Investment committees face a variety of considerations when managing pension plans. In the past, these committees focused mainly on strategies for investments, but now they need to consider multiple dimensions. Taken together, the multiple aspects affect the value of plan assets and liabilities when effectively managing a pension plan. They also affect the development of an investment strategy for the plan assets. As a pension plan sponsor, it is important to fully understand the various areas that will affect the volatility of assets, liabilities, and contributions on the pension plan and to develop a strategy that will lessen this impact. This paper authored by Jeff Marzinsky offers some perspective.
The Wall Street Journal recently published an article (subscription required) that indicated individual investors are returning to investing in stocks, but that this could have negative implications for Ma and Pa’s retirement savings accounts.
Optimistic figures about the stock market, such as a 29.32% increase (as of November 26, 2013) of broad market indexes and potential for the Dow Jones to hit 20,000 this year, have been tossed around like rice at a wedding. While these numbers have encouraged the average investor to return to stock investment it’s important for retirement plan participants to keep a few things in mind.
Source: Carl Richards, The Behavior Gap.
While the short-term returns on stocks may have looked incredible on your third-quarter statements, you absolutely cannot invest based solely on short-term returns. Investors in 2008 likely saw the same incredibly high returns right before the market took a downward turn. All too often I overhear people saying, “Wow, did you see returns are up to 20% on Fund XXX, I need to sell out of Fund YYY and buy in.” Because the prices are being driven up, your hard-earned money actually buys fewer shares than if the prices were lower.
I’m not saying that our economy is building up for a fall but it’s important to keep in mind that, even while the market is doing well, you need to protect the nest egg that you’ve worked so hard to build.
Regardless of the market, the key to investing your retirement assets is diversification. Financial advisors tell us that, by spreading the investments in a retirement account across different asset categories, investment risk can be greatly reduced. By investing in a mix of stocks and bonds you are creating your own small “cushion” of protection against losses in case of market fluctuation. It’s important to remember that you’re investing for the long term, and more than likely those incredible returns will only last for a short period of time.
Traditionally, hedge funds have sought to achieve outsized returns relative to the level of market risk in their portfolios while simultaneously maintaining a low correlation with the market at large. In other words, they seek high alpha and low beta. Proprietary investment strategies and relaxed reporting requirements have helped to make these goals possible, but also aiding the endeavor was a lack of appropriate investable benchmarks against which hedge funds might be measured. However, the emergence of hedge fund replication strategies (subscription required) might help institutional investors to more accurately assess the performance of hedge funds and correctly identify and quantify the components of their returns. Furthermore, hedge fund investors suspicious of the relative value of investing in single funds or funds-of-funds (“I can’t believe it’s not beta”) may now have a lower-cost avenue for accessing hedge fund beta.
Hedge fund replication is the general name for strategies attempting to replicate, or beat, the returns of hedge fund indices using assets that are potentially more liquid and transparent. For instance, a replication strategy might attempt to achieve returns similar to a particular hedge fund index while only investing in equities. Successful strategies would achieve returns very similar to their target indices, creating lower-cost, investable hedge fund beta.
Potential investors should consider carefully before allocating assets to hedge fund replication strategies as there are potential downfalls. First, the replication strategy may or may not perform as expected, meaning that an investor may or may not be able to access hedge fund beta. Second, although fees associated with replication strategies are generally lower than direct investment in hedge funds or hedge funds-of-funds, they are still rather high, typically comprising either a 1% to 2% management fee or a 15% performance fee, according to a recent Pension and Investments article. And finally, investors should consider their goals in making any asset allocation. Hedge funds, or hedge fund replication strategies, may provide diversification, but at a significant cost. Further, if risk management is the end goal, and diversification simply a means for achieving that goal, it is important to remember that diversification relies on correlation and, as correlations vary over time, diversification alone may not prove an effective risk management tool. Focused risk management strategies may be more effective in meeting those goals at a much lower overall cost.
In our recent article, “Developing an alpha beta pension plan portfolio,” we reviewed some of the basic concepts in developing allocations for pension plans. By using a combination of index and actively managed investments, known as an “core/satellite allocation,” a sponsor can diversify across a wide variety of asset classes and strategies while focusing on target return, volatility, and diversification.
The starting point, setting goals for the portfolio, allows for monitoring of the results, which include:
• Diversification: Overall allocation across classes, as well as correlation of returns
• Target return: The desired annualized return to meet retirement goal requirements
• Management expenses: The investment manager expense
Index investments represent the beta, or the market return that is the basis of the portfolio. Active managers can be used to generate the alpha, returns in excess of the market (or index) return. Also, active managers can be used to moderate downside risk in declining markets. The combination of the two approaches can be a prudent strategy in developing an alpha beta portfolio.