Two roads to risk-management

05 / 08 / 2012
by Charles Skorina | Comments are closed

In this issue:

Farouki Majeed – a CalPERS vet heads back to Ohio

Interview with Peter Stein: an endowment CIO reinvents himself

Risk management: strategic or tactical?

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Comings and goings:

Farouki Majeed: A small pension finds happiness with a big-pension vet

 

Farouki Majeed, senior investment officer for asset allocation and risk management at the $235 billion CalPERS pension, has accepted a job as Director of Investments at the $10.2 billion Ohio School Employees Retirement System. He will be the fund’s senior investment officer, equivalent to a CIO. (Ohio SERS, for non-teacher school employees, is separate from the much larger $67 billion Ohio State Teachers Retirement System.)

Mr. Majeed was one of Russell Read’s last hires before Mr. Read left the CalPERS chief investment officer post in 2008. Mr. Majeed had previously been CIO of the Abu Dhabi Retirement Pensions and Benefits Fund, and also had a previous job in Ohio as deputy director of investments at the Ohio PERS pension in 2002-2004.

Insiders tell me that Mr. Majeed never quite got his footing at CalPERS and was also not happy with a rather modest bonus last year.

CalPERS had a good 2011, reporting net return of 20.9% for the fiscal year. So, we’d expect to see some respectable bonuses paid to the people who ran the money. According to the Los Angeles Times, CalPERS paid a total of $4.5 million in bonuses, averaging 41% of employee base pay.

We aren’t privy to the exact formula used in the CalPERS performance bonuses, but we presume they’re supposed to reflect the individual’s overall contribution as evaluated by the higher-ups.

There were four CalPERsons (including Mr. Majeed) with the rank of “senior investment officer” in 2011.

 

Eric Baggesen (global equities) got a bonus of 43% of his base pay, Curtis Ishii (fixed income) got 42%, and Ted Eliopoulos (real estate) got 37%.

Mr. Majeed’s bonus was just 14%. According to the L.A. Times, it was the lowest percentage bonus paid by CalPERS that year.

Performance-for-pay isn’t always pretty. The economist F. A. Hayek argued that the real role of prices is to carry information that helps individuals coordinate their plans and actions. CalPERS isn’t a free market, but pricing the work of managers like this does, indeed, convey information about what’s going on. It seems to have done so in this case.

Whatever the reasons for Mr. Majeed’s move, he seems to be just what Ohio SERS was looking for. Per their press release, this relatively small pension specifically wanted someone with big-pension experience, and CalPERS is the biggest we’ve got.

We don’t have a figure for the pay of retiring Ohio SERS Director of Investments Robert Cowman, but we note that John Lane, CIO of the much larger Ohio PERS pension ($76.5 billion AUM) made about $340 thousand in 2009, so Mr. Cowman almost certainly made much less than that. Mr. Majeed’s total comp at CalPERS in 2011 was $391,510.74.

Mr. Majeed earned an engineering degree from the University of Sri Lanka, an MBA in finance from Rutgers University, and is a CFA Charterholder. He’ll take up his new post in Columbus, Ohio in July.

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Scott Malpass: Joining the Vanguard

 

Scott C. Malpass, CIO of the $7 billion Notre Dame University endowment, has been elected to the board of Vanguard Group (including a seat on each of the Vanguard mutual funds).

Mr. Malpass has racked up an enviable 12.1 percent annualized return over 15 years at Notre Dame, putting him among the very best in the business.

Vanguard is, as Emerson would have put it, the lengthened shadow of one man, the remarkable John Bogle, who virtually invented the low-cost indexed mutual fund. Then, in the teeth of general indifference and ridicule, he created an engine to sell them to ordinary investors.

Nobel laureate Paul Samuelson, who taught freshman econ to Mr. Bogle back at Princeton, once said:

“I rank this Bogle invention along with the invention of the wheel, the alphabet, Gutenberg printing, and wine and cheese: a mutual fund that never made Bogle rich but elevated the long term returns of mutual fund owners.”

Mr. Malpass is joining a relatively small and very distinguished board currently including such luminaries as University of Pennsylvania president Amy Guttman, and HighVista Strategies CIO (and retired Harvard professor) Andre F. Perold, as well as Vanguard CEO William McNabb.

Along with Mr. Malpass, IBM CFO Mark Loughridge, (a University of Chicago MBA!), will also be joining the board as a new member.

A lot of American financial institutions have let a lot of people down in recent years, but Vanguard wasn’t one of them. We recall, for instance, the smelly mutual-fund scandals of 2003 when we learned that some large investors were allowed to trade after-hours to their advantage, while hurting the remaining investors. Several name-brand mutual fund managers were implicated. One of them, giant Janus Capital, for instance, went through five CEOs in one decade, lost many of its best managers and a ton of reputation. But Vanguard’s skirts were conspicuously clean.

Neither Mr. Bogle nor the leaders who came after him would have tolerated that kind of thing for a moment, and they have the kind of corporate governance that transmits those values to the troops. That’s why Vanguard is still trusted, admired, and making money for its clients, while many other financial players…aren’t.

Mr. Malpass should be a good fit at a good company.

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Chicago guys:

A conversation with Peter Stein:

Peter D. A. Stein was chief investment officer for the University of Chicago (2005 to 2009), and previously a managing director at the Princeton University Investment Company (2000-2005).

He recently completed an assignment with the Pacific Alternative Asset Management Company (PAAMCO), where he led strategic allocation for a $10 billion fund of hedge funds.

 

Mr. Stein serves on the investment committees of The Annenberg Foundation and the Rhode Island School of Design (RISD). He earned a BS in mathematics from Brown University and is CFA Charterholder.

Skorina:

Peter, as a Chicago grad myself, it’s always good to talk to you. You’ve gone from Wall Street to the Princeton and Chicago endowments, then to a big southern California fund of funds. Now here we are just around the corner from each other in downtown San Francisco as you start up a new CIO-outsourcing effort with the Presidio Group. So, you’re sort of back in the endowment world again.

You’ve really touched all the bases, so let me ask you my favorite easy question: What one big thing have you learned from your investment career so far?

Stein:

Well, more than one thing, I hope!

But, one big thing would be that, back in my endowment days, before the 08/09 crash, we were always talking to the rest of our colleagues in the university about their institutional spending needs and cash requirements, however, in big university systems it takes time to develop consensus and get buy-in.

Endowment and foundation investment offices are there to generate returns, not to set spending requirements; but it’s all related. Each institution has specific needs and risk characteristics. Some were looking to the endowment for 20% to 25% of their yearly budget; some needed much less. But the big ones were all moving towards the same kind of portfolios: complex asset allocations with lots of alternatives to reap the “illiquidity premium”.

And, let’s not forget that universities, in particular, are very competitive. They compete against each other on many fronts, for many things. They compete for the best students, the best faculty, and the biggest research grants; and, of course, for winning athletic programs.

 

Skorina:

That’s right. People forget that University of Chicago has an actual football team, sort of. The mighty Maroons, the terror of Division III!

 

Stein:

Absolutely, Charles. After all, somebody has to play Carnegie Mellon!

 

Skorina:

Sad, but true.

 

Stein:

Every leader wants his institution to move up in the pecking order. What could be more American? So, it seemed only natural that an endowment should compete for returns against its peers.

We all worked hard to maximize returns, but many endowments, including mine, were also beginning to reduce risk and build a safety cushion when 2008 came along.

It’s like when one of Ernest Hemingway’s characters asked somebody: “How did you go broke?” The other guy responded: “Two ways. First gradually, then suddenly.” Big institutional portfolios just cannot turn on a dime.

 

Skorina:

Are you saying, and I hate to use the cliché, but here goes: that the “endowment model” really is broken?

 

Stein:

No; in fact, quite the opposite. Significant allocations to non-traditional assets such as absolute return, private equity and real estate are appropriate for most long-term institutional investors. But that doesn’t mean every one of them should be taking on the same level of liquidity risk as Yale. Diversification has to be tailored to the needs of each specific investor.

When I talk to institutions and investors, I sum it up this way: an institution may have a long time horizon, but it’s made of people with very short time horizons.

And given what we’ve been through, the virtues of maintaining an extra level of liquidity are now, perhaps, better appreciated.

After all, market crashes and liquidity squeezes like the one we experienced a few years ago have happened many times in history and will surely happen again. So we need to keep that in mind as we calibrate the investment requirements of each client, whether university or foundation.

For example, Mark Schmid, my successor at the University of Chicago endowment, has done a good job of looking at the entire universe in which the endowment operates and how different scenarios can impact the university and the endowment.

In fact, I believe, Charles, you were the one who pointed me to the excellent paper Mark and his Chicago team wrote about their “total enterprise” approach to managing the investment. It really explains how all the parts fit together.

 

[CAS comment: We’ve posted that paper on our website, front page center, under “People in the News”, and I highly recommend it.

See www.charlesskorina.com/ A Total Enterprise Approach to Endowment Management. It’s co-authored by Mr. Schmid and Que Nguyen, his Managing Director of Strategy.]

 

Skorina:

You recently spent some time at PAAMCO, one of the biggest fund of hedge funds managers. How has that shaped your outlook?

 

Stein:

My time at PAAMCO has directly affected the way I’m looking at my new business as an outsourcer for mid-sized endowments.

PAAMCO was not offering a one-size-fits-all product. They focus very strongly on the specific and unique needs of each client and the importance of providing a custom solution. That’s how the fund of fund industry is evolving, and that’s how the outsourced CIO model must evolve.

It goes back to the lessons I cited above. Each institution has different cash needs, different debt-service pressures, different levels of dependence on the endowment, different flows of support from donors. And finally, each board is different; some can live with more risk than others.

And, since each institution tends to operate in its own little bubble, they may not even understand, themselves, how different they are from each other. An outside firm with a wider perspective can often see things they can’t see themselves.

The only way an outsourced investment office can succeed is by understanding those differences and the implications they have for constructing and managing a portfolio.

I’ve spoken at a lot of development events and listened to many donors and trustees, with the emphasis on “listen”. They are seldom shy about expressing themselves.

With the help of Presidio Group, we are going to offer a best-of-class outsourced investment office. We are going to do it step by step, scale it properly, and do it with superior execution. We will report directly to the client’s board, just as an internal office would do, but offer a level of management excellence that our target institutions could not otherwise afford.

 

Skorina:

One last thing, Peter: We’re doing some investment office cost studies (which we’ll be talking about soon in our newsletter), and looking generally at the drivers of investment management costs and the implications for boards and CIOs. As a former CIO, and now an outsourcer, how do you think about managing those costs?

 

Stein:

When we evaluated external managers we always thought about whether their fees made sense relative to the specific strategy they were offering.

I always told my people that I would rather have high returns net of high fees, than low returns net of low fees.

Of course, you want low fees as a general proposition. But it isn’t always smart to squeeze too hard on any specific manager. You have to understand what he’s doing and how his strategy scales. Push back too hard on fees and you can force them to make it up by taking on too much capacity; perhaps more than the strategy or staff can handle.

Fees and costs should always be a consideration, but not the determining factor. Each piece of the portfolio has to be cost-effective in its own way, on its own terms.

As an outsourcer, this concern with return vs. cost translates into an open-architecture approach, meeting the client’s specific needs with maximum transparency. No black boxes. Institutions should demand nothing less from an outsourcer, and it’s what we intend to deliver.

 

Skorina:

Thanks so much for your time, Peter. Good luck with your start up, and welcome to San Francisco!

 

Stein:

Thanks, Charles, it was great talking to you.

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Two roads to risk-management:

New views from a strategist and a tactician:

In the old paradigm, 90 percent of the risk was allocated to equity, so a lot of time was spent trying to generate incremental return relative to the equity benchmarks. This was analogous to a search for mathematical models placing the Earth back at the center of the universe.

Michael Litt, Chief Investment Officer, Arrowhawk Capital Management

Every CIO I speak with is talking about risk, but I don’t know of one endowment, foundation, or pension fund that has actually implemented a portfolio risk system or is using one to manage their money.

Bill Ferrell, Ferrell Capital Management

Two very knowledgeable guys – Michael Litt and Bill Ferrell – recently gave me a peek at draft white papers they’re preparing. And, although they’re the product of two independent thinkers, I was struck by how they intersected with regard to risk management.

A whole new generation recently had to learn that risk isn’t just a number. It can leave you standing out on the curb in front of Lehman Brothers with your handball trophies in a cardboard box and no particular place to go. Then risk gets a whole strange new respect.

Both Michael and Bill argue that most institutional investors are still not dealing adequately with risk; i.e., they’re not earning the best risk-adjusted returns possible with the capital that’s been entrusted to them.

Michael is a fellow Chicago MBA who led the corporate pensions group at Morgan Stanley before he jumped to hedge fund management, first at FrontPoint, then with his own Arrowhawk Capital. He’s adopted the risk-parity approach to asset allocation (with certain variations on the theme) and in his paper explains why he thinks it’s no less than a Copernican revolution in portfolio design.

Bill was a trader at CitiBank when the Value At Risk (VaR) technique was being invented there, then went out on his own to found Ferrell Concert Fund. He also offers risk control services to institutional investors using a proprietary approach to tactical, real-time risk-mitigation. In his paper he focuses on how to actively control risk within existing allocations (whether they’re Copernican or Ptolemaic, from Michael’s point of view!)

Two different perspectives: one is strategic, one is tactical. But, they’re more complementary than contradictory, and both are worth hearing.

Michael, in his draft paper Money for Nothing, Growth for Free, argues that most institutions still use a capital-based approach to asset allocation, ultimately driven by their target returns. He says this is a paradigm that needs to be up-ended.

Of course, funds have to relate current assets to future liabilities, and this implies a minimum required rate of return. But letting this number drive the whole investment process may be a “fatal error” if it’s applied to a fundamentally flawed asset allocation. This process, he says, won’t get you where you want to go if your allocation is already too equity-heavy. We need to flip this picture the way Copernicus overturned the Earth-centered world of the Middle Ages, and start with risk-budgeting.

A 60/40 portfolio is still the benchmark for most institutional portfolios. But, he says: “A 60/40 allocation implies structural superiority for the risk-adjusted returns of equities, yet the opposite has been true on average over the past 85 years.

He cites research showing that stocks have historically generated 90 percent of the risk in a 60/40 portfolio. But what if the return from those stocks hasn’t justified that risk? Trying to hit a required return with a fundamentally suboptimal allocation gets everything backward. Michael says we need a Copernican revolution in portfolio allocation that gets rid of the 60/40 myth before we think about what returns are attainable.

He again cites recent research to support his argument.

For example: Asness, Frazzini and Pederson in 2011 mined the CRSP database and concluded that for the past 85 years the SML (Securities Market Line) has had a flatter slope than predicted by the Capital Asset Pricing Model. This implies that bonds have had better risk-adjusted returns than stocks, even if “market efficiency” predicts otherwise.

This leads back to the same conclusion: traditional portfolios are over-weighted to stocks and therefore aren’t really optimal, even if standard mean-variance algorithms say they are.

The Asness paper claims to fill an explanatory hole in the previous case for Risk Parity. That too-flat SML line is the result of past manager who couldn’t – or at least didn’t – just lever up their bond portfolios to get better overall risk-adjusted returns. Asness, et al say it’s because of “leverage aversion” on the part of investors: institutions have been culturally allergic to such “borrowing.”

The Asness paper is online, here:

http://pages.stern.nyu.edu/~lpederse/papers/LeverageAversionRP.pdf

Michael has picked up the Asness ball and run with it. His new paradigm depends on boards and CIOs who can shed that leverage-aversion.

Ease those constraints, and maybe you can get to a portfolio that is actually more efficient than the ones generated by traditional approaches.

There’s more in Michael’s paper about all the implications of his new paradigm going forward, but I think that’s the gist of it.

Now, some very smart people think risk-budgeted portfolio construction (i.e., Risk Parity) is the way to go; and other very smart people disagree.

Of course, there’s a big difference between risk-budgeting as a philosophy at the portfolio-construction level (per Michael Litt ), and the specific risk-parity products being offered by various vendors. Those RP-advocates include such distinguished folk as Dr. Cliff Asness, who is the lead author of that study cited above. Dr. Asness, wearing his CEO hat, also builds risk-parity products for institutional customers in his AQR Capital shop.

By way of visiting these contrary views, take a look, for instance, at these board minutes from October, 2010; as CIO Gary Dokes and his Arizona Retirement System board debate and then shoot down NEPC’s risk-parity proposal with a 4-to-zero vote after some very thoughtful discussion. See:

https://www.azasrs.gov/content/pdf/minutes/20101012-ic.pdf

On the other hand, Pensions & Investments announced not long ago that Pennsylvania SERS is allocating 5 percent of AUM to a risk-parity strategy. It will go into the All Weather Fund of Bridgewater, the grand-daddy of risk-parity vendors. See:

http://www.pionline.com/article/20120312/DAILYREG/120319987

And so it goes. But, between the theoreticians and marketers, Michael’s new paradigm might yet emerge in some fashion.

According to Bill Ferrell, most CIOs do not actively manage risk because most investment boards and managers are still asset-allocators. They believe that the only risk that matters in equities is the risk that they will miss a benchmark return.

And, as a headhunter focused on the pay and incentives of investment managers, I note that most bonuses are firmly anchored to benchmark-related returns, not to risk-based measures.

“But who is managing the risk of the benchmarks?” asks Bill Ferrell.

“No prudent investor would add an investment to his portfolio if that investment exhibited historical or implied volatility of 40%. So why would anyone want to hold the S&P 500 when the VIX soared above 70% in 2008?”

Risk managers, as opposed to return-chasers and benchmark-huggers, focus on changes in the internal components of risk that represent the greatest threats to stability. And those components are the volatilities and correlations within portfolio allocations.

They are aware that, during periods of stress, equity-oriented and higher-risk bond assets tend to become more negatively-correlated to low-risk bonds. In practice, this means that there is a “flight to quality.” Low-risk bonds often generate positive returns in those situations.

Whether you go at it strategically or tactically, or both, Michael and Bill agree that there are still under-used tools available to boards and CIOs which could improve risk-adjusted returns, reduce overall volatility, and don’t depend on the arcane art of superior manager-picking. They converge on the idea that you manage risk, not capital, and that risk should be managed dynamically, not statically.