Niels Jensen: Investment Outlook (June 2012)

Sunday, June 10th, 2012

The Absolute Return Letter
June 2012

First Mover Advantage

“The problem with socialism is that you eventually run out of other people’s money.”
- Margaret Thatcher

Bubble? What bubble?

Sometimes I wish I could have a second go at my writing. Last month, and not for the first time, I realised that what had seemed pretty clear and unequivocal to me was misunderstood by many readers. More specifically, I am referring to the concluding remarks in last month’s Absolute Return Letter where I stated that Asia has the potential to become a re-run of Europe. My argument was based on the simple but undeniable fact that policy rates are well below where they ought to be when taking into consideration the overall level of economic activity and inflation (the so-called Taylor rule).

Those comments were interpreted by many readers as if I expect an imminent crisis in Asia of the sort we currently suffer from in Europe. Nothing could be further from the truth. Allow me to explain:

Following the introduction of the euro, Spain and Ireland, and to a lesser degree Portugal, experienced an enormous construction-led economic boom which was the direct consequence of easy access to cheap capital. The ECB was certainly aware of the potential problems this might create down the road; however, it had no choice but to set the policy rate at a ‘one size fits all’ level, and the German economy badly needed some stimulus back in the early stages of the euro era. By choosing to support the weakest link in the chain, the ECB had effectively sown the seeds of a bubble which would blow up almost a decade later.

There are at least two lessons to be learned from that experience, the first one being that bubbles take a long time (as in many years) to build up and, in the meantime, there is usually a great deal of money to be made. Secondly, when the ECB responded to the bursting of the dot.com bubble, as most central banks did in 2001-02, the law of unintended consequences kicked in. By their very nature, bubbles create echo bubbles. What is currently happening in Asia – and I throw in Australia for convenience – could very well turn out to be an early to mid stage echo bubble.

I had been planning on writing on the topic of Asia in much more detail this month, partly to clarify my views expressed in last month’s conclusion (which I hope I have accomplished now) but also to address some of the nearer term issues Asia is facing. Then things in Europe got out of hand again, following the Greek elections, so Asia will have to wait until next month.

As a primer to next month’s letter, I couldn’t resist the urge to throw in just one chart, produced by the great economist and blogger Steve Keen from Down Under. Steve has produced a long term chart of Australian versus US property prices (see chart 1 below and the whole paper here). Steve finds it outright comical that Australians are in complete denial as to where they are in the property cycle. Bubble? What bubble? Much more on this topic next month.

It is a banking crisis idiot!

Now back to Europe. The eurozone crisis has always been a banking crisis. It only morphed into a sovereign crisis because of political incompetence. Solve the banking crisis and you have solved the euro crisis. That is my prediction. On the other hand, as long as the Germans continue to say Nein to pretty much anything that anyone puts on the table, we are still a long way away from solving the crisis. Only a few days ago Angela Merkel reiterated her rejection of the idea of mutualising eurozone sovereign debt. The proposal came from SPD, the major opposition party in Germany, with the idea being that all eurozone debt within 60% debt-to-GDP should be mutually guaranteed. However, Merkel said Nein. Again.

Tags: Absolute Return, Central Banks, China, ECB, Economic Activity, Economic Boom, Enormous Construction, First Mover Advantage, German Economy, Imminent Crisis, Introduction Of The Euro, Investment Outlook, Margaret Thatcher, Niels Jensen, Stimulus, Taking Into Consideration, Taylor Rule, Undeniable Fact, Unintended Consequence, Weakest Link, Weakest Link In The Chain
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The L Word?

Thursday, April 28th, 2011

by Leo Kolivalis, Pension Pulse

On Wednesday I had a nice chat with Jonathan Jacob of Forethought Risk, an independent risk advisory firm that educates and advises public and private pension funds, asset managers, an insurance companies to create a greater understanding an appreciation for the nature of risk and how to use it to the firm’s advantage. They also advise treasury management functions on risk, risk valuation, how to hedge risk and provide transaction oversight to ensure pricing fairness.

Jonathan traded interest rate swaps for many years at Bank of Montreal and even worked a year with the Fixed Income division at Ontario Teachers’ Pension Plan during the financial crisis. After speaking with him, I simply don’t understand how Teachers’ let a guy like this slip through the cracks (absolutely terrible decision and just goes to show you that really smart and honest people get the short end of the stick during tumultuous times).

If you want someone to help you hedge risk, this is the person you want to talk to. Stop paying consultants who provide you with cookie cutter “one size fits all” solutions and get a hold of Jonathan who will provide you with tailor made strategies that fits the maturity of your plan and the duration of your liabilities. We both agree that the state of pension consulting is simply atrocious, with too many consultants cutting corners, offering the same advice to all pension funds without taking into consideration their unique characteristics.

Jonathan and I talked a lot about leverage, specifically how pension funds are using or misusing leverage. In June 2010, he wrote a comment for Benefits Canada, The L Word:

The global financial crisis has acted as a catalyst for many things—perhaps most importantly for pension funds, a renewed focus on risk. No longer does a lack of obvious correlation between assets presume protection, and the startlingly simple mantra “don’t buy what you don’t understand” has taken renewed prescience.

However, the decision to increase efforts at risk management does not make the process any easier. There are many mathematical measures of risk, including:

• volatility: the magnitude of potential returns of a particular asset;
• leverage: the borrowing of funds to increase exposure to a particular asset; and
• correlation: how assets perform relative to one another.

Watch your liabilities

A pension fund may choose to measure the risk of its assets on a stand-alone basis or it may choose to measure it against the risk embedded in its liabilities. This second method of measuring risk often leads to liability-driven investing (LDI), which attempts to manage the risk of the assets in tandem with the risk of the liabilities. The implementation of LDI is subject to vast interpretation and may include the use of various tools, such as derivatives and hedge funds, not previously accessed by many pension funds.

One interpretation of liability-driven investing involves the hedging of all interest rate risk while maintaining current allocation to equities. Hedging is the attempt to minimize exposure to a particular risk (in this case interest rate risk), and it can be done through the use of a derivative called an interest rate swap, which does not require the use of cash, thus enabling the fund to maintain its cash in equities. It would seem that the use of swaps in this fashion reduces the financial risk of the pension fund as interest rate risk has now been hedged, while it retains upside exposure to equities. However, the fund has exchanged one form of risk for another.

The fund has undertaken a degree of leverage in that the notional value of the assets exceeds that of the liabilities. While this may be within acceptable risk parameters, it depends significantly on the expected correlation (how two securities move in relation to each other) of two asset classes. For example, the fund that layers interest rate hedging through derivatives on top of a cash equity mandate must consider the expected correlation of bonds and equities. Experience over the past 25 years shows that in times of stress Treasury prices are highly negatively correlated with (or opposite to) equity prices. Our pension fund manager can thus feel comfortable with the decision to layer on leverage since the interest rate hedge will outperform in an equity meltdown, while a rally in equities will likely improve funding ratios regardless of the underperformance of the interest rate hedge.

In the current environment, however, such analysis is fraught with potential pitfalls. The world economy is facing a tug-of-war between inflationary and deflationary forces. In the late 70s and early 80s when the world last faced significant inflation, equities and bonds were positively correlated as both sold off. A fund with leverage can lose much more than its allocated risk budget in such a scenario.

Another matter to consider is the “basis” risk between the interest rate hedge and the liabilities. There are many health ratios for pension plans, including the funding ratio and the solvency ratio. Depending on the ratio in question, the yields discounting the liabilities may be determined from the use of only Government of Canada bonds or it may also include corporate bonds. Interest rate swaps are highly correlated to both Government of Canada bonds and corporate bonds as the core interest rates are the same in each subclass of fixed income. However, both corporate bonds and swaps trade as a spread to Government of Canada bonds and these spreads can fluctuate significantly and in opposite directions. For example, at the outset of the credit crisis, corporate spreads widened significantly while swap spreads simultaneously tightened.

A final consideration for any pension plan considering leverage is the funding rate for the financed asset. The minimal benchmark for any asset should be the funding rate; otherwise, the leverage employed is a financial drag on performance. The asset being measured against this minimal benchmark depends on the outlook of the plan sponsor. If, in our example above, the benchmark asset allocation is a typical 60/40 equity to fixed income ratio then the additional 60% of assets used to hedge interest rate risk would be measured against this minimal return hurdle. On the other hand, if the pension fund’s benchmark asset allocation is a full interest rate hedge, then the equity allocation should be measured against this hurdle even though the interest rate swap is the financed asset.

Historically, strategic leverage of assets was not employed by pension funds because many did not use derivatives nor were they able to issue bonds. As funds have become more sophisticated, however, new avenues have opened up including the ability to use leverage. If employed with the proper understanding and risk limits, leverage can assist pension funds in reaching their funding goals.

Benefits Canada also had a recent summit notes on one plan’s use of leverage:

Calvin Jordan, CEO of the Nova Scotia Association of Health Organizations Pension Plan (NSAHO) in Bedford, N.S., discussed how this DB plan uses leverage to improve its asset liability matching at the Pension & Benefits Conference today in Toronto.

The $3.6-billion plan’s asset mix is 25% fixed income (65%, but 40% is leveraged), 40% equities and 35% alternatives. “That [alternatives] may be on the high side,” said Jordan, “but it’s not including hedge funds.”

Using leverage in its asset strategy causes an increase in risk to the assets but a decrease in risk to the balance sheet, he explained.

Strategy has nothing to do with past results, said Jordan, it’s whether your strategy glues everything together.

Watch for more to come on this topic.

Jonathan and I also discussed the increasing allocation to private markets in many of the large Canadian pension funds. He rightly notes that a lot of this is done for mark-to-market reasons because pension fund managers have more flexibility marking these assets up and down whereas they can’t do this in public markets.

I told him that when I started my blog, I started writing on the ABCPs of pension governance and blasted pension funds that were using bogus benchmarks in alternative investments. I strongly feel that it’s critical that we demystify pension fund benchmarks once and for all, and stop claiming that added value at pension fund A is the same as added value in pension fund B. Importantly, if they use different benchmarks for their individual investment portfolios and if one uses a lot more leverage than the other, then added value is not the same!

Go back to read my recent comments on apples and oranges, OTPP’s Neil Petroff on active management, and a look at the Caisse’s 2010 Annual Report. It’s worth noting that while Teachers’ is leveraging up, the Caisse is reducing leverage across the board. Does this mean Teachers’ is better at managing risk? Maybe or it just means they’ll get whacked harder during the next crisis as they did in 2008 when they crashed and burned.

I have discussed how public pension funds are increasingly leveraging up to make the returns they’re looking for. I have also discussed how public pension funds are increasingly allocating to private markets and hedge funds, another source of additional leverage (juice). The truth is private markets have been good to pension funds and senior pension fund managers. Guys like Claude Lamoureux, the former president and CEO of Ontario Teachers’ made millions by allocating to private markets. In fact, almost all of the added value among all the large Canadian pension plans in the last 10 years or more came from private equity and real estate (and more recently infrastructure). No wonder senior pension fund managers can’t get enough of private markets — they’ve become stinking rich allocating to these investments.

To be fair, if you look at how corrupt and manipulated public markets have become — with high frequency trading and naked short-selling — you have to ask yourself why would pension funds not move all their assets into private markets. I used to think funds like OMERS were nuts to set long-term strategic asset allocation of private markets at 60%. I still feel this is going to be difficult but I understand why pension funds want to have more control over their investments and not rely as much on volatile public markets.

Getting back to the use of leverage at public pension funds, Jonathan shared some additional comments with me:

Just to let you know, I believe that many pension funds employ some use of leverage either knowingly or unknowingly. Some of the large consulting firms are recommending use of interest rate derivatives to hedge interest rate risk even while maintaining exposure to equities.

As I mentioned in the Benefits Canada article I sent you, there is extreme danger in times like these where the potential for serious inflation is non-negligible, to take care as fixed income is not necessarily negatively correlated with equities. My research has shown that this negative correlation (equities & FI) was a Greenspan invention which he used to fix the market after the ’87 crash by lowering administered rates. If you go back to the ‘70s, equities and fixed income both sold off due to inflation. Therefore, I recommend funds using these strategies to employ stops on some form of the leverage – either the equity or fixed income portion.

You should also be aware that I am not fundamentally against leverage as I think good uncorrelated alpha product on top of interest rate derivatives used to hedge the interest rate risk in a pension fund is a relatively solid approach. The trick is to find those types of assets.

Funds that employ leverage but may not be aware of such will find it buried in some private market investments such as private equity or real estate, which may use borrowed money to lever funds.

Funds that use leverage knowingly include OTPP, which issued bonds to back its real estate portfolio (this is a continuation of the way Cadillac Fairview managed its real estate portfolio).

I want to emphasize again that not all leverage is bad, but it should be used with the proper level of risk management and portfolio expertise.

On the question of inflation, I told Jonathan I don’t see it without wage inflation. He agreed with me and sent me a recent comment of his on the wall of worry:

The stock market continues to climb a wall of worry, buoyed by “free money” – zero interest rates. But zero rates are really here to create inflation – real inflation, not the kind that increases prices of food, metals and energy. Real inflation is wage inflation and with high unemployment in the US, it is hard to see a way into real inflation. Meanwhile, the inflation generated by zero rates (higher prices of food, energy and metals) are simply taxes on the normal citizen. With greater funds set aside to drive, eat and build (shelter), there is less room for discretionary spending.While the demographics are not similar, we could be seeing a new iteration of Japan.

I thank Jonathan for providing me with his comments on the use of leverage in pension funds. We both agree that if used properly, leverage can add value to overall results. But we also fear that fiduciaries don’t understand all the risks of using leverage in both public and private markets and all too often rely on spurious “one size fits all” advice that pension consultants routinely peddle. Unfortunately, much more needs to be done to address this lack of knowledge among fiduciaries.

Tags: Advisory Firm, Asset Managers, Bank Of Montreal, Canadian, Canadian Market, Cookie Cutter, Cutting Corners, Forethought, Global Financial Crisis, Infrastructure, Interest Rate Swaps, L Word, Management Functions, Ontario Teachers Pension, Ontario Teachers Pension Plan, Pension Consulting, Private Pension Funds, Risk Risk, Short End Of The Stick, Taking Into Consideration, Teachers Pension Plan, Treasury Management, Tumultuous Times
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