Tuesday, January 16, 2007

2006 Capital Market & Fiduciary Review

Investors enjoyed strong returns across a broad spectrum of assets classes in 2006 as ample liquidity and low market volatility encouraged and rewarded risk taking. Pension plans generally improved their funding status. Asset increases, averaging 12% for moderate risk diversified portfolios, outpaced a 1.2 % increase in average liabilities according to Mellon Financial. Despite improving pension plan economics, the regulatory and accounting changes enacted this year increase the defined benefit plan burden for many plan sponsors. As defined contribution plans shift from being a supplemental to a primary retirement resource, political, regulatory and legal scrutiny is on the rise.

Capital Markets Trade Higher in 2006
Global capital markets traded higher in near unison as a combination of cash, generated by strong corporate profits, petrodollars and Asian central banks, and financial leverage, provided by cheap debt, sought investment opportunity. Though market activity seemed generally rational, there were signs of momentum buying in certain areas.

Domestic equity –Almost half of the S&P 500’s 15.7% return for 2006 was delivered during the strong 4th quarter rally. Though market capitalization and style performance return differentials narrowed through the year, value investing maintained its global market leadership, marking a 7 year trend. The Russell 3000 growth index retuned 6.2% during the 4th quarter (9.5% ytd) vs. 8.1% for Russell 3000 Value (22.3% ytd). Investor’s reluctance to adopt growth investing - a residual of the tech boom, continued as elevated oil prices and a huge level of private equity transactions supported value style investing.

Despite expectations to the contrary, US small cap stocks dominated larger capitalization stocks again in 2006. The Russell 2000 small cap index returned 8.9% (18.4% ytd) for the 4th quarter vs. 6.7% (15.5% ytd) for the Russell Top 200 large cap index. Small cap strength can be attributed to the market’s low risk aversion as well as by private equity and hedge fund interest and the increasing use of ETF’s which may proportionately favor small caps.

In the US, indexing outperformed active management. Only 19% of all funds in the diversified stock fund category were able to beat the S&P 500 vs. 61% last year according to the WSJ. The “mega cap” discount and value and international active management biases provided less of an advantage to active managers in 2006. In addition, fewer than ½ the companies in the S&P beat the index according to Merrill Lynch, making stock selection more critical.

International Equity - Returns were equally strong based on strong global earnings growth, moderate equity valuations and a foreign currency kick for US investors. The MSCI EAFE Index returned 10.4% (26.9% ytd) for the quarter. Mutual fund investors piled into the non domestic markets in 2006 as an estimated $5 flowed into non domestic equity funds for every $1 that went into a domestic equity fund. Strong trends in flows like this can be self perpetuating as momentum investors tend to follow and reinforce the trend. Trend reversals however, can be equally powerful. Emerging markets recovered from a sharp sell off in the spring and retuned 17.6% (32.6% ytd) for the quarter according to the MSCI Emerging Markets Index%. Value and growth enjoyed similar gains in emerging markets, perhaps indicating less discriminating buying.

Private Equity - Fund raising set a new record in 2006, collecting over $320 billion as pension plans and institutions added or increased allocations to make their “8%”. With this kind of money to invest (over $1 trillion levered by with 3-4 times debt), private equity funds did bigger deals and started looking beyond the safe, high cash-flow companies they normally prefer. Questions abound as to whether traditional private equity approaches will continue to work in an era of mega buyout deals and how these investments will fare in a more difficult economic environment.

Commercial Real Estate- The rally continued in 2006, providing returns of 34.4% per NAREIT. The top performing REITs targeted international real estate, REIT privatization (Equity Office Properties Trust) as well as apartment REITS, which benefited from the reduced affordability of single family homes. US REIT share prices are rising faster than earnings, driving dividend yields below Treasuries, indicating a speculative element in this market.

Hedge Funds - Overall, hedge funds returned 12.1% in 2006 according to the Greenwich Global Hedge Fund Index. While research indicates that portfolio diversification rather than returns is the primary reason why hedge fund allocations are increasing, the correlation of hedge fund strategies to the equities markets have increased significantly over the last few years. It will be interesting to see if a new breed of low cost hedge fund “indexes” can successfully mirror the “beta” or market component of these strategies and absorb some of the growing demand for absolute returns.

Fixed Income – The anticipated turn in the credit cycle didn’t materialize in 2006 and credit spreads remained tight, perhaps not fully reflecting market risks or the growing but unknown impact that the dramatic increase in credit derivatives might have in less serene times. US bond yields reached a peak at mid year and drifted lower as the market anticipated Fed easing in response to slower economic growth. Credit risk was generally rewarded while duration was not.

Three month T–Bills returned 1.3% (4.8%YTD) for the quarter vs. Long Term Governments .48% (1.8% YTD). The yield curve remained inverted at year end, with yields on short term bonds (5.02% - 3 month T Bill) exceeding those of long term Treasuries ( 4.71% - 10 year Note). This has traditionally been a recessionary signal and continues to puzzle the markets as it contradicts the consensus forecast for a “soft landing” in 2007. Event risk challenged investment grade corporate bonds as leveraged acquisitions and new debt issuance put downward pressure on credit ratings.

Investor appetite for higher yield debt drove the boom in leveraged buyouts and boosted returns, yet compressed yield spreads, in the high yield bond market. High yield bonds returned 4.1% (11.6% ytd) for the quarter vs. the Lehman Brothers Investment Grade Bond Index 1.2% (4.3% ytd). Defaults, another driver of high yield bond prices, remained low at 1.3% in 2006 vs. a 20 year average of 4.5%.

Emerging market debt provided substantial returns for the quarter 4.6% (11.6%) according to Merrill Lynch.

Housing and Rates- Key to 2007
US economic growth slowed throughout 2006, particularly in the second half, largely due to a sharp falloff in housing activity and weakness in the motor vehicle sector.
At the same time, corporate profits and consumer demand remained strong and decreases in energy prices have substantially reduced overall consumer price inflation and core inflation showed signs of slowing. New job formation and low unemployment also suggest continued strength. The markets seem priced for an economic “soft landing” in 2007. According to John Neff, “the Goldilocks school has a very large class.” The future direction of housing and Fed action on interest rates will probably have a primary impact on US economic and market direction in 2007, not withstanding other wildcards like oil prices, geopolitical strife, etc…

For now there is much uncertainty about where we are in the housing cycle and its future impacts. Though there have been early signs of stabilization, significant evidence suggests more trouble ahead. Housing prices have decreased but remain historically high vs. rents and rates and while sales seem to have stabilized, cancellations which are not accounted for in government sales and inventory figures, have risen significantly.
The Fed has been encouraged by expected downward tilt in inflation but seems satisfied with its current monetary policy and will probably be satisfied to hold rates to ensure the positive trend is structural and not simply related to recent oil price and inventory adjustments.

Capital Market and Fiduciary Challenges Ahead

In 2006 ERISA fiduciaries had to confront substantial regulatory and accounting changes. With regard to defined benefit plans, sponsors are beginning to consider liabilities as their asset benchmark and broadening their asset allocations to include alternative non-correlated assets to diversify risks and improve returns.

Liability Driven Investing (LDI) – Recent regulatory and accounting reforms penalize under-funding and plan surplus volatility. As a result, plan sponsors are becoming more aware of their risk versus plan liabilities. LDI focuses on managing assets versus a liability benchmark rather than an asset benchmark. LDI strategies can be implemented in a variety of ways, but typically involve a combination of fixed income and derivative instruments, and can also include alpha transport components. The practice of LDI will be driven by large firms with the resources to develop products. Broader acceptance of LDI will likely be limited to plans that are fully funded and wont go down market until cost effective products are developed to allow plans to match liabilities but not altogether forego equity risk premia.

Increasing Portfolio Diversification - Equity losses during the late 90’s and a low expected return environment is altering pension plan and institutional investing behavior.
Pension plans are systematically diversifying portfolio into riskier asset classes, justifying their inclusion by the statistical risk reducing property of non-correlated returns. This diversification is conceptually warranted based on the idea that portfolios can simply expend a different risk in each of these uncorrelated asset classes. For instance illiquidity risk (private equity, private placements, commercial real estate), credit risk (high yield, emerging markets bond), skill risk (actively managed funds, hedge funds).

This has worked splendidly in hindsight. However, there is substantial estimation error implicit in the risk, return and correlation inputs used to model these new “asset classes”. We suspect that “crowded trades” and the reality that all correlations go to 1 when investors most need diversification will moderate this trend at some point in the future.

As Defined Contribution plans transition from being supplemental to primary sources of retirement security, fiduciaries will face increasing scrutiny and risk but, thanks to the Pension Protection Act, have additional ways to limit their liability,

Additional Disclosures - Defined Contribution Plan sponsors have been systematically disadvantaged by “asymmetric information”. Nobel Prize winner George Akerlof pointed out the implications of a market in which sellers are better informed about product quality and characteristics than buyers. The prevalence of negative alpha, poor investment benchmarking and obtuse fee structures in the 401k industry are all reflective of the information disparity in this market. In these kinds of markets, vendors focus on marketing and brand name development as proxies for the quality and attributes of the investments, which buyers often can't discern.

At least a dozen large lawsuits have been filed against large industrial company plan sponsors as well as retirement plan providers including Fidelity and some of the major insurance companies such as Nationwide, Principal, ING and Hartford Financial Services group. The common claim is that fiduciaries did not have and did not disclose sufficient information on plan expenses to enable prudent fiduciary decisions. While regulators will likely attempt to level the informational playing field via broadened disclosure requirements, fiduciaries will need to allocate more time and resource to stay current with the growing domain of disclosures.

Better Liability Protection - As fiduciary risks are better recognized, sponsors will increasingly take advantage of the new safe harbors in the PPA legislation. Life Cycle funds will capture an even bigger portion of plan allocations in 2007 as sponsors take advantage of the likely fiduciary safe harbor associated with their utilization. Unfortunately, Lifecycle fund choices will proliferate beyond what is necessary, making prudent selection more difficult. At the extreme, some sponsors may choose to reduce their liability further by eliminating all actively managed single asset class options from their plans and offering strictly index funds or life cycle retirement funds.

We think structural risks in both the capital markets and fiduciary domain have risen over the past year. Liquidity and the search for yield has likely driven interest rates and risk premiums to unsustainably low levels making a broad swath of assets vulnerable to risk reappraisal. Maintaining broad diversification to core assets and limiting substantial new mandates to risky assets seems a prudent approach for 2007. Proactively understanding and managing emerging fiduciary risks remains a high priority in 2007 as well.


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