Monday, August 8, 2016

Forget the reach for yield - actually a stretch for return

While there has been a consistent set of stories about the reach for yield, the real issue is the stretch for return. If a pension fund has to obtain a targeted rate of return, the question that has to be solved is the mix of assets that will get you to the target without taking more risk. Reaching for yield is not a solution. Stretching for returns creates a bigger problem.

Many pensions still have expected returns of approximately 7.5% used as their targets for actuarial purposes. If the pension lowers the expected return, more funds will have to be committed to offset the actuarial shortfall. 

Twenty years ago, you could get your 7.5% return through just holding bonds. Your risk was limited. Today, the bond allocation would be only 12% using estimates from Callan Associates. Investors will have to hold a basket of riskier assets. The price that has to be paid for this return is a volatility that is almost three times greater than twenty years ago. For the same expected return, you have to lever the risk. Of course, there is upside with higher volatility, but a pension is less than one standard deviation away from double digit downside risk. 

If there is one question that has to be posed to any hedge fund managers, it is simple. How can you get us out of this problem? How can you bend the risk-reward trade-off so we have a chance of hitting our target without taking undue risk? If you cannot provide a good answer or even appreciate the question, then you don't belong in a pension portfolio. 

The solution is not a glib answer to pander to the pension, but a thought response on how the manager's particular alpha or diversification will offer a better alternative than the asset class choices presented above. 

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