As the book’s title suggests, real money managers – those that don’t use leverage and tend to have a long bias, such as pension funds and university endowments – should rethink their approach to portfolio management after having suffered some of the most significant drawdowns on record during the 2008 financial crisis.
This is not a trivial matter, said Drobny, as the implications will be more far reaching than just for the financial community, potentially impacting all taxpayers in the case of pension shortfalls. Pension funds represent the largest pools of professionally managed capital in the world, controlling trillions of dollars. Moreover, millions of retirees depend on pension funds for living expenses.
Drobny thinks these real money managers can take certain lessons from global macro hedge fund managers, especifically those who successfully avoid large drawdowns by focusing on downside risk and capital preservation. By avoiding large drawdowns, these managers achieve higher rates of return over the long haul.
Drobny cited the following recommendations during an interview with IBTimes:
1. Real money portfolio managers should begin the investment process by asking how much they are willing to lose, rather than trying to achieve a certain return target (often 8 percent annually for pension funds). Avoiding significant losses translates into superior long-term performance as those return streams are compounded into the future.
Moreover, a steady growth of capital to meet future obligations mitigates the risk of asset/liability mismatch during certain shorter discreet time periods. Many university endowments, for example, had tied a significant portion of their operating budgets to the endowment capital, forcing them to rationalize budgets and cut costs in the wake of 2008.
2. Real money portfolio managers should consistently implement hedging strategies to limit downside risk, such as buying deep out-of-the-money put options on large exposures. These instruments are relatively low cost and protect against market dislocations such as the 2008 credit crisis, the Asian financial crisis of 1997, the Russia debt default crisis of 1998, or Black Monday in 1987.
3. Real money portfolio managers should understand the true risk-adjusted return streams in their portfolios. While conventional wisdom purports that equities produce the best long-term returns, on a risk-adjusted basis, equities and bonds offer about the same total return over time. Moreover, while many of the illiquid assets that university endowments invest in produced higher returns in periods of calm, they were also more risky.
4. The corollary to #3 is that all managers need to pay careful attention to liquidity. As mentioned, university endowments long claimed that they are “in it for the long haul,” enabling them to take on more illiquid positions. While such an approach yielded high returns during buoyant markets, they produced considerable pain during 2008 when even the most liquid markets experienced tremendous illiquidity.
5. The way to understand portfolio risks is to run rigorous scenario analyses and stress testing. First, real historical examples can be employed, such as the 2008 credit crisis, September 11, 2001, etc.
Then, further shocking the portfolio for extreme examples with no historical precedent can add incremental cushion. One manager interviewed in Drobny’s Invisible Hands discussed the potential market reaction should belligerent aliens land on earth – extreme, perhaps, but a good exercise to understand the inherent risks in a portfolio. The recent events at nuclear facilities in Japan are a case in point.
Compensation and Structure
Drobny concedes that pension managers themselves are sometimes not to blame. Rather, they are victims of a bureaucratic structure that greatly impedes them from being more effective. Even if a manager wanted to adjust portfolio allocations more dynamically, board structures and other rigid constraints make this very difficult in practice. Furthermore, compensation in the public realm pales in comparison to the private sector, meaning that hedge fund managers earn multiples of their pension counterparts.
Some of these “under-paid and under-motivated” real money managers simply formulate a return target of, say, 8 percent annually, and then construct their portfolio according to historical performance in order to achieve this target. But doing that is “an exercise in futility,” said Drobny.
Given the important role real money managers play in society, Drobny strongly advocates rethinking this flawed model.
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