bit of money into those two areas. We also raised liquidity. We didn’t want to be in a position of having to raise cash in a weak market. As a $67 billion pension fund, we need to pay benefits of more than $300 million each month.
Hunkeler: Getting back to your question, “Has the increase in risk caused big changes?” I view this as nothing more than a repricing of risk after many years of extremely low volatility. So it’s not really that unexpected. But there have been some really big issues that have come up over the past couple of years that have affected corporate plans, such as changes in the regulatory environment, changes in the accounting environment and the freezing of defined benefit plans. All these things working together are causing a slow but significant shift in asset allocations, away from equities and toward fixed income and alternatives.
How concerned are you about inflation?
Russ: We have been predicting lower returns and higher risks since the bubble. We have in place many inflation hedges, Treasury Inflation-Protected Securities, commodities and real estate. We may have been early on our decision to go into TIPS, but it’s working right now.
Ruth: We have a large allocation in real estate and other real assets. If we get into a situation with slower growth and high inflation, we will be glad to have those. Inflation may be on the rise.
Lawler: I think sometimes a little humility is in order. We’ve had quite a large part of our portfolio addressed to our concerns about inflation because of our fears about paper currency, not just in the U.S. but in Europe and Japan. All major currency pots have inflated their currency. We felt a number of years ago that inflation was going to be a problem, so we put a lot of money in inflation-protecting assets. And frankly, inflation hasn’t been a problem to date. We were wrong, but those assets have done very, very well. So it really is better to be lucky than smart. It seems to me, though, the piper is going to be paid at some point with large increases in the money supply.
Van Noord: The emerging markets are demanding more and more commodities and putting pressure on prices, particularly China and India. The Fed is in an awkward position right now. It needs to stimulate the U.S. economy, but to stimulate it, theoretically, the inflation rate will increase. We established a commodities allocation, partly as an inflation hedge, but also as a risk reducer. The negative correlation of commodities to equities was one component that we did look at when we established the commodities program.
Lawler: We’ve actually been cutting back on commodities and TIPS. When oil goes from $20 to $100, when gold goes from $260 to $920, when copper increases significantly and when the real return on a short TIPS is less than 1 percent, then it’s time to reexamine the allocation of inflation-protecting assets. Let’s remember that the government gets to define what inflation is. I love my government, but I trust and verify [laughter]. We’ve also been cutting back on real estate. We’ve had a good run on these inflation-protecting assets, but they are just so highly priced. If you look at a 100-year track record of commodities, the real return is zero. You’ve taken care of inflation, but in real terms the return on commodities over 100 years is less than Treasury bills. So I’m just a little nervous at these prices.
Ruth: It’s always a question of what time period you’re investing for. There have been times, such as the ’70s, when some of these real assets were a tremendous benefit, and there have been times more recently when hard assets have been a tremendous benefit during a rising inflation environment.
Lundberg: The first question was, “Is this 1987? Is this 1929?” It’s 2008. It’s a very different economy. There are many more participants in the global economy than in previous times. So with more participants you’re going to have different experiences, which is what’s supporting commodity prices.
Russ: We have the rising middle class in China and India. We have a demand for all these commodities. The question is, Is China a bubble, or is this the beginning of a 50-year trend? I don’t think it is a bubble.
Speaking of commodities, let’s talk a little about oil. Are the biofuel and gasoline mileage mandates in the Energy Independence and Security Act that President Bush signed in December going to have an effect on your commodities strategies?
Van Noord: We are taking a diversified approach to our commodities allocation using active and passive strategies and would not alter that based on any changes to the mandates.
Lawler: We have a big oil position, and oil has gone up so much. The folks that we have talked to truly believe that nuclear will be an important solution, but I’ll be darned if I can figure out a way to invest in nuclear power.
Ruth: Emerging alternative energy sources are really hard to invest in right now. They are early technologies. The leading managers in this area are not evident yet.
Russ: If we plant the entire country in corn for ethanol, I think the number is possibly 5 to 10 percent of our fuel needs that could be met. There’s no infrastructure to transport it, to get it into cars. Who knows what the effect on the environment will be? One of my neighbors in New Hampshire knocked down his mixed forest of hardwoods and pines to grow corn for biofuel. Then the corn wasn’t harvested. The trees are gone, so they are not producing oxygen. In fact, the lumber is still piled up. The resulting field is just a big muddy swamp producing nothing but mosquitoes. How many other landowners blindly jumped into corn production without considering the supply chain from seed to fermentation to filling station? Look at the run-up in other grain prices as corn displaces their production.
Lawler: And the impact on food prices.
Lundberg: There’s no existing storage for ethanol. If you look at oil, the whole infrastructure is fully depreciated, right? So any new alternative source is coming in at a huge cost disadvantage because it has to have infrastructure developed around it. Ethanol may not be the right final solution, but maybe it’s an okay interim solution in that it will get people thinking and beginning to develop the infrastructure. We may all be supportive of alternative fuel, but we also have to invest to make great returns, and approach it rationally and ask, “Is this an investment that’s going to make some money or not?”
David and Erik, while you and other university endowment CIOs have enjoyed excellent investment returns lately, you have also started to get some pointed questions from the Senate Finance Committee about those returns. Can you tell us what’s happening there?
Russ: I think the inquiry started out as looking at hedge fund and private equity profits and morphed into the question of “Why aren’t endowments reducing tuition and spending more from the endowment to help reduce the cost for our students?” In our case, we did announce, and please verify this on our Web site, that students with a household income of $75,000 or less will get free tuition. It’s not loans, it’s free tuition. And then we have a scale for students with higher family income levels. But I think it is a misunderstanding of what an endowment is. Endowments are restricted to a specific purpose. So if we have an endowed chair in history, funds flow to that chair and are restricted to that chair. We can’t just say, “We want to reduce tuition, let’s take some money from the endowed chair.” In our case, 75 percent of our endowment is restricted. We have created smoothing formulas to spend a portion of the endowment each year for the endowed activities. Endowments are perpetual: We have annual budgets that are supported by the endowment. Foundations award grants and must pay out 5 percent annually, but they may change the way in which they distribute the 5 percent. For example, the proportion of our annual budget supported by tuition dropped from 50 percent to 39 percent from 1992 to 2008, while the proportion of the budget supported by the endowment has grown from 17 percent to 27 percent over the same time span. The rest of our annual budget is funded by the Dartmouth College Annual Fund, nonendowment gifts, sponsored research and, to a lesser extent, revenues from sporting events and from licensing the Dartmouth College brand.
Lundberg: An endowment is not only there to support the purpose of the gift, but to do so for perpetuity. At Michigan last year, before this inquiry, we started to look at how we can increase giving for scholarships. The university came out with an initiative that matches donors’ gifts for scholarships. For a needs-based scholarship, the university would match donors dollar for dollar.
Russ: We have entered into agreements with donors that very clearly set out the purposes of the gift. We cannot deviate from that. We have some endowments from the past where the purpose no longer exists.
Like firewood for the president’s office?
Russ: Yes, you know about that [laughter]? I’m a little surprised that we have this inquiry now. I think we should have been proactive, but it’s too late. I have two children who are college students, and, sure, I’d love to see tuition drop. I know it’s expensive, being on the other side of the ledger. We are investing in the future by investing in tuition today: The multiplier effect for the U.S. and global economy is immeasurable.
Lundberg: One thing public universities used to rely on a lot is state appropriations. Those appropriations are declining every year. Just as they are declining, universities have to face increased costs every year for expansion and from inflation. They have to find ways to make up that shortfall, and one of the biggest sources of revenues to make it up is tuition.
Russ: One thing people don’t understand is that whenever tuition rises, a percentage of that is rolled back into financial aid, which is extremely important. At the University of California, where I was treasurer for the regents, one third of any “fee” increase — UC doesn’t call it tuition — was used to offset the increase for financial aid students.
Let’s talk about a subject that concerns all of you, namely hedge funds. How have your portfolios of funds held up?
Hunkeler: We doubled our hedge fund allocation at the start of 2007. We use hedge funds in our portable-alpha program, and they did quite well last year. That is, they performed extremely well through July and then hit some rocky points in the second half of the year, but by and large they did quite well. We have many funds of funds and multistrategy managers. We don’t make any direct single-strategy investments ourselves.
Van Noord: Our global macro funds have performed well. I think investors, in general, are quite disappointed with quant-based strategies. Over the past six months, they haven’t done well. I don’t know what really happened in January in terms of returns. And I was curious if you guys know [laughter].
Ruth: We’ve discussed the current environment with all of our managers. In our multistrategy managers there is exposure to such events as mergers and buyouts. The breakups of these deals have caused some event managers to see more softness than the other managers. From conversations with credit managers, it appears that we’re still in the correction part of the cycle. We are getting involved with some of the best distressed managers, yet it’s all about timing. We hire them to decide the timing to get further invested. Because if you’re early on credit, you’re going to get caught.
Van Noord: I think managers still are trying to take some risk off the table, and that, in and of itself, has created some issues.
Lundberg: We came out of an era of great complacency, and we saw it in the credit markets and the equity markets, everywhere. And now things are changing, and we’re going to have better, more rational markets.
Hunkeler: The thing I’m most concerned about is our ability to generate alpha. It’s gotten tougher over the past couple of years. I attribute this to the fact that there has been too much money chasing too few good ideas, squeezing out a lot of alpha opportunities. And since August it has only gotten worse. We’re trying to uncover the common thread, if there is one, that’s weaving through our different strategies — equity, fixed income, hedge fund — that might explain this phenomenon.
Lawler: Perhaps a good example is emerging markets. I’ve talked to some of my peers, and it’s rare that your emerging-markets manager has beaten the index. It doesn’t bother me at all. I don’t think it should bother us at all because emerging-markets returns have been so splendid that you don’t care if you’re up 40 percent instead of 43 percent. I actually think that that’s a good sign because it means your managers are being selective and careful. It appears there’s a lot of speculation in China. The market is, perhaps, way overvalued. So those managers that are showing discretion may have short-term negative alpha. A lot of what we were hearing from managers for the two or three years leading into July was about quality: “It’s the junky junk bonds that were getting big returns, it was the lower-quality equities.” That’s unwinding itself now.
Russ: Their investment philosophy hasn’t changed. The circumstances have changed.
Hunkeler: No, no. Just the excuses [laughter].
Van Noord: When you look at active managers, they haven’t done well. Forget the past six months; for the past couple of years, they really haven’t done well. If you look at statistics on how they’re doing against their benchmarks, many of them are underperforming. When we go through our portfolio, 60 percent are underperforming their benchmarks. That’s a lot for active management. We’ve taken the view that we’re going to do more beta management in-house, and we’re going to look for specialized alpha management externally. So we’re willing to pay for alpha. But looking forward, I think you’re going to see us have more performance-fee mandates rather than fixed-fee mandates.
Lundberg: At the end of the day, some of what we thought was alpha will eventually to turn out to be beta.
Ruth: One trend we’ve seen in our portfolio over the past year is that some U.S. managers have an increasing amount in emerging markets. So we’re getting emerging-markets beta and calling it U.S. alpha.
There has been a tremendous blurring of asset classes and hybridization of investments in recent years. Has that made it more difficult for you to make asset allocation decisions? Has it made it harder for you to explain your investment strategies to your boards?
Lundberg: Just to be clear, a hedge fund is just a business structure, it’s a catch-all. It doesn’t tell you anything when someone says it’s a hedge fund except that it’s going to be expensive [laughter]. You have to look at what’s in there. What we’ve done over the past several years, we’ve been encouraging all our managers to relax their restrictions. To go out and do other things because the restrictive process model that we ended up with didn’t do well. The boxes model didn’t seem to work so well. I think it’s on us as investors who hire these guys to understand what’s in there. How does the manager actually handle it, what do they invest in? Are they just going into other markets and just getting beta exposure? Sometimes getting beta exposure and knowing which market to go into is a skill.
Lawler: We did a very crude study on our hedge funds that have done quite well, mostly on the long-short side. We asked if the shorting mechanism has added value. And what we found is that for most of our hedge fund managers, it has merely offset the higher fee structure. So it hasn’t hurt us and it hasn’t hurt them. They’ve gotten their second homes up in Stowe, which is very nice [laughter]. But I think it’s hard to figure out what the real beta and what the real alpha of these managers are. At least we’re finding it very difficult to analyze on our own.
Lundberg: It just gets more complicated to do our jobs.
Lawler: Our trustees are finding it increasingly difficult to understand what we do. So they rely more and more on the expertise of the staff, which may be somewhat troubling. This trend has been evolving over the past 20 years. As to asset allocation, we’re trying to ask, “What function does the asset serve for our portfolio?” So we have liquidity, inflation protection, deflation protection, cash flow and capital appreciation as functional sectors of the portfolio. If you look at the wide range of assets available to institutional investors, it is difficult to make a distinction now between alternative and traditional assets.
Russ: How do you benchmark these new five categories? Are you using traditional benchmarks, or did you throw them out?
Lawler: Well, each manager has a particular benchmark. We can benchmark against our peers, but we can also benchmark against traditional measures. Then again, the traditional benchmark with an MSCI-ACWI and a Lehman bond mix may be a respectable proxy for how well we are doing in terms of our asset allocation. But that doesn’t really answer your question.
Russ: Is that like Peter Bernstein’s idea from a few years ago: Get rid of the benchmarks and hire the most-skillful managers we can find to add value? Is that the concept?
Lawler: I think it’s evolving. But I am fairly confident the old way of looking at benchmarks doesn’t serve our purpose in today’s world. I recall at a foundation endowment conference, there was a discussion about benchmarks and whether we should establish standards for risk as well as return. In my opinion, we do not have adequate tools for measuring risks. Most of us around the table are now incentivized, but in most incentive comp plans there is no adequate quantifiable measure of risk.
Russ: That’s why it’s so difficult to analyze and measure risk. There is no common definition.
Lundberg: As we get into more alternative asset classes, the tools to manage the risk and understand what’s in there are not as good, as sharp, as they are for fixed income and equities. I think we are all trying to understand what we actually own in the portfolio, how it all works together.
Van Noord: Over the past five years at Pennsylvania Public School Employees’ Retirement System, the basic asset classes haven’t changed, with the exception of the addition of commodities. But it’s within those asset classes that we have further diversified, using more sub–asset classes and more-exotic trading strategies. This has resulted in more risk-based asset allocation. From my standpoint, I need to know how much risk I am allocating to each asset class. For example, if executing a currency overlay program, I need to know what my total exposure is to certain currencies. So it’s getting at some of these major things and addressing them from a risk-budgeting standpoint.
Lawler: We are not at the level to know what we don’t know. For example, we have hedge funds, and some of them use leverage. Some of them don’t. It would be useful to try to quantify overall leverage in the asset sector and the overall portfolio.
Let’s look ahead. Some of you mentioned raising cash and exploring distressed opportunities. Do you think managers may start to become more opportunistic? And what kind of return do you think you might see this year?
Van Noord: I think that will depend on the manager. Opportunistic fixed-income managers will be taking advantage of opportunities in the distressed mortgage and bank loan markets. I’m not so sure that a traditional equity manager is going to be real eager to do much of anything right here. Most equity managers will likely wait and see how the credit crisis plays out. There also is a reduction of risk that is taking place. I think managers may stay on the sidelines right now.
Did any of you find that you had subprime exposure that you hadn’t known about?
Van Noord: No, we didn’t. We tried to turn over every rock that we could and really had very, very, very little exposure. Could that change? Yes. Right now we’re fine with subprime issues. But they are really throwing the baby out with the bathwater, so to speak, so it’s an opportunity, and we’re taking advantage of that too.
Hunkeler: We have very little subprime exposure, but what the subprime debacle did expose was what I call benchmark parkers. These are fixed-income managers that for years have maintained overweight positions in the higher-yielding sectors of the bond market. This type of strategy works until a market like the one we’re in right now exposes its weakness. For a while you pick up the additional yield, you generate what appears to be alpha, but then you realize that your manager wasn’t that skilled after all, he simply was “parking” his investments in higher-yielding sectors of the bond market.
What’s your broad feeling right now about the U.S. economy? What do you think the rest of 2008 is going to look like?
Van Noord: The U.S. is in a period of economic slowdown, with a high probability we will enter a midcycle slowdown or a mild recession. The U.S.-led economic slowdown is affecting the European economies. They’re slowing down. There are some exceptions. The really bright spot still seems to be emerging markets. We’ve always had this big connect between U.S. markets and non-U.S. developed and emerging markets. I think this time around you’re not going to find that. They’re going to slow a little bit, but not to the extent the U.S. will slow. The fiscal stimulus package, I think, will help a little bit. It’s small, but it should be somewhat effective. The Fed is aggressively lowering interest rates, which should also stimulate the economy. The one benefit we are seeing with the lower dollar is that our exports are increasing. So I don’t think you’re going to see quite the severity that maybe some people are looking for. Bottom line, I think it is going to be a volatile market in 2008, more volatile in the first half than the second half. At the end of the year, one will probably see that equity markets are actually going to have some appreciation.
Hunkeler: We don’t get too preoccupied with what’s going to happen in a particular year. I would say what we’re looking forward to is that once this period of risk repricing is behind us, we’ll have much better opportunities to add value. So whether the markets are going up or going down, I just hope we’re going up a little more than everybody else or going down a little less.
