Who needs alternatives like managed futures the most? Underfunded state pensions

The Tax Foundation map of state funding ratios for public pensions is very sobering. The amount of state under-funding is significant. These numbers are determined by the discounted expected liabilities relative to the assets held. To stay even with these ratios and assuming there is no surprise increase in liabilities, the states have to return the discount rate. These discount rates or expected returns seem unrealistically high. 

A lower rate of return and the under-funding will get worse. If returns are higher, the gap will be closed, but a reasonable excess return of say two percent will still require years of good performance to eliminate the gap. 

What is critical for the states is ensuring that downside risk is minimized given that any return shortfall will be needed to be offset with future higher returns in order to just get back to a prior funding ratio. In this sense, pensions do not need high returns with risk but more stable returns with lower downside. In simple terms, the underfunded pension should not go for broke in order to make up shortfalls. 

If a state believes that the discount rates are too high perhaps for political reasons and equity valuations cannot be sustained then investments that provide crisis offset or have the ability to do better in bad times should be held. This should happen even if the crisis offset strategies have returned less than equities over the last few years. The past may not repeat and there should be less premium received for assets that are uncorrelated with the market portfolio and can do better during market downturns.

Market trends for May - Some developing strength

Going into the month, there are good up trends in place with global equities and down trends in oil, precious metals, and selected commodities. What is interesting is the inconsistency across some markets sectors. The reflation risk-on trade is still apparent in the global equity indices, but we are not seeing strong evidence of bond sell-off or rally. Oil prices suggest both supply strength and demand weakness. Gold and precious metals are out of favor with long-only investors. The idea that we will have a dollar rally on Fed hikes seems misplaced and there is less risk-on demand for the US relative to the rest of the world. 

Generally, we find sector indicators to suggest a more opportunity rich environment for trend-followers especially for those who have a greater tilt to energy, metals, and commodities. Nevertheless, history has proved in the past that performance in managed futures will usually be especially strong if there are well-established bond trends. 

Hedge fund performance consistent with environment

No hedge fund strategy will make money all of the time. As the market and economic environment changes, the performance of different strategies will also change. Hedge fund factor exposures will be different based on the strategy employed by the manager. If you cannot predict the environment factor exposures, there is value with holding a diversified portfolio of hedge funds. April performance clearly shows the difference in strategy behavior.

We are in a risk-on environment. Hence, those strategies that do well in "bad times" or risk-off regimes will underperform other hedge fund strategies. We should not be surprised by the current macro/systematic/CTA performance. We may not like it, but it is within some tolerance of expectations. 

Given the average beta for many equity hedge fund strategies, performance is within expectations. Long-only hedge positioning should do better in a reflation environment. We may expect better alpha generation; however, the low volatility regime may limit the set of opportunities for stock-picking or relative value trades.

Sector analysis supports the risk-on market sentiment

The positive equity performance for April and the strong year-to-date returns show that the risk-on environment continues. What is noticeable is the switch to global and emerging market gains although this has been helped by the declining dollar which may have added about one percent to performance. Performance has rotated from the reflation trade in the US to a broader investment in global equities.

On a sector level, the year has not been positive for the energy sector which is down almost double digits. Finance is also having a difficult time this year based on regulation uncertainty and shifts in the yield curve. The technology and consumer discretionary sectors are both up double digits for the year. The gains in equities may be more concentrated than what many would expect if there is supposed to be stronger economic growth this year.

Many country equity indices are up over ten percent for the year with especially strong performance in countries that have strong export trade flows. Returns in Asian markets and Mexico have been stand-outs this year. The chance of a major trade war has diminished since the harsh talk at the end of the year. 

The bond sectors have shown much lower returns than equities, but that does not mean they have been return losers. Returns are consistent with a reflation trade. All sectors are positive for the year with the strongest gains in long duration and non-US bonds. Again, the decline in the dollar has been helpful for international bond investments. 

We have been surprised with the continued strength in equity returns, but with a low volatility environment, good financial conditions, and a growth environment that is positive, it is hard to fight the trend. We are concerned about the gap between sentiment and real economic data, but at this point following trends is a reasonable strategy.