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Thursday, January 28, 2010

Do People Never Learn ?

To see the managers responsible for the pensions of tens of thousands of employees attempt to secure the future retirement income of those people by increasing their risk is amazing. What's worse is that when these strategies blow up and create large losses, the taxpayers will be on the hook to make up the shortfall to meet the financial committments to the public retirees. It's bad enough to see individual investors fall into the traps outlined so well by researchers into behavioral finance. To see the same behaviors: unrealistic expectations of returns, use of leverage and underestimating the riskiness of a strategy, faith in "genius managers" by "professional managers" is jaw dropping.

And it is clear from the article that the pension managers are jumping from one strategy to the other inevitably chasing past returns....and "consultants" and managers from Wall Street are at the ready to offer the latest and greatest new strategy.

The losses that these same institutional investors suffered in hedge funds and private equity showed that there is no prospect of increased returns without increased risks. The large returns of these strategies that attracted these investors masked the fact that the higher returns came at greater risk due to leverage and illiquidity. I have a sense that the same will happen with the new "hot" strategy to boost returns.

from the wsj my bolds and my comments in blue

JANUARY 27, 2010

Public Pensions Look at Leverage Strategy

Public pension funds needing to boost their returns but frustrated with hedge funds and private-equity investments are turning to one of the oldest investment strategies—using borrowed money to boost performance.
The strategy calls for leveraging pension funds' safest asset—government or other high-grade bonds—while reducing exposure to stocks. 

 It's not completely clear from the article what the strategy is composed of but it seems to be composed of leveraging up bond holdings to buy more bonds while reducing stock holdings. This would be a variation of the sort of carry trade that many investment banks are pursuing financing short term at very low rates and investing longer term with the bond holdings. While the immediate environment may be attractive for this strategy it is hardly riskless. Long term bonds bottomed last year after a tremendous rally : treasury bonds rose in a flight to quality in 2008 and have pretty much declined in price since then. Corporate bonds recovered in 2009, the economy improved and spreads of corporates over treasuries declined bringing prices up.

At this point it would seem that most of the easy money has been taken out of these strategies :interest rates are likely to rise as the fed unwinds its easing strategy. The result would be doubly negative for the strategy: financing costs would go up and there would be capital losses on the bond holdings. I am getting the uncomfortable feeling that these pension managers are chasing returns, entering into a strategy just as the prospects for its success are declining. Will they be nimble enough to avoid the double whammy of higher financing costs and lower bond prices that will accompany a future move up in interest rates...I doubt it. And there is little doubt they are dialing up the risk in search of higher returns.

The State of Wisconsin Investment Board, which manages $78 billion, became among the first to adopt the strategy when it approved the plan Tuesday. The fund will borrow an amount equivalent to 4% of assets this year, and as much as 20% of its assets over the next three years.
Fund officials say that use of leverage could eventually go higher—in theory, at least, up to 100% of assets, according to the staff analysis. But Chief Investment Officer David Villa says that level wouldn't be palatable for the Wisconsin fund. He said the pension fund was advised by four money managers, including Connecticut hedge-fund firms AQR Capital and Bridgewater Associates

It is interesting that AQR Capital is involved in this. Just last Saturday in a WSJ excerpt from what seems likely to be a great book on the fiinancial crisis entitled The Quants by Scott Patterson we get the following description of Mr. Asness' firm AQR struggling in the midst of the 2008 financial meltdown as his fund was suffering extensive losses.:

The quants did their best to contain the damage, but they were like firefighters trying to douse a raging inferno with gasoline—the more they tried to fight the flames by selling, the worse the selling became. Quant funds everywhere were scrambling to figure out what was going on.
Tuesday, the downturn accelerated. Applied Quantitative Research, the Greenwich, Conn.-based quant fund giant run by former Goldman Sachs Group whiz Cliff Asness, booked rooms at the nearby Delamar on Greenwich Harbor, a luxury hotel, so they could be available around the clock for stressed-out, sleep-deprived quants.

Not only was Mr. Asness current fund bleeding money the fund he created at his previous employer was quite possibly at the center of the market meltdown:

Nervous managers traded rumors by email and phone in a frantic hunt for patient zero, the sickly hedge fund that had triggered the contagion. Many were fingering Goldman Sachs's Global Alpha, the quant fund founded by Mr. Asness in the 1990s that had grown to massive proportions. But no one knew for sure.
The article on the pension funds continues:

Wilshire Consulting, which advises pension funds on investments, says leverage helps the funds meet their long-term return targets without relying too heavily on volatile stocks, or tying up their money for long stretches in private investments. Low interest rates make it impossible to meet those targets with simple bond investments. Wilshire managing director Steven Foresti says he has been in discussions with about a half-dozen funds that are interested in the leverage strategy. ..

My views are certainly in line with these skeptical views in the article in pension funds' new strategy:

That public pension funds would contemplate the use of borrowed money so soon after a credit crisis stoked by financial leverage is already setting off alarms for some in the industry.
These analysts wonder if this is little more than the latest gimmick peddled by investment consultants. In previous years, consultants pitched a strategy called portable alpha, an aggressive bet involving leverage and hedge funds that magnified returns when the stock market was surging but aggravated losses when the market turned down.
"When people reach for return with non-traditional approaches they can take on risks they don't fully appreciate," says Daniel Jick, head of HighVista Strategies, a Boston-based firm that manages money for small schools and other investors. As many investors found out in 2008, he added, "using leverage can force you to sell assets you'd rather not sell."
Moreover, he questions the timing of leveraging bonds when many economists are forecasting a pickup in inflation and an increase in interest rates as the economy recovers. That would cause bond prices to fall, and leverage could magnify those declines.
Some advocates of the leveraged approach acknowledge these drawbacks, but say the strategy makes sense anyway. Most big public pensions have expected annual rates of return between 7.5% and 8%. Wisconsin, for example, assumes 7.8%.
Many analysts consider those return rates unrealistic. Yet pension funds are loath to change them because that would require local governments to get more money from taxpayers to compensate for lower projected returns. Even at an 8% return, the average public fund will have about 55% more in liabilities than in assets 15 years from now, due to recent losses and challenges in raising contribution rates, according to PricewaterhouseCoopers.
Most pensions piled into stocks in the late 1990s, counting on a booming market to increase assets, which in turn allowed these funds to increase retirement benefits or reduce state contributions. Since the tech-stock bust, however, many pensions became queasy with the volatility attached to stocks and have been trying to find a substitute to help meet their return targets.
During much of the previous decade, many pensions thought they found the answer in private equity, which put up big numbers. But these funds collapsed in value in 2008 alongside the stock market while locking up pension fund capital for 10 or more years.
"We started talking to the board about this two years ago," says Mr. Villa, Wisconsin's investment chief. "It would have been nice to have this in a place prior to the crisis." That's because the strategy calls for leveraging assets that held value in 2008, Treasurys and other highly rated bonds.

Could there be more evidence than the above that the fund managers are flailing in their quest for unrealistic returns grasping at a strategy primarily because it worked in the past 2 years ? No doubt the consultants and money managers had great powerpoints emphasizing the past returns of this strategy highlighted by the outsized returns of 2008.

The losses in private equity and hedge funds that the pension funds experienced in 2008 should have taught them 1) that leverage is a 2 edged sword magnifying both gains and losses 2) In extreme market moves leveraged positions could trigger force liquidation to meet margin requirements leading to selling assets when they are extremely low values . But instead of reducing the amount of investments of any type that involve leverage these managers misread the lessons of the past. They have simply moved their leverage from one market to another not eliminating the fundamental perils in leveraging.

Some pension fund managers seem to actually believe that the newest "strategy" being peddled by Wall Street (as noted above the last faddish idea "portable alpha flopped) can turn stones into gold or at least give equity like returns with fixed income type risk in an amazing act of financial alchemy. Considering one firm peddling it was put in crisis mode in 2008 as it faced a blow up of its strategy at that time, I think caveat emptor is very good advice indeed.

"Fixed income is a good hedge in a crisis scenario," says Rick Dahl, chief investment officer for the Missouri State Employees' Retirement System, who said he is considering using this strategy. "If I can ramp up my fixed income to the point where it gets equity-like returns that makes a lot of sense."
But he isn't yet convinced. "I'll need to think through all the ramifications, too," Mr. Dahl said.

 I would point out to Mr. Dahl that treasury bonds (not all fixed income) might be a good hedge during an economic crisis but that hardly makes the leveraged bond strategy a hedge for all scenarios. When the interest rate environment changes and rates turn up there will be a large scale reversal of the billion$ if not trillions leveraged in the fixed income market to take advantage of the current low short term rates and to increase the returns above the meager interest rates earned through unleveraged fixed income investments. When that happens we will once again see what happens when a leveraged strategy is reversed en masse: large and volatile market moves. The leveraged bond strategy will turn out not to have been a stable or "hedged" strategy at all but rather simply a way to increase risk in search of higher returns. And Mr. Asness of AQR may once again find himself in a market environment his quantitative models didnt anticipate as everyone runs for the exits at the same time.

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