This post is in response to a post on the Intercept which can be found here. In case you don’t feel like following a link, the story goes something like this:
Financial lobbyists are looking to divert America’s pension plans’ funds to higher risk and higher fee alternative assets. The article suggests that instead of investments in these products, pension funds should make allocations to local economies thereby supporting the growth of businesses where the pensioners live.
To be fair, the article identifies a couple issues correctly. First, lobby groups in the United States have too much power over policy, but this is not exclusive to Wall Street lobbyists. Second, the managers of alternative asset classes often charge higher fees than their more conventional counterparts. The issue of fees is one that that pension funds are very aware, and is usually a point of negotiation between a fund and its potential investors. The old model of “2 and 20” is going the way of the dodo as the balance of power shifts to investors that are becoming more savvy and are demanding an alignment of interests.
There is, in fact, a very good reason as to why pension funds (and not just American pension funds) are increasing their allocations to alternative asset classes, and it has more to do with the current environment than lobbyists. The case study “Yale University Investments Office: February 2011” by Josh Lerner and Ann Leamon at Harvard Business School explains the necessity for external managers and an increased allocation to alternative assets for institutional investors.
But the following is my take on it.
The Current Environment
Put yourself in the shoes of a pension fund manager, and consider your objectives. First, you need to provide cash flow to service current and future pension obligations. Second, you need to preserve the capital in your portfolio in order to be able to do complete the first objective in future years.
Traditionally, pension funds have allocated the majority of their funds to fixed income, and fixed income-type, products in order to meet these objectives. These products would pay out a regular cash flow stream to the pension which could then be distributed among the beneficiaries, accomplishing the first objective. The remainder of the portfolio would be allocated between several asset classes, primarily public equities, in order to grow capital and meet future obligations.
Today, however, investing in fixed income does not have the same effect that it once did. Persistently low interest rates means that the coupon on safe debt instruments is no longer enough to keep up with pension obligations. Also, if interest rates rise at any time, this would erode the value of the pension’s fixed income portion of the portfolio. The other side of the portfolio, which would be largely in public equities, would be very vulnerable to market downturns, an effect that pension funds need to avoid. Most pension funds are content to sacrifice the upside of market bull runs if it means that they will also avoid the downturns during market panic.
As risk averse investors, pension funds have been slowly experimenting in alternative assets to meet their objectives in a low interest rate environment. They began by testing the waters while increasing their understanding of the products in the space. If the only thing driving an increase in alternative assets were powerful lobby groups, then we would not see the same thing happening where these lobby groups do not have as much power – but we do see just that. In Canada, where lobbyists do not have the same sway as in the United States, we have seen an increase in private equity allocation by pension funds. In fact, CPPIB (Canada’s largest pension fund) is currently the world’s largest private equity investor and a world leader in pension fund performance. CPPIB has accomplished this through a strategic combination of direct investment and external managers.
Alternative Assets
The article talks broadly about alternative assets as high-risk and high-fee investments. This definition misrepresents the asset class. The right way to think about the space is that alternative assets is to the investment space what the technology sector is to business at large. Like the technology sector, the alternative assets space is very diverse and is constantly trying new business models. Managers in this space might include high-risk investments in the form of highly leveraged arbitrage, venture capital and private equity funds, but can also include less risky investments like market neutral, private corporate debt and infrastructure funds.
What fits into the alternative asset bucket is ultimately decided by the individual pension fund. The CFA Society, for example, lists real estate as an alternative asset class, but most pension funds will allocate to real estate and infrastructure as separate asset classes distinct from their allocation to alternatives. It is likely that as certain parts of the alternative assets space mature, those managers will be lumped into a category outside of alternatives.
Transparency
The article states that alternative asset classes “are often arcane and opaque”. I tend to agree that it is difficult to articulate exactly how the alternative asset class invests, but this runs parallel to the technology sector whose revenue models are often poorly understood until a specific company reaches a certain stage of maturity. Within the alternative assets space there do exist certain funds that will function as a sort of “black box”, but institutional investors will rarely (if ever) give these kinds of strategies the time of day unless they open their “black box” and grant full disclosure.
An institutional investor has to walk a tightrope between two spaces. In the first space products are very well understood, but because of this they are also close to market efficient and all potential gains have been priced in. In the second space products are “arcane and opaque”, but the potential gains are greater due to the inefficiency of the market. The institutional investor is therefore looking for a manager that can exploit the gains of an inefficient market while understanding the drivers of that manager’s strategy.
The “arcane and opaque” nature of the space is mostly in the eyes of public perception. Strategies that must remain secretive or cannot be understood are currently frowned upon by managers and investors alike. I recently attended a panel where four major hedge fund managers spoke about various global macro issues. During the question portion of the evening, I asked the panel a question about their respective policies regarding transparency and the articulation of their strategy. All four managers agreed that full disclosure was foundational to their business with the exception that they would not always publicly disclose current positions due to concerns around market manipulation. The reason we know the managers were telling truth is because two of their investors were also in the room and were adamant that they would not invest in those funds if they did not understand the strategy driving their returns.
Fees
Anyone who works in investment management knows that there is a lot of discussion and news around fees. The goal of a good fee structure is to align the incentives of managers and investors while minimizing informational asymmetry and possible conflicts. Institutional investors are very aware of the discussion and perception of fees claimed by external managers and as a result are negotiating hard to have fees restructured to match their needs. The pension funds and other institutional investors, really have the balance of power in their favor since they ultimately control the allocation of funds. Large, powerful managers like Blackstone and the Carlyle Group are the exception, not the rule, when it comes to the size of asset managers. Ironically, smaller assets under management (AUM) is correlated to better performance (as seen here and here) but this performance does not always result in bargaining power since the investor still holds the check book.
External Managers
Any responsible pension fund manager will need to use external managers for at least a portion of their portfolio. If a fund reaches a certain critical mass then it may make sense to bring an external manager in-house thereby saving fees, but external managers offer a valuable, and irreplaceable, service to pension funds in a variety of ways. I will cover two of those ways here.
First, an external manager might be more familiar, or have better relationships, within a particular industry or strategy of interest. Bringing such a manager, or similar manager, in-house means that you must either hire the manager, robbing them of their independence and other investors or compete with the manager in question with no guarantee that you can match their performance. Bringing the manager or strategy in-house may erode your returns, create bad will in the industry or be prohibitively expensive.
Local Investment
The article suggests that pension funds should steer funds into communities where pension beneficiaries live. It mentions the Quebec government pension fund as an example. It's a good suggestion, and it’s why many pension funds will invest in infrastructure of the local economy, but the motivations are not altruistic, they are motivated by risk and return. By investing in local infrastructure, an investor can avoid currency risk and stay in a familiar regulatory environment.
I am skeptical about the long term repercussions of the example of the Quebec government pension fund given in the article. The Quebec government is currently very supportive of investment within the province and often offers subsidies, grants and co-investment opportunities. The support of these investments is looked upon favorably by investors who see an advantageous risk/reward profile. But a Quebec government pension fund investing in something that is supported by the Quebec government seems like a type of pyramid scheme that will eventually collapse in on itself.
While some investment in the local economy is prudent, pension funds necessarily need to allocate a larger portion outside of the economy so that the growth of the fund can outpace the economy in which it exists. Virtually all Canadian pension funds, like CPPIB, OMERS, OTPP and others, have to invest outside of Canada to get the return and diversification needed to meet their objectives. The Canadian economy is simply too small, and does not have enough growth potential, to support pension fund commitments. American pension funds are typically smaller than the Canadian pension plans mentioned, and therefore have more opportunity to invest locally. But even American pension funds look outside the United States for investment opportunities in order to mitigate the possibility of a stagnant US market.
The Lobbyist’s Agenda
The fact that lobbyists have considerable control over public policy in the United States will get no opposition from me, but I doubt that the core of the agenda that these lobby groups have is to siphon public dollars into alternative investments in order to gain higher fees. It is far more likely that lobbyists, advocating on behalf of alternative asset managers, would be trying to keep a favorable regulatory environment. In Europe, public pressure has caused policy makers to enact the AIFMD (Alternative Investment Fund Managers Directive) which is aimed at closing the perceived regulatory gap between alternative assets and their vanilla counterparts. A similar directive in the United States would put many alternative asset managers under a very uncomfortable magnifying glass that would standardize transparency and reporting requirements.
Ultimately the AIFMD and the Intercept are guilty of the same fallacy; the belief that all alternative assets should be treated the same way and have the same problems. Returning to the analogy of the technology sector, this kind of painting with one-brush would be the equivalent of treating a company like Uber as if it were Facebook. Both companies are certainly in the technology sector, but to say that the risks or revenue model in both are the same, or even similar, would be misleading.
It would be equally misleading to say that there are no issues in the investment industry - because there are major issues. But lobby groups are not exclusive to Wall Street, and investors are more aware than ever of conflicts of interest, informational asymmetry and alignment of incentives.
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