More from London (see yesterday’s posting for background)…
A pension plan as a financial services firm
As some pension funds begin to shift from funds of funds to single-manager hedge funds, they usually create what amounts to their own internal fund of funds. The only difference between this fund of funds and a real fund of funds is that the pension has only one client: its own pension plan.
It turns out that this view of the hedge fund portfolio as a sort of arm’s length asset manager with only one client can also be applied to the pension fund as a whole. That’s how one major private pension fund described it to a gathering here in London today â€“ as a financial firm that produces pensions.
This view also has implications for liability-driven investing (LDI). Some said that the process of liability-matching and return-enhancing should be kept separate within this financial services firm. For example, one major pension fund here created a team focused on removing interest rate and inflation risk (via a matching portfolio designed to match the plan’s future liabilities to pensioners) and a separate team focused solely on trying to squeeze additional returns out of those assets. In true arm’s length fashion, the return portfolio is required to literally borrow assets from the matching portfolio â€“ creating a real economic incentive to beat the short-term rates charged on this internal loan.
Separation of the “matching” portfolio and “return” portfolio was seen as critical. One panellist even blamed the credit crisis, in part, on the simultaneous (and often competing) goals of matching liabilities while also trying to generate excess returns. He said an organizational bifurcation between the two would have reduced some of the excess demand for higher yield that eventually exposed credit markets to a correction.
Busting Down Silos
When we artificially segment our thinking on the basis of superficial labels, we often say we are thinking in silos â€“ mutually exclusive categories with little assumed commonality and no integration across ideas.
The same is true for organizations – where the term silo also refers to separate and un-integrated departments on an organizational chart. Pension funds, for example, are beginning to recognize that traditional asset class definitions may be too superficial and that underlying risk factors must be managed holistically across traditional asset class boundaries â€“ in other words, without any “silos”.
One US pension manager here acknowledged the historical existence of silos and even silos within silos at his plan, but said there was a great blurring of the lines between asset classes. His response was to create cross-departmental teams â€“ thus breaking down barriers between investment personnel.
The CIO of a UK-based financial services firm acknowledged that silos will always exist. But he said the key issue is how those silos are defined. They should be divided by unique skill sets, he said, not just by asset class or geographic focus. And since organization structure tends to influence compensation policies, sub-optimal silos can actually work against the best interests of pensioners.
Who’s to blame for the domination of silos? At least a couple of investors here felt that investment consultants tend to pigeonhole managers â€“ leading to a “silo-mentality”. An audience member and former consultant pushed back a little on this by accusing institutional investors of sometimes nickel and diming their consultants. If they were treated more as partners, argued the audience member, then the consultants would be enabled to provide more customized services.
“Disintermediation” of chickens
The late chicken magnate, Frank Perdue (of Perdue Chicken fame) was once quoted as saying that the goal of his company was to create the wings for free. Purdue’s strategy amounted to skimming the consumer surplus by pricing various parts of a chicken separately and marketing them to specific segments. The wings, of course, became staple fare in US restaurants – not bad for what originally amounted to a waste by-product.
Financial technology has enabled a similar disintermediation in capital markets according to George Main, CEO of hedge fund manager Diversified Global Asset Management (DGAM) and member of the President’s Working Group on Financial Markets. For example, by slicing securities into tranches, investors can now buy separate individual risks (e.g. mortgage pre-payment risk). Main used the US residential mortgage market to elaborate on this theme. (read full speech).
To use his chicken analogy, it seems that (BBB-rated ) chicken wings were once hugely popular, but then people learned that they were actually really bad for you.
Naik: Alternative beta to eventually become part of manager compensation schemes
Narayan Naik, Director of the BNP Paribas Hedge Fund Centre at the London Business School and one third of the Transatlantic Trio (see related posting) counselled the audience to include alternative beta in the benchmarks they use to measure manager success. he said that alternative beta, commonly associated with so-called hedge fund replication, is also an important part of the equation required to reveal the true value added by managers.
Picking up on George Main’s food analogy, Naik described alternative beta as analogous to the ingredients in a dish at a 5-star restaurant. One could always purchase the ingredients and try to assemble the dish themselves at home. While the dish wouldn’t have the alpha of the restaurant meal, it would be roughly approximate and much cheaper…an alternative restaurant meal, if you will.
Naik predicted that performance fee hurdle rates would eventually include alternative betas â€“ thus denying the manager any financial reward for simply exposing the fund to various exotic risk premia.
It’s only a flesh wound!
Using one of the more colourful analogies of the day, Wharton’s Sandy Grossman compared the current state of the US economy to a car accident victim with a bleeding wound. While frightening in appearance, such a wound could easily be staunched (using direct pressure we assumed â€“ but we’re not doctors). The wound? Asset mark-downs at financial institutions. The bandage? Fed intervention.
The far more serious wounds from the car accident, according to Grossman, were less obvious internal wounds. I don’t watch Grey’s Anatomy (this is exactly why), but apparently those are the “bad” injuries that require more attention. The internal wound, says Grossman, is the US fiscal crisis. Grossman concluded that the Fed has created an unavoidable moral hazard by appearing ready to bail out any troubled financial institution.
But his co-panellist, Nobel Laureate Myron Scholes, was more sanguine concerning the culpability of the Fed. He felt that financial executives never actually factored a possible Fed rescue into their business decisions. However, Grossman countered that they didn’t need to explicitly factor it in â€“ the Fed’s safety net had the effect of dropping the cost of capital faced by these firms.
Scholes warned that the financial aftershocks from the credit crunch weren’t over and that falling housing prices could be the mechanism that precipitates the next temblor.
[Important call to action: Scholes shares the same birthplace – the tiny mining community of Timmins, Canada – as country superstar Shania Twain. Yet to our continued dismay, only Twain has a local museum dedicated to her career (no kidding see website of the “Shania Twain Centre”). We think that’s just wrong and urge you to write Timmins mayor Tom Laughren to demand construction begin on the new “Myron Scholes Interpretive Centre” as soon as possible. Hey, if you build it, they will come, right?]