“You can’t eat Sharpe ratio,” the pension CIO professed. Battle-tested through multiple cycles, the CIO gazed down the long path toward fully funded status just over the horizon, finger ready to pull the next LDI trigger.
“Funded status volatility is the primary metric many of your similarly funded peers use,” stated the actuary, matter-of-fact math whiz and key holder to the authoritarian asset/liability management study. That mandatory exercise nudges investment practitioners toward suboptimal portfolios focused on relative risk and return instead of absolute risk and return.
“We can’t afford to de-risk. Our budget will not balance,” said the official, fully aware of the difference between the accounting of the pension liability versus the economic reality of the liability.
“You can lock in your funded status by purchasing investment-grade corporate bonds that act as a proxy for your discount rate,” noted the fixed-income manager, trying to gain further scale as pressured fees squeeze profit margins and investors decrease active risk.
“We aim for high-single- to low-double-digit returns,” explained the private credit manager in a tone that made it sound like the outcome was a foregone conclusion.
Many of you have heard real-life versions of the above — especially if you’re a pension investment professional. Yet these platitudes are endemic among all types of institutional investors. Dogma and conventional wisdom run deep.
I bring this charge to the industry fully aware of why suboptimal decisions on portfolio construction, asset allocation, and risk management persist. After all, as my industry brethren remind me, career risk and peer risk are real. Those factors are so strong that they seem to outweigh the reality most investors face today: Expected returns are low as plunging discount rates cause liabilities to balloon.
Liability-driven investing is the prescription corporate pensions get sold to cure the disease.
In its simplest form, traditional LDI calls for covering the payments promised to a pension’s beneficiaries with inflows from fixed-income investments. Buying corporate bonds rated AA and above tends to help pension funds achieve this hedging goal, because how much the funds owe their beneficiaries (known as the accounting liability) is calculated using a discount rate based on these corporate bonds. LDI is all about investments and liabilities moving in tandem. If the pension stays at, say, 90 percent funded regardless of markets, then it’s not impacting the parent company’s financial performance and earnings per share. That makes stakeholders happy. Volatile pension funded status makes them unhappy.
So in sum: Loading up on the credit spreads of a universe of investment-grade corporate bonds hedges the accounting liability and reduces funded status volatility. Apply this traditional remedy, and voilà! Your outcomes will closely mimic those of your peers, as most take the same medication. As a fiduciary, you have done well for the beneficiaries because their future pension checks are backed by low-risk assets. As a team member, you have shored up the parent organization’s confidence in steady financial statements (as far as the pension fund, at least).
But not so fast.
It’s not feasible for most corporate pensions to buy corporate bonds rated AA and above as the universe is limited, thus forcing them down to at least single-A and perhaps BBB (tracking error — gasp!). I have a technical term for the result of this widely adopted strategy: C.R.A.P., aka Corporate Rates Are Puts. They’re short puts, to be precise, as shown below. Corporate credit spreads have provided –12 basis points in annualized excess return over the past 24 years. And yet most pension systems still expect asset returns of 6 to 8 percent.
Also, immunizing a pension according to the liability’s discount rate is an accounting hedge — not an economic hedge. The amount of benefit payments going out the door every month doesn’t change based on the discount rate. In fact, many corporate pensions are frozen and closed as changes in mortality assumptions, Pension Benefit Guaranty Corp. premiums, and potential lump sum payment options are the main variables affecting the liability.
Moreover, pension expense/income is a noncash item in financial statements. You can’t eat pension income, just like you can’t eat a Sharpe ratio. We should heed these words of wisdom from Charlie Munger: “Show me the incentives, and I’ll show you the outcomes.”
Lest I forget about career risk and peer risk, perhaps I’m being a bit too tough on the conventional wisdom.
There is still a (major?) role for traditional LDI. But beyond a certain point, I believe it is imprudent to bet on essentially one risk: credit spreads. In other words, beyond that point I believe LDI should stand for Lower Diversification Investing (a self-coined acronym, like C.R.A.P.). Complementary approaches do exist. No, I am not talking about just dipping down into lower-quality corporate bonds, mortgage-backed securities, or private credit. Those may be worthy up to a point, but they bring only marginal diversification benefits. Rather, I’ll be bold and throw out two controversial phrases in the pension world: hedge funds and portable alpha.
As I argued before, corporate credit spreads are C.R.A.P. If an investor wants duration, then he or she should just go straight to U.S. Treasuries and replace the credit spread component with a diversified portfolio of hedge funds. In my experience, 200 to 300 basis points of excess return over cash, net of fees, is achievable. That comes with a much more attractive downside and upside risk profile compared with investment-grade corporate credit spreads. Yes, it introduces funded status volatility — but the good kind, upside funded status volatility, while materially reducing downside funded status volatility. Also, it enables an investor to customize duration exposure synthetically via futures and swaps and not be beholden to where a corporation decides to issue on the curve.
Are there challenges to the implementation of such an approach? Of course there are.
First, investors need to recognize that historically, many portable alpha implementations were shoddily constructed. This tends to be the case for investment flavors of the year pushed by tourist investors.
A successful portable alpha program needs to have a vast majority of its underlying assets in hedged funds, not hedge funds. These hedged funds need to be hedged at the position level, not the strategy level. Correlations cannot be relied on to bail you out during tough times (structured credit in March 2020, anyone?). Equity futures combined with short-duration credit strategies? Not portable alpha. A portfolio of long-short equity managers combined with an equity beta 1 overlay? Not portable alpha. Alternative risk premium strategies combined with beta overlays? Not portable alpha. Filling up various hedge fund strategy buckets in pursuit of a diversified alpha stream? Not portable alpha!
Second, there are educational and governance hurdles an investor must overcome: the ability to use derivatives, a philosophy of active versus passive, high fees versus low fees, relative risk and return versus absolute risk and return, liquidity, etc. The height of those hurdles varies based on an investor’s specific circumstances. It takes real leadership and time to gain creditability through stakeholder education and meaningful relationships. As John Maynard Keynes wrote, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Cherry-picking information to justify inaction has gotten too easy in a world of big and democratized data. For any narrative we’d like to tell ourselves and others, data exist to back it up. The art of investing was overshadowed by overengineered, commoditized products in the past decade. Hyperconnectivity allows us to seek out and take shelter in our own echo chambers. I believe it stifles forward progress and leads many investors to surrender to the group think of their industry peers. Or at the very least, it sows creative destruction and will eventually distinguish the tourist investors from the disciplined investors.
To paraphrase Howard Marks: If you invest like the average, then you will never beat the average.
Jason J. Josephiac is a steward of capital for an institutional allocator. He is experienced in portfolio construction, asset and risk allocation, LDI, overall pension strategy, and using hedge funds in a portable alpha program.