Thursday, January 31, 2008

Longevity Securitization

These days 401(k) investors are focused on what they perceive to be their largest risk ….the risk that that their investments will lose value. In fact, many are unaware that a much larger risk looms....longevity risk.

Longevity risk is the risk of either under-living or outliving their planned asset base/income stream. As the level of defined benefit plan, longevity- protected, distribution streams fade and the baby boomer cohort faces retirement, the demand for individual annuities, which address this risk, will probably increase. The adoption rate of retirement annuities will however, be influenced by; investor perception, pricing, insurance industry risk retention models and the state of the structured investment markets.

As demand for individual annuities increases, insurer’s capacity to handle this exposure is ultimately limited by a risk warehousing approach and by industry capital requirements. Just as the securitization phenomena allowed banks to increase their underwriting capacity and disintermediate mortage risk, so securitization of longevity risk could attract more capital and provide a lower priced more flexible annuity product than is available today.

Advancements in capital market solutions and tradeable indices for longevity risk could contribute substantially to defeasing one of the most significant risk transfers from the demise of the defined benefit retirement model.

Tuesday, January 29, 2008

Fiduciary Challenges II

Market events in 2007 reinforced that simplicity can be a valuable attribute of an effective fiduciary investment strategy. In today’s capital markets virtually any income stream can be transformed into an asset class. Financial engineers have found it lucrative to reformulate and leverage common risks into complex alternative asset structures with supposedly superior investment characteristics. The complexity of these structures leads to information asymmetry which is an uneven distribution of information to the parties at risk. This enables risk premiums to be transmogrified into much more attractive “alpha”.

The current mortgage credit crisis is an obvious example of how complexity and information asymmetry worked against investors. The “excess” return in structured mortgage products was, in fact, compensation for the unlikely event that the mortgages would default. As it turns out , the cost of this uncompensated tail risk could be quite high. Investor’s faith that sophisticated global banks and money managers properly understood and were managing these risks was obviously misplaced. Moody’s Investor Services warned that “the complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined, probably forever”.

Fiduciary responsibility and prudence has long required a detailed evaluation of under-performance. In the future, fiduciaries may have to be just as vigilant about examining the true nature of out-performance. Despite all the financial innovations, the most significant risk and return generator for most portfolios remains common stock. Managing the extent and concentration of that exposure is still one of the most important and consequential fiduciary responsibilities. The single strategic decision about how much stock to have in a portfolio should occupy the majority of an investment fiduciary’s consideration since it alone can determine much of the outcome of the portfolio.

Investors who understand and implement a prudent investment process will be sucessful, in at least a relative sense, in part because the utilization of a disciplined process will help them take advantage of the benefits available to long termism and escape some of the pitfalls inherent in investment complexity. While this seems simple…it is not easy. It requires patience, self restraint and the discipline necessary to overcome strongly ingrained instinctive behaviors.

Sunday, January 27, 2008

Target Retirement Funds - Home Squeezed or Heart Healthy

The Target Retirement Fund is a recent investment product innovation that fulfills a basic need for a simple, professional lifecycle driven asset allocation for uninvolved investors. It promises to provide a healthier financial retirement. From a marketing and product development perspective, an analogy can be drawn to a basic consumer commodity…orange juice. The primary virtue of orange juice is its high vitamin C content which helps the body fight infections like colds and is essential for tissue repair as well as wound and bone healing. It promises to provide a healthier physical lifestyle.

For both products, innovation in product development and marketing is a key factor in driving sales and revenue for the seller. The differentiation of products (target retirement funds or orange juice) by key features and minor details is an important strategy by which sellers both promote their brand and defend their fees. Yet these innovations may have limited realizable marginal benefit for consumers while in aggregate substantially complicating their selection decision making.

In selecting and evaluating Target Retirement Fund’s, fiduciaries are effectively faced with a “walk down the orange juice aisle” where product selection has become impossibly complex due to the phenomenal growth of brand extensions. For instance, Tropicana alone offers these choices; Original with No Pulp, Homestyle with Some Pulp, and Grovestand with Lots of Pulp. Calcium + Vitamin D with No Pulp, Grovestand (Lots of Pulp) with Calcium, Organic Orange Juice, Orchard Medley, Fiber, Low Acid, Healthy Heart, Healthy Kids, Antioxidant Advantage, Light n Healthy with Calcium, Light n Healthy with Pulp and others.

Target Retirement Funds are offered under different brands by competing firms. They fulfill the same basic need but typically do not have identical features. The differential features of Target Retirement Funds include their; core asset allocation and asset class diversification, equity glide paths and the investment structure by which the funds are implemented (active vs. passive investments, proprietary vs. sub-advised managers).

Because of the substantial variation in how Target Retirement Funds can be developed and implemented, it has been difficult to establish general standards and benchmarks by which fiduciaries can objectively measure the value of each fund’s distinctions. The industry is focused on this question and at least several firms have addressed the Target Retirement Fund benchmarking. Capital Group and Vanguard both offer some alternative thinking on approaches. An obsession with developing the perfect Target Retirement Fund benchmark can be somewhat academic however.

Given the single age based risk parameter and average investor assumptions upon which these funds are based; intrinsic investment uncertainty and the relevance and dispersion of individual investor circumstances probably far out-weight any additional ex ante performance improvement that can be developed via a better benchmarking process. Target Retirement Funds can be a good investment solution for everybody but can never be a perfect ex post investment solution for anybody, regardless of how well they are constructed.

While random selection is perfectly acceptable in the orange juice aisle, it is not quite that simple for fiduciaries selecting Target Retirement Funds. However, by following some basic selection criteria, (such as reviewing funds from reputable firms, with low costs, good asset class diversification and a reasonable equity roll down), fiduciaries should be able to avoid the investment equivalent of a Sunny Delight.

Wednesday, January 23, 2008

No Fiduciary Mulligans

Many unsuspecting investment fiduciaries will be forced to pick up some pieces of their portfolios resulting from the breakage of the housing bubble and the structured investment and credit market collapse. While most prefer to spend their resources looking ahead, all should look back over this episode and try to learn something about they can improve of modify their investment philosophy and/or investment allocation and selection practice.

The Federal Reserve Bank of New York recently hosted a Liquidity Conference to go through this process. Reflective fiduciaries can take advantage of some esteemed thinking in this area. I have provided 3 examples of work that can be found at their conference site.

Understanding the Subprime Mortgage Crisis
"We find that during the explosive growth of the subprime market in 2001-2006 the quality of loans monotonically deteriorated and underwriting criteria loosened. In this respect, the rise and fall of the subprime market resembles a classic
lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. We show that the
problems in the subprime market were imminent long before the crisis in 2007, securitizers were to some extent aware of it,
but a high house price appreciation in 2003{2005 masked the true riskiness of subprime mortgages."

Understanding the Securitization of SubPrime Credit

"In this paper we provide an overview of the subprime mortgage securitization process and the seven key informational frictions which arise. We discuss how market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how the rating agencies assign credit ratings to mortgagebacked securities, and outline how the agencies monitor the performance of mortgage pools over time."


What Happened to the Quants provides the following conclusions:
"A small random shock in the global financial system can propogate rapidly"
"certain hedge funds and investment strategies may be more correlated than assumed", and
"regulations and registration may not address the systemic risks that hedge funds pose to the global financial system"

Unfortunately, fiduciary responsibility doesn't provide for mulligans. Fiduciaries should take full advantage of the unique clarity that is only provided by direct experience and hindsight to understand what happened to their investments. This will yield dividends in their futre decision making process.

Saturday, January 19, 2008

Mediocrity - A Superior Investment Strategy?

Investment selection and monitoring is an important responsibility for investment fiduciaries. The investment vehicle of choice for most investment fiduciaries will be a diversified investment fund managed by either; a bank, an insurance company or an investment advisor registered under the Investment Advisors Act of 1940. Investment selection is subordinate in terms of impact to the asset allocation decision for fiduciary driven investment plans such as defined benefit plans but of central importance to fiduciaries of participant driven investment plans such as 401(k) plans.

The investment selection decision tree first branches at the choice between using actively managed funds or passively managed funds. Utilizing a complete array of market based index fund alternatives requires low fiduciary maintenance and provides minimal fiduciary exposure and a highly reliable opportunity for "average" investment outcomes. In practice, institutionally managed portfolios have long recognized the benefits of supplying at least a portion of their portfolio's "beta" or market exposure via these low cost funds. Most fiduciaries understand the basic value proposition for index funds.

In electing to utilize actively managed funds, fiduciaries are implicitly acknowledging a belief and a desire to accept additional risks in return for the potential to outperform a market index on a fee adjusted and risk adjusted basis. The historical returns based decision making criteria broadly used by fiduciaries to profile, differentiate and select actively managed funds is woefully inadequate. It does little to help them understand what risks may be present in the Fund or help them set reasonable performance expectations as they monitor the fund prospectively.

While there are many complicated statistical tools and fundamental characteristics that fiduciaries can use to guide their active fund selection process, one simple attribute to examine is portfolio concentration. Portfolio concentration refers to the number of individual holdings (stocks or bonds) in a fund. The general rule is that the more concentrated the fund (fewer holdings) the more volatile its returns will be, both on an absolute basis (measured as standard deviation) and relative to a benchmark (measured by tracking error or volatility in returns relative to the benchmark). Whitney Tilson, a concentrated value manager describes the arguments behind both highly concentrated and more diversified investment approaches in an FT article.

Simply put, the impact of having an investment decision turn out to be right or wrong in a concentrated portfolio is much higher than in a more diversified portfolio. The degree of appropriate fund concentation depends principally on the fiduciaries confidence in the manager as well as the context in which the fund is offered. Investment fiduciaries whose prime objective is to limit the potential for large losses, would need to have a much higher confidence level (or have a lower overall allocation) in choosing a manager of a concentrated fund over a manager of a more diversified fund given the magnified impact of any bad investment outcome.

In terms of context, a concentrated fund might be suitable (or, in fact, preferable) as part of a carefuly managed portfolio where unique manager specific risks due to concentration are diversified with other non-correlated concentrated funds (ie a concentrated portfolio
fund of funds). From a fiduciary perspective, concentrated funds may be least suitable as part of a participant selected offering such as a 401(k) plan. The performance volatility of many concentrated funds make them difficult to satisfactorily maintain under most general investment policy performance criteria. In addition, higher performance volatility invites irrational investor behavior (sell low buy high) which can be detrimental to long term wealth accumulation.

There is no free lunch in the sense that tracking error & volatility must precede excess returns. Investment fiduciaries however face assymetric risk & rewards. There is significant fiduciary exposure for exposing a portfolio or its investors to downside risk and "unsuitable" diversification. There is little reward for providing opportunities for upside return.

We agreed with Whitney that "the level of diversification exhibited by many mutal funds - holding 200-300 stocks" - can be a "form of closet indexation that invites mediocrity". Yet , diversification can be a post hoc fallacy with regard to mediocrity. Will Danoff is an example, amongst others, of managers who can rise above mediocrity with a very diversified portfolio.
In fact, mediocrity of this calibre, is often superior from a fiduciary standpoint. It reduces the chance of a major loss and with lower volatility than a concentrated portfolio reduces the opportunity for behavioral mistakes that can ruin a long term investment strategy.

Friday, January 18, 2008

Fiduciary Challenges I

In 2007 we witnessed increased market volatility, greater dispersion in returns and fallout from innovations in financial engineering and quantitative finance. These conditions intensify the challenges that face investment fiduciaries, particularly with regard to maintaining a long term investment perspective and appropriately utilizing new products that seemingly offer risk-less portfolio enhancements.

While managing a long term investing strategy is not synonymous with doing nothing, it has many advantages over a process which is predominated by a series of short term oriented decisions. As Jack Gray, a strategist from Grantham, Mayo & Otterloo put it “long-termism is not a panacea for investment decision making, nor is it a paragon of investment virtue, but it does offer some advantages over short-termism, namely better predictability, lower risk and lower cost[i]. Jack noted that barriers to long term commitment are plentiful and can be rooted in psychology and organizational behavior.

Psychologically, investors can fall into many cognitive traps. Over-reliance on data such as historical returns and believing the future will look like the past are perhaps the most common. As Ray Dalio, founder of Bridgewater Associates noted recently, with the quantum leaps in technology it is very easy to see what would have worked in the past and then lever up and over optimize those relationships. Leveraged bets on the safety and consistency of mortgage spreads over Treasuries cost billions in financial losses, jobs and organizational reputations in 2007.

Organizationally, fiduciaries should understand that while doing nothing is not responsible performance, neither is feeling compelled to adjust their portfolios to compensate for current market conditions. We have been conditioned to expect that successful meetings result in specific outcomes (usually decisions and action items). However, fiduciary committees should feel most accomplished when they think more than they act. Generally…but not always, the option to do nothing should be their favorite option. While reacting to short-term market fluctuations can often be financially destructive, fiduciaries should not feel guilty about adjusting an investment strategy based on well reasoned short term signals that may have long term relevance. Those fiduciaries who reacted quickly to the substantial realignment in the credit markets this summer seemed to have fared the best.


[i] Avoiding Short Termism in Investment Decision Making -, Jack Gray, CFA Publications December 2006 Presnetation avaiable here

Wednesday, January 16, 2008

Capital Markets 4th Quarter 2007

Concerns about the economic and financial risks associated with continued deterioration in the US housing market and a revitalization of the credit crisis during the fourth quarter drove losses in the equity and corporate debt markets while Treasury bonds rallied as investors fled from risk and uncertainty.

Asset prices recovered early in the quarter from midsummer’s credit panic as investors believed the Fed’s liquidity intervention in mid September and large write-off’s by bewildered bankers would substantially address the deteriorating credit and liquidity conditions. However, a substantial new batch of mortgage related downgrades along with escalating oil prices (57% increase in 2007) and an emerging picture of slowing corporate earning growth soured investor sentiment and depressed most market indices for the remainder of the year.

Global stock market results were heavily influenced by troubles in the credit markets for the quarter, though strength in international markets helped US investors and large US companies. Overall, US stocks lost -3.3% for the quarter per the Russell 3000. Full year stock returns were 5.14%, as growth outperformed value for both the quarter (-0.88% vs. -5.91%) and the full year (11.4% vs. -1.0%). Export exposed large capitalization stocks continued to outperform small cap stocks as the Russell 1000 outperformed the Russell 2000 for both the quarter ( -3.2% vs. -4.6%) and the full year ( 5.8% vs. -1.6%). Large capitalization companies derived about 44% of their revenue from overseas sources according to S&P. Financials, which is the largest capitalization weighted sector in the S&P 500 (17% weight at year end vs. 22% at the beginning of 2007), lost -15% for the quarter while energy, the best performing sector, gained only 4.1% for the quarter.

Sector performance generally followed the geographic exposure theme. Energy (32%), materials (20%) and technology (15.5%) were supported by strong international demand while financials (-20.8%), housing , real estate and consumer discretionary (-14.3) were stunted by domestic issues. Utilities (15.8%) traded as a higher yield alternative to bonds. Commercial real estate peaked early in the year and softened significantly through the rest in the face of tightening credit. The NAREIT index lost -12.0% during the fourth quarter, ending the year down -17.8%.

International stocks outperformed the US for the fifth straight year based on stronger growth prospects and a US dollar that reached new all time lows during the quarter. For the fourth quarter the MSCI EAFE lost -1.7% but ended the year with an 11.6% return, almost doubling those of the US. Amidst generally lackluster European returns, Germany stood out with a 22% annual return while Japan lost -4%. Emerging markets continued to benefit from the perception that their strong economic growth would be sustainable in the face of a global developed market slowdown. Emerging-markets stocks returned 3.7% and 39.8% for the forth quarter and full year respectively. Emerging markets overtook the US on a price/earning ratio basis this year. Net redemptions for U.S.-stock funds totaled nearly $31 billion, the highest outflows since 2002, while funds investing outside the U.S. enjoyed net inflows of $100 billion in 2007 per Bank of America.

High quality bonds for the most part had a strong fourth quarter, though spread products were challenged as the price of risk returned and spreads widened. The risks implicit in the “originate and distribute” model of mortgage banking became apparent this year. Structured investments became the markets “hot potato” as investors could not track how losses due to sub-prime mortgage related delinquencies, which rose to 16% in 2007, were distributed through these products. SIVs – a banker’s structured “sleigh of hand” to avoid regulatory capital requirements, came under further pressure as their funding source in the commercial paper market seized up. As a result, investors fled to the safety and security of US Treasuries driving their yields down for the quarter. Even safe havens such as enhanced cash funds and money market accounts became unsuspecting victims as the market for AAA short term collateralized issues sank.

Despite the fact that inflation appeared to be ascending, long duration Treasuries outperformed stocks and other domestic bond sectors for the year. Annual inflation growth was at a 17 year high of over 4%. The Lehman US Treasury Long Index returned 5.7% for the fourth quarter and 9.8% for 2007.

The lack of bond supply and strong demand no doubt offset an expected inflationary premium priced into bonds. Investment grade bonds had a good year, returning 3% for the quarter and 7% for the year per the Lehman Brothers Aggregate. The dispersion in returns across bond managers and bond index funds was high as individual credit positioning and mortgage exposure had a large impact on performance. The cost to buy credit protection also rose significantly through the fourth quarter. As spreads widened, high yield bonds lost ground, returning -1.1% and 2.2% for the fourth quarter and 1 year periods respectively.