In response to frothy market conditions, some firms began de-risking their portfolios in advance, while others maintain course hoping to ride out what is perceived to be near-term market conditions. Accounting for unexpected market changes is always difficult, but a well-positioned portfolio will be able to adapt to changing conditions quicker and with fewer losses.
In this week's edition of Trusted Answers, we look at some institutional investors’ insights on creating a long-term strategy in a frothy market:
Sometimes you just want to go home and pull the covers over your head.
I could give you an opinion on the next year. It wouldn't be worth all that much. We do tend to look at a five-to-ten year view. I say five years only because it’s hard to see out much farther than that. But I also say 10 years because many of the private funds that we are committed to have a 10-year life.
What’s really important now is to be invested with managers who have as much varied market experience as possible. I’ve seen this before. I’ve lived through the tech bubble and bust and so have many of our managers. We have one manager that is in his 70s and he was talking about managing in 1974. Two of my colleagues rolled their eyes. We were on a call and I said, “Some of the people on this call were not born in 1974 and others were not managing money. In fact, it’s very valuable to talk to people who have been there, done that and who are not running around like Chicken Little.
Specifically to VC, private equity and real estate, the last year has been great for selling. The very conditions that make it good to be a seller, make it hard to be a buyer. We really rely on our managers to either look for those opportunities that are less market dependent or to simply sit on their capital. I feel as though we are paying people to make the determination as to whether a deal fits their parameters. Sometimes the best thing to do is nothing. And I'm fine with that. I would much rather a manager not call capital for a year or so than to find that they bought a bunch of stuff and then two years from now say, "well, in retrospect, we overpaid."
These are really difficult times. Even for those of us with experience, we have not experienced this before. Some of us remember high interest rates, but none of us have managed through these virtually zero interest rates. I don’t think any of us expected rates would stay so low, so long. And may continue to stay low.
We try to stay away from anything that appears short-term hot. If we don’t have it, we are not likely to initiate a relationship. Some of the things that have been terribly beaten down, like energy, we do believe that nobody is going to stop using gasoline and natural gas. We are not going to stop air conditioning our homes or driving, and it’s a worldwide phenomenon.
You are constantly bombarded with short-term results, and often there is a lot of drama around those short-term results that can distract a program that is set up for a long-term return, even a one-year return. There is a lot of focus on one-year results. That is a function of the fact that financial statements are audited on an annual basis and returns are publically announced on an annual basis to coincide with the audited financial statements. It’s a natural milestone in a business, but that doesn’t mean it’s a natural milestone with respect to the investment strategy. It’s an arbitrarily short period of period of time compared to most equity strategies.
What’s more meaningful is if you make a commitment to a 10-year fund, how much cash did you get back at the end of 10 years? Of course you want updates, you want to see progress along the way, but summing all of that into a single number is over simplifying what’s going on inside a strategy. Especially if you simplify that for a one-year time period, it’s too short a period of time. So I would say the issue with respect to being focused on things that might be too short term versus the long-term strategy that endowments are pursuing.
Our portfolio has reasonably priced assets with solid cash flows or a clear path to future predictable cash flows. We believe that if we buy good assets at good prices, based on bottom-up evaluation, our portfolio will capture upside returns and protect our assets in declines regardless of what the markets are doing. We are long-term investors, so we can take advantage of short-term inefficiencies and complex securities that others may not be willing to do the work to figure out. In addition, as long-term investors, we can take advantage of situations where shorter-term investors and forced sellers are exiting.
I've been in the investment business for over 25 years, and I've seen many careers truncated when people try to time the markets. That's especially pertinent this week and this month (Jan. 21, 2016). Pretending to know which way the market is going on a near-term basis is not an exercise worth spending your time on. We try to think longer term, and I think very many people on both sides, both the asset owners, and on the supplier side, focus way too much on trying to time the market.
Michael Trotsky, Chief Investment Officer, Massachusetts Pension Reserves Investment Management (Mass PRIM)
Read the full interview here.
The starting point is that you never really know for sure. The level of government and central bank involvement in the global economy and the market volatility that stems from rapid 24/7 dissemination of information make it clear that trying to do a macro call on where the markets are going is a risky basis on which to build an investment strategy. While we are in an environment that is filled with plenty of potential perils, the fundamentals of the endowment model remain sound.
Diversify broadly to incorporate different sources of return, ideally as uncorrelated as possible. Stay alert to opportunities that may arise from under or over valuations. There will continue to be a premium over public markets for investing in some illiquid investments, but dispersion of results makes manager selection critical in those asset classes. Fees are important to consider, especially in a low return environment, but ultimately it is net risk-adjusted return that matters.
Every market has its challenges and the current pain points are focused primarily around tepid economic growth and an absence of inexpensive assets. In evaluating any investment, we have two relatively simple guidelines:
1) Is the investment attractively valued? This is basic adherence to Graham & Dodd’s principles of value investing, which overwhelmingly demonstrate that, over time, a basket of undervalued assets will substantially outperform those that are valued otherwise.
2) Is the investment uncorrelated to our existing portfolio? This is the key tenet of Modern Portfolio Theory (Markowitz), which clearly concludes that you can achieve excess return by combining widely uncorrelated assets.
In the current market, there are relatively few assets that are inexpensive, but there are pockets of value in master limited partnerships, which have arguably been oversold, and in emerging markets, especially parts of Asia, where low pricing is out of sync with above average economic growth. Investments that are uncorrelated to the richly valued public markets can be found in niche markets. For us, we have recently reviewed or made investments in direct private equity deals with unique circumstances (“special sits”), rail-car leasing and appraisal rights.
Andrew Eberhart, Chief Investment Officer, A Prestigious Family Office
Read the full interview here.
I would say that it's less about looking for sustained growth right now. At this point, I'm just looking for the U.S. to have some sustained growth. I would say it's more of an issue of looking at places where there's been change created in board rooms, how technology's being adopted? It’s a lot of soft factors like that that create growth in different ways. Basically, it would be innovation, operational improvement, changes in the board room, those kinds of things. It's people who can gain market share. I don't think the top line is really going to be able to grow.
...It is literally company by company, manager by manager, asset class by asset class. This is why we run a concentrated portfolio. It's so we can have an active dialog with our partners about what opportunities they're seeing, and we can use that to understand how their portfolio is going to create long-term value.
...We've talked to the investment committee and the board, and we're expecting that it'll be really hard for the benchmarks to get much more than a 6% annual return for the foreseeable future. Once U.S. rates start to normalize, in however many years it takes us to get to 1% on cash, then you'll see that go up, but you just can't keep expanding risk premiums just because you need it to make your number. It just doesn't happen magically.
The public markets and real estate feel kind of late cycle-ish. I don’t know when that cycle breaks, and I don’t know what’s going to be the cause of it, whether it’s going to be interest rates or something else. People focused so much on interest rates, and lo and behold everything that happened with the currency in China in August was what did it, and people seemed blindsided.
I don’t know what it will be that will get people anxious next, but it does feel very late cycle. Perhaps not as bad as it was before August. We have gotten a little bit of a reprieve on valuations, but I don’t feel like we are at a point where you want to double down, particularly in real estate or public developed markets.
I do think emerging markets are becoming really interesting. I am a bit more of a contrarian. They have had a really tough year. They were kind of mediocre before that. Not nearly as bad as this year. Over the last few years they have been mediocre. I think there are some interesting opportunities there.
I think there’s interesting opportunities in the energy space. You have to tread carefully and pick your partners well, but there will be interesting opportunities that come about there as well. On the margin, we are starting to see more interesting stuff there. I think that could potentially play out much longer, given the change in dynamics of the industry from the shale revolution.
We move relatively slowly, but on the margins when we see valuation dislocations, we try to keep a bit of flexibility in the portfolio from a liquidity perspective so that we can take advantage of those on the margin. You won’t see us go “Let’s put 20% of the portfolio in energy.” It’s more of a slow move. It drives where the team spends their time.
Trusted Answers is a weekly series that delves into some of the most pertinent issues within institutional investing, and shares some of the insightful responses from the 40+ institutional investors we have interviewed in the past year. Take a look at some of our other Trusted Answers.