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May 2002

State Street helmsman urges change of tack


Fund management




Fund managers and pension funds should not be duped by their good fortune of the last two decades and should be looking to alter their investment strategies radically, according to a leading investor.
       
Alan Brown
Alan Brown, group chief investment officer at State Street Global Advisors says that while things have not been so rosy by comparison over the last two years, this should be seen not as a blip but as a sign of things to come and the investment world should react accordingly.
"Anglo Saxon pension plans have generally had a terrific run for the last 20 years or so, at least until the last two years," says Brown. "But there is a danger that our industry may make the mistake of regarding the last two years as being the exception. Even worse, the longer-run record may seduce us into an unwarranted complacency that we have the right model. Or, to put it another way, we collectively may be guilty of making the egregious error of mistaking good luck for skill!"
Brown argues that industry best practice is potentially fatally flawed. That process typically involves a fund using a consultant to conduct an asset/liability study then selecting a strategic benchmark. The fund hires managers to invest on its behalf and then monitors their performance.
But Brown says recent experience highlights a problem. In the US in 1999 when interest rates rose liabilities fell and equity markets were still rising with the result that surpluses went through the roof. General Electric, as an example, booked $1.38 billion to its bottom line from its pension plan. But then in the following two years the reverse occurred and surpluses collapsed.
Many pension plans chose an equity-heavy strategic benchmark 20 years ago and hoped managers would provide added alpha. However while many managers underperformed, this was counterbalanced by the great bull market run.
The huge returns over this period were not a result of underestimating earnings or dividend growth rates, says Brown, but came from unexpected capital gains through P/E multiple expansion. If multiples become static that implies much lower returns in the future but if they revert to historical norms it would mean bad times ahead for equities.
As Brown puts it: "If the realized returns of the last 20 years were in some sense luck and, if looking forward, we expect much lower returns from equities and returns which are more comparable to bonds, then this has profound implications for asset allocation." Pension plans commonly assume an annual return of 9% and above but Brown predicts equity returns of only 8.5%.
Brown says pension funds should realize their similarity to hedge funds. "If I were to approach the CEO of most corporations with a great idea that the company should go out and borrow money and allow me to speculate in the equity markets, I could expect to be shown the door very quickly indeed," he says. "Yet, legal niceties apart, that is exactly what pension funds are doing."
Their liabilities are a form of debt and they are essentially short in fixed income and long equities. "Debt is like leverage and that's what a hedge fund has. Both have assets. A pension fund calls the difference between its assets and liabilities its surplus (hopefully); a hedge fund calls it net asset value." And while a hedge fund manages its surplus position directly and uses risk control devices to boost returns and manage downside risk, pension funds typically do not.
Brown believes funds should get away from simple return targets and look instead at preserving surpluses, minimising contribution volatility and managing shortfall risk. Funds should redefine their risk appetite and managers should align their mandates and fees directly with the aims of the fund.
Managers get paid more if the value of assets go up, regardless of whether they outperform or track well and whether or not assets go up by more than liabilities. But equities are not a natural hedge to a pension fund's liabilities - corporate index linked bonds are far superior.
Add to this the likely fall in equity returns, he says. "As a result, pension funds today take on a high degree of risk for likely a relatively low reward by being so heavily invested in equities."
Brown says funds should consider all asset classes, particularly as traditional equities will be less significant in the future given the hedge qualities of index-linked fixed income and the risk/return potential of alternative investments.






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