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Public Pension Plans Doubling Down

I am not a gambler, and I never will be.  I take the risks of a businessman as I invest, and not those of a speculator.  I found it interesting to to read this Wall Street Journal article where public defined benefit pension plans are not fleeing hedge funds.  This is an area where I half agree.  Because the yields of high yield bonds are so high, this is not a time to abandon aggressive strategies.  Rather, it is a time to embrace them, slowly and carefully.

I looked through the database of my writings in the CC at RealMoney, and I found these two comments that fit the moment well.


David Merkel
Avoid Esoteric Diversification
4/13/2006 4:00 PM EDT

This isn’t a burning hot issue at present, but I have been impressed with the increasing amount of money getting thrown at esoteric asset classes by pension plans and endowments, in an attempt to diversify and gain higher total returns. In the intermediate term, it is not sustainable. For now, party on, we are in overshoot mode.

By esoteric asset classes, I mean: commodities, timber, credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of asset- and mortgage-backed securities, hedge funds and private equity.

Many novel asset classes provide both higher returns and diversification when they are first used. As more and more players get comfortable with it, they buy in, lowering the required total return needed to attract investors, but pushing up returns to pre-existing holders as the price rises.

This can be self-reinforcing for quite a while, with a lot of money blindly flowing in, until some player games the system, selling securities that fail miserably. A panic ensues, and the asset class goes through a maturation process that learns to distinguish quality within the asset class.

With the rise in yields, high quality bonds have been giving holders a hard time in total return terms. But you don’t buy bonds for total returns; you buy them for income, and diversification; they tend to do well when risky assets break down.

I guess my short summary is this: with risky asset classes so highly correlated at present, if you want to diversify, go to high quality bonds, or cash. The theoretical diversification of risky assets based on correlation measures calculated over long time periods is no longer valid.

Position: none

and —


David Merkel
Alternatives to the Terror of Actuarial Funding Targets
9/27/2007 2:57 PM EDT

Jordan, my deep suspicion with respect to the pension plan sponsors is that they are looking at the gap between the yield they can get from investment grade bonds and the yield they need to fund the pension promises, and they realize that they are going to have to make a larger allocation to risky assets. After that, they look at the past track record on public equities, and conclude that they have been hurt by the lack of returns over the past seven years. Then they look at the returns in alternative investments, and say, “What great returns! Why have I been ignoring these? If David Swensen can do it, so can I!”

Well, David Swensen is a bright guy who went to the party early. Alternative investments were truly alternative when he arrived. Today they are mainstream, and some of them have gotten overfished. The plan sponsors can allocate all they like to alternatives, but they aren’t magic… they can do just as bad as public equity, and with far less liquidity.

If I were a plan sponsor today, I would begin trimming alternative areas that look crowded, like private equity, commercial real estate, and certain types of hedge funds while the door is still open. For some areas, like CDOs [Collateralized Debt Obligations] the door is already closed.

I would also lower my return expectations, and plan on contributing more. Heresy, I know. But alternatives are over-used, and no longer alternative. They won’t deliver the same high returns in the future that they did in the past.

Position: none

I am not unsympathetic here as public pension plans essentially say, “Well we have to earn enough to meet our actuarial funding targets, and at this point, bonds of the highest quality don’t help us.  Hedge funds promise high returns regardless of market movements, so we need to allocate money there.”

At this point in the cycle, I might have some sympathy, because enough arbitrage relationships are broken, offereing some opportunity.  At the same time, and ordinary investment in a basket of lower investment grade and high yield bonds offers a nice return for those willing to live with some default risk, which is over-discounted here, even with things as bad as they are.

In a bear market, once you have taken a severe amount of damage, the question is “what offers the best return from here?”  The answer might be unpopular, but it should be pursued.  Even as defined benefit managers pursued seeming diversification with bad payoffs as noted above, and should have sought long term guarantees, at a time like now, where guarantees are tremendously expensive, and yields are high  because of possible default, it is a time to take risk, and fund the best entities that may not make it.

These are ugly times, but we have to think like Ben Graham during the Great Depression.  What will survive?  Where can a little bit of additional capital spell the difference between death and survival?

This is a time to take risk.  Things could get worse from here, so don’t overcommit, but don’t fail to commit either.  Make some reasoned judgements about what is likely to do well ten years out, and invest for it.

This is a rough time.  I offer solace to those that are battling the markets; you are having a rough time of it.  The challenge here is whether the risk premium in fixed income assets offers enough compensation versus Treasury quality assets.  My answer is yes, realizing that this is a bumpy trade, and will require patience to receive the returns promised.






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4 Responses to Public Pension Plans Doubling Down

  1. Dobuling down, at least in stocks, always seemed like a bad idea to me. It’s cost averaging. My brother tends to do it at a casino when playing blackjack, and there it tends works out. But the odds are different. What I am worried about is that the people who these pension funds are for won’t be able to get the money they have been allocated via contract. If some of these funds have lost 40% or so in the last year, how are they going to meet their goals and requirements? How many more years will it take for them to regain what they have lost?

    I’m glad that’s not my job,

    CP

  2. matt says:

    Mr. Merkel:

    I think I remember you saying(?), recently, that now might be a good time to carefully enter the investment grade corporate bond market. I started looking for some bargains here and prices seem to have recovered. I don’t see many deals. Are there any particular issues that you are looking at right now?

    Cheers,
    Matt

  3. CP — doubling down is a figure of speech… I am implying that they are being forced to increase their asset risks in order to meet their funding targets.

    Matt — no, no issues in mind… I would not recommend individual bond issues at my blog, mainly because individuals would likely get bad execution from their brokers. I think corporate credit risk is cheap here.

  4. I have a pension plan with my current employer. Due to economic crisis, I am fearful that it may be in jeopardy. Does your advice to “double down” apply in this instance? I will do anything to protect my future security.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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