Column: The Institutional Elephant | Chief Investment Officer

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The elephant in the room for institutional investors is whether target return assumptions of over 8%—established in times of rosier equity risk premia—are achievable in the future. To posit that the median plan will reach 8% is, at best, greatly optimistic, especially in the “risk-on/risk-off” environment post-2008.

However, after what the industry has gone through over the decade, it is not surprising that fund sponsors are evaluating alternatives to the equity-centric policy standard.

How Low Can You Go?

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Interest rates are at historic lows, but for plans approaching fully funded status, lengthening durations and increasing fixed income is high on the list of risk and volatility management.

A number of institutions have switched from an equity-biased asset allocation model to a liability-driven investment (LDI), risk-parity, or factor-based approach. Typically, addressing the asset/liability mismatch includes combining long corporate (10 years+) and government credit (two to three decades+) with options and derivatives to hedge certain exposures.

Large corporate and defined benefit (DB) plans are moving to LDI to reduce market and balance sheet volatility. Compared to their five-to-ten year brethren, multi-decade credit looks more like a liability than an asset.

Plans that are not fully funded—and there are many of them—potentially face significant risks if they lock in low yields now, since shorter duration bonds could improve their funded position should rates rise. According to Aon Hewitt (which by the way has one of the best apps in the industry, “HRevolution”), 86% of DB plans were underfunded as of January 2011.

While long duration bond funds are a possible solution, the strategy faces a number of challenges: the possibility to lock in losses by going long now, convincing trustees to approve the necessary portfolio changes, and the overall question of supply for long duration bonds in the marketplace.

How Long Can You Go?

The UK, driven by the depth of its pension market and regulatory impetuses, in 2005 started with a 50-year gilt. This summer, the UK’s debt management office reported sales of long-dated government bonds of £11 billion in under an hour (50-year gilts accounted for £4 billion), which prompted the chancellor to put forth the idea of a 100-year “Osborne bond” or a perpetual gilt, similar to bonds issued after the South Sea Bubble and WWI.

On the emerging front, Mexico—encouraged by the success of Rabobank and Norfolk Southern—issued 100-year debt at a 6.1% yield, while Peru post-2008 sold 40-year sovereign bonds. Often, such issues have been a result of specific requests. For pension funds, the longer, the better.

For the US markets, getting longer exposure has been an uphill battle.

Going beyond the existing 30-year offering, the discussion by the US Treasury to create 50- and 100-year bonds as a sensible thing to do in this environment is built around $2.5 trillion+ in possible demand in the next few years as a result of financial and pensions regulation.

The 2008 crisis forced the US government to issue $800 billion in Treasury bills, along with some $500 billion in short-term financing to deal with the financial crisis. Since then there have been efforts to transition to longer term financing with auctions of 10- and 30-year bonds, alongside 10-, 20-, and 30-year TIPS for a total of more than $2 trillion in various instruments with long maturities.

Still, the average maturity in the UK—close to 15 years—is three times longer than in the US.

As a result of the limited long-term supply, asset holders have been stacking up on long-term corporate debt instead of US Treasuries. 2012 is already a record year for 30-year corporate bonds. Halfway through the year, long-term corporate debt sales had already surpassed the $85 billion 2011 full year totals, capitalizing on the low-yield environment and institutional demand for alternatives to government debt. For example, the University of Pennsylvania issued $300 million in 100-year bonds at 4.64% (lower even than the California Institute of Technology last November) in a strategic move to take advantage of low borrowing cost.

So while LDI implementation and long duration bonds are a risk management solution for some well funded plans and a good way for corporations and schools to raise money, most institutional investors must first decide whether rates could potentially go lower or remain low, and then perform a balancing act of risk allocation, interest rate assumptions, and board education around new investment policies and implementation triggers. Moreover, as Callan Associates speculated in a recent risk parity research study, “Given the underperformance in the 1990s and the practical difficulties to implement a levered policy portfolio, it is unlikely that the levered risk parity approach would have survived at any major institution.”

And assuming this communication conundrum can be solved, good luck with breaking the news that future returns might be closer to 5% than 8%.

Daniel Enskat is Senior Advisor to Asset International and Founder of Enskat & Associates.

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For a generation and more in asset management, a rising tide (more assets, more asset classes, stable fee levels, tolerance for underperformance) has rewarded players of every stripe. Occasionally, firms imploded or hemorrhaged assets—but only on the margin.

In a handful of years, we have rocketed into very different territory. The margin has become the mainstream. Most asset managers are looking into an abyss. For most managers, stagnation will replace prosperity. To survive, let alone thrive, radical rethinking needs to replace complacency. We are about to see a great concentration of institutional assets in a handful of firms.

Much of the change stems from the radically different demands of the ultimate consumer, particularly institutional investors. Many large asset owners, corporate defined benefit plans in particular, no longer require what the vast majority of asset managers purport to be selling, which is the ephemeral promise of alpha. Instead, they want strategies that are heavy on risk mitigation (alternatives, overlays, and liability-driven investing [LDI]) and are on a path to risk transfer, which means termination. In short, they want solutions, not product.

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Public funds face a different challenge, but their ultimate resolution will be no less kind to most asset managers. The big winners here will be private equity firms, a handful of large hedge funds with no capacity issues, and, most importantly, the handful of large multi-class asset managers with the ability to create and service strategic relationships.

Foundations and endowments will increasingly move into the alternative space; they have specific risk/return needs that simply can’t be met by the long-only community. Outsourced CIO solutions will continue to thrive.

The defined contribution marketplace is also moving away from the traditional asset manager. As 401(k) plans become increasingly target-date centric, which they inevitably will, a handful of providers will enhance their dominance. These target-date solutions will evolve, but the winners (again!) will be risk-mitigating strategies like LDI, hedge funds, and retirement income overlays.

Retail is the last refuge of the stock-picker and, indeed, of long-only. But even there the future is about ETFs and not mutual funds, and about passive rather than active. The dirty secret is, of course, that few really believe any longer in active long-only management. There are no more Bill Millers or Peter Lynches who, year after year, produced alpha and hoovered up assets. No doubt they’ll come back into favor—after all, everything does—but not for decades to come.

How many asset managers are relevant to this new world? Perhaps 10 out of the top 50 asset management complexes in the US. And exacerbating this ruthless winnowing in the asset management community is the evolution of client service. The investment world has become so multi-dimensional and complicated that most asset-owners can no longer get by as decision-makers, even with the help of a consultant. The rise of outsourcing is, in large part, a function of the growing understanding that asset management has become too complex for plan sponsors. Going forward, the top tier of asset managers are going to have to bring to the table a whole new level of intellectual capital, analytic tools, and client service mechanisms—as well as an ability to offer open-architecture investment outcomes—to properly serve their institutional customers.

Few asset managers can even pretend to play in this space. Which, of course, is why this reality will be denied for some time yet to come. Even if you can read the writing on the wall, it doesn’t help you if you don’t have the product, culture, or capability to thrive in a new environment. For many, like Die Antwoord’s Ninja, you might well be able to see the future, but you’ll still have nothing in your hand.

Charlie Ruffel, the founder of aiCIO and Asset International’s other media brands, is a global authority on retirement, asset management, alternative investments, and securities services issues. He is now Managing Partner at Kudu Advisors, which provides M&A and strategic advisory services to institutional asset management and global asset servicing businesses.