Institutional investors in hedge funds such as pension providers have to adapt to a changing investment landscape by following new models of diversification. They rely on the tried and tested investment strategies and demand closer client engagement. In the process they are changing the way hedge funds and other asset managers operate successfully, says Amin Rajan, CEO of Create Research.
Speaking at the Cayman Alternative Investment Summit, Rajan summarised the results of five research studies, conducted over the last four years with pension fund providers.
Beginning by outlining the changed investment landscape since the financial crisis, Rajan emphasised that investors are no longer managing risks, they are managing uncertainty.
Changed investment landscape
During the financial crisis it became clear that the assumptions underlying modern portfolio theory did not work. The risk-return tradeoff became much more volatile and unstable, and the correlation between historically lowly correlated asset classes turned out to be highly correlated at a time when investors relied on it most.
The efficient frontier analysis that attempts to determine the optimal investment portfolio offering the highest expected return for a defined level of risk or alternatively seeks to deliver an expected level of return at the lowest risk, can no longer only take into account the two dimensions of risk and return, Rajan said.
Now there are multiple foundations, including volatility, which was just a noise has become an asset class in its own right, and liquidity, which was incidental and has become centre stage, Rajan noted. As a result even pension funds had to add more dynamic elements to their historically strategic asset allocation.
Moreover, “from a pension fund’s point of view there has been a lot of regulation as well, which has severely curtailed their ability to do sensible investing,” Rajan said and “accounting changes have turned from benign to malign”. Especially mark-to-market accounting and Solvency 2 with its imposed solvency buffers have resulted “in a regulatory regime that gives pension providers the worst of both worlds: It costs too much and delivers too little”, said Rajan.
What if …
Quoting the chief investment officer of a large European pension fund, he explored the question what if the next ten years are going to be the same as the last ten?
The last ten years have shown that when it comes to investing the most important factors were a strong belief in investment choices based on the intuition which strategies work in which type of market cycle, a disciplined approach to buying and selling, including the skills to capitalise on an early mover advantage and a clear idea about the circumstances for getting out of an investment.
However, the nature of institutional investing is such that investors want to see a track record before making an investment, Rajan said. What followed from this was an overreliance on a rear view mirror, a strong herd instinct and at times panic selling.
Pension funds also had low engagement with their asset managers, something that cost them dearly during the crisis, he noted.
“Institutional investors don’t like to go into anything new that has not been tried and tested,” said Rajan, referring to the agency principle problem which means only managers and strategies that are tried and tested are favoured.
This poses a problem for new investment approaches, which also need to respond to the wider context clients are operating in.
Investors fully expect (78 per cent) the frequent volatility and price dislocations to persist for the rest of the decade and the majority (60 per cent) anticipates two or more financial crises in the next ten years.
Rajan argued current problems are not going to go away because markets are driven more by politics than economics and have no clear anchor point in an environment that is dominated by fiscal paralysis on both sides of the Atlantic. Due to the prevalence of austerity measures, confidence for immediate improvement is low.
New model of diversification
Rajan further sketched how pension plans are thinking about the future.
In terms of diversification he explained the evolution from the typical 60-40 equity and bond portfolio in the 1990s to an approach in the 2000s which contained long only (70 per cent), exotic beta (8 per cent) and alternative investments (22 per cent). By the time pension funds had diversified into alternatives, however, the peak returns of hedge funds were history, he said.
In the past three years the distinction between buy and hold investing and opportunistic investing has become more pronounced. Institutional investors realise that there is a lot of noise in the market, which can lead to opportunities, but when it comes to choosing between taking more risk and squeezing more out of the existing risk portfolio, the message from institutional investors is clear, said Rajan.
“Don’t try to invent new investment opportunities because we cannot invest into new things. What we really want you to do is get better at what you are doing.”
The other message is that their investment diversification follows a distribution into five buckets: Growth assets consisting of equities, hedge funds and private equity (50 per cent), high income including bonds and credit (20 per cent), cash flow assets such as property or infrastructure (15 per cent), high liquidity assets in the form of cash or treasuries (10 per cent) and inflation protection assets such TIPS and commodities (5 per cent).
Overall there is a clear emphasis on risk minimisation over return maximisation and a focus on absolute returns rather than relative returns. Institutional investors now see investing as a loser’s game, noted Rajan. “The winner is going to be the one who makes the least mistakes.”
The main question is whether hedge funds have the ability to capitalise on the volatility in the markets.
Institutional investors believe that asset managers can convert market ruptures into investment opportunities, only as long as they become trusted advisors and regain client trust.
This in turn requires client focus and the understanding of client needs and risk tolerances, together with the development of a solutions alpha rather than product alpha. Asset managers have to share their investment horizon and beliefs with the client and present proactive investment ideas. Institutional clients want access to the thinking behind the products, said Rajan.
In addition to the established track record, investors are looking for a strong alignment of interests with clients and the structure and nimbleness to capitalise on new opportunities and client remoteness. Hedge funds in turn have to manage expectations and ensure that they are at a realistic level.