Ordem e Progresso

02 May 2010

AllAboutAlpha.com is broadcasting from our worldwide headquarters again this week after a road trip that took us through Singapore, Hong Kong, an ash cloud, Frankfurt and Sao Paulo attending industry conferences and meeting with CAIA members and candidates.

The Brazilian “multi mercado” community was out in force last week at the Brasil Investment Summit, one of the “go to” events in that country for institutional and alternative investors.  If you missed it, organizers “live-blogged” it in both English and Portuguese here.  Not being exactly fluent in Portuguese, I was curious to see what bloggers had to say about my panel on trends in portfolio construction.  So I plugged the post into Google Translate.

You gotta love the well-meaning folks at Google (and other online translation engines).  They get an “A” for effort.  But it’s tough for robots to translate languages.  Here’s an excerpt from their English rendition of this panel write-up:

“To discuss the formation of a portfolio by pension fund managers had Christopher Holt, Sebastian Lafosse [Lyxor], Manuel Carvalho [Towers Watson] and Roberto Gremler [Petrobras pension fund]. The debate started with an approach of how each one was riding his wallet.”

In any case, we suggest you also “ride your wallet” down to Brazil this year to check out the quickly changing alternative investment landscape.

With the Olympic Games and FIFA World Cup on tap, and an economy that largly dodged a bullet in the recent financial crisis, Brazil is attracting a lot of attention these days.  Our friends at Opalesque have just published the transcript of an interesting roundtable discussion featuring some of the country’s hedge fund managers (some who were also present at last week’s conference).

If there’s one theme that arises out this roundtable discussion – and out of last week’s conference – it’s that Brazil’s hedge funds are well-regulated (essentially, they are treated as mutual funds).  Chalk it up to the national motto “Ordem e Progresso” (“Order & Progress” – and you don’t need Google Translate to figure that out).

Siegel’s Myths

One of my fellow speakers at a breakfast session for Brazilian pension plans last week was Larry Siegel, Research Director of the CFA Institute’s Research Foundation, Senior Advisor to Chicago-based Ounavarra Capital and AllAboutAlpha.com contributor.  Larry is always a crowd favorite since he doesn’t mince words.  Last week, he urged the audience to pay attention to “Nine Myths of Investing”.

With Siegel’s permission, we have listed out these myths below (taken verbatim from his slide presentation).

Myth #1:  “Asset allocation is the only thing that matters.”

  • True: asset allocation explains the greatest part of return variation
  • But “asset allocation” currently seems to mean market timing. This is a misunderstanding
  • Asset allocation = policy mix of betas designed to be the best long-run investment
  • Ideally, equal to mix of betas in liability
  • Timing away from the liability-defeasing asset mix is an attempt to add alpha, like any other.
  • Results from beta timing matter
  • Conventional active management (to add alpha through security selection) matters too

Myth #2: “Liability-relative investing is good in theory, but interest rates are too low.”

  • Every pool of assets was gathered to pay a liability (Pensions, endowments, foundations, individual savings, sovereign wealth funds, etc. (liability is less clearly defined))
  • Interest rates could go down (stranger things have happened) – you would then be much worse off
  • Interest rates could go up, but A & L would decline at same rate if duration matched
  • You might eliminate deficits through interest rate timing, but how has that hopey-changey thing worked out for you in the past?

Myth #3:  “It is a good thing to be an absolute return investor.”

  • There is no such thing as an absolute return investor
  • Except for a very few completely market-neutral hedge funds
  • Basically all funds are market-exposed
  • All funds have a benchmark (whether the manager likes it or not, whether the fund is liquid, etc.)
  • Even a market-neutral fund has a benchmark, cash, which explains much of return variation of this type of fund

Myth #4: “Active management only makes sense in markets that are inefficient.”

  • Well, of course
  • But all markets are inefficient to some degree
  • Best track record ever (Berkshire Hathaway) was achieved in U.S. large cap
  • Active management is a zero-sum game in all markets, no matter how efficient or inefficient

Myth #5: “You should try to minimize fees.”

  • No, you should try to maximize expected return after fees
  • Which means maximizing expected alpha after fees if you meet the criteria for selecting active managers
  • Minimizing fees would mean a pure index strategy, missing out on some of the most interesting economic opportunities in the world

Myth #6: “Alternatives are where the return is, so these managers deserve their high fees.”

  • Parable of the skilled manager with no capital [AAA: more on this in a future post]
  • For truly skilled managers, 20% profit share might not be enough!
  • But how many geniuses are there?
  • Fewer than 200 hedge funds in 1990
  • More than 8000 now
  • Aggregate alpha available in the market was zero in 1990.  It still is.
  • High fees attract mediocre as well as superior managers
  • Burden is on fund sponsor to find superior managers from a population that is close to average (i.e., that delivers benchmark return)

Myth #7:  “Diversification doesn’t work any more”

  • Claim is too silly to take seriously, but some people believe it so let’s address it
  • The “original alternative asset,” Treasury bonds, provided excellent returns during crash
  • So did cash
  • Nobody ever said that diversifying among 50 kinds of equities would reduce risk very much
  • And credit, private equity, equity hedge funds, etc. are all types of equity!

Myth #8: “The endowment model is broken”

  • If the endowment model is that “anything worth doing is worth overdoing,” then it’s broken
  • But that is not the essence of the endowment model
  • Endowment model properly understood:
  • Think broadly about diversification
  • Take all asset classes, not just public, liquid asset classes, as your opportunity set
  • Be a long term investor
  • Be willing to sacrifice liquidity for higher returns, if there is a liquidity premium, and only up to the point where liquidity sacrifice doesn’t threaten the financial soundness of the institution

Myth #9:  “We are in a low return environment.”

  • Don’t confuse the future with the recent past
  • If you’re in a low return environment for long enough, you’re in a high return environment!
  • But interest rates are low…
  • Wait a while and that will change. Inflation expectations from fiscal policy will become embedded in rates
  • Equity return expectations are not low

That’s all from the República Federativa do Brasil.  Our take: solid GDP growth, low debt/GDP ratio, regulated hedge funds, pensions under-invested in alternatives, soccer, Olympics and best of all, no jet lag for North Americans!

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