Exploring New Standards for Fixed Obligation Investments
By Craig Bardo, senior director of investor relations at BroadRiver Capital.
Institutional investors have long labored under methodologies that have placed many in a bind. Since Ford Motor Company petitioned the State of Michigan to allow them to invest pension assets directly in the capital markets in 1950, most institutional investors followed the lead of pioneers like Markowitz and Sharpe to help them construct portfolios capable of delivering the promised pension benefit or spending plan requirements their portfolios were assembled to provide. Subsequent innovations, though beneficial for some, have left most to ponder whether the assumptions that led to the creation of these pools are sustainable and, if not, what can be done to change the seemingly intractable trajectory toward increasingly difficult decisions.
While many of these machinations have remained behind closed doors, some investors have not been able to hide. Publicly held corporations, for example, have had to accurately recognize their pension obligations and it has caused such a problem that many are shuttering their defined benefit plans, utilizing old strategies that are now expensive to implement. Because they must now recognize these liabilities on the balance sheet (and not simply footnote un-funded liabilities), CFOs have had to take aggressive action to prevent erosion in enterprise finances. Impending changes in the Government Accounting Standards Board and pressure on funding are also requiring government pension managers to rethink their approach to portfolio management.
Churchill once said, “golf is a game whose aim is to hit a very small ball into an even smaller hole, with weapons singularly ill-designed for the purpose.” He might have been a portfolio manager! Endowments, which are increasingly being relied upon as a principle source of funding, pension and even treasury managers are all being asked to do a job that their toolbox does not equip them to handle.
So while obligations roll predictably along, market volatility has eaten up 35% of the funded status of pensions in the last 14 years, twice! Managers have often reverted to familiar, if relabeled, strategies: leverage on risky assets, seeking asset mixes with greater beta to capture the potential upside of certain strategies, viewing risk as volatility rather than the probability of losing capital (and doing that with proxies), moving down the capital waterfall, etc. Once in place, the results are celebrated in annual reports when it “works” or comfort is taken in benchmarks when it doesn’t.
As managers employ these various strategies, another challenge persists: cash flow. Above market returns may be realized in hedge fund and private equity structures but they’re often in lumpy, unreliable tranches that put pressure on other assets when cash is required.
Are there assets that behave as reliably as the predictability of investor’s liabilities? Are there assets that offer strong downside protection of principle, produce reliable cash flows and returns in excess of what’s required for treasury managers, endowment funding and by pension actuaries? Do some of these assets have the added benefit of not being correlated with the capital markets or general economy?
The short answer is yes, but they’re often accessed via non-traditional vehicles and are sometimes capacity constrained. Accessing this risk/return profile requires managers to look beyond proxies for risk. It may also demand reassessment of the purpose for fixed-income portfolios. With what appears to be at least a slowing of Fed bond buying and increased volatility in the capital markets, it may be time for managers to find a home for these types of assets in their allocations.