FM: Do you place equity based hedge funds in your equity bucket as opposed to your alternative bucket?
LP: We put it in our equity bucket. We don’t think about hedge funds as an asset class. We have a specific allocation to what we think of as divergent strategies, which is 10% of our overall allocation. So those are global macro and CTA managers, then we have a 10% allocation to market neutral relative value which we really have a modest objective for that. We are trying to earn the cash rate plus 2% for active decision making. Any other case of our traditional asset class framework whether it is equities or high yield bonds, we can implement those with a passive vehicle like futures or ETFs, we could implement those with an active traditional manager that is long only or we could implement them with a hedge fund like a long short equity fund and the only thing we would do with a long-short equity fund is complete the exposure of their portfolio so if they are 70% long we would compliment that with another 30% allocation to that basket. We don’t really care if we [allocate] to long only managers or hedge fund managers on those traditional asset classes. It is just that we have a hard time ensuring that we are going to achieve the net results that we want after adjusting for incentive fees. That is where we have a harder time plugging them into those buckets but I think those are the right places for them. [Our allocation] is roughly one third liquid alternatives, one third private alternatives and a third traditional.
FM: Are most investment strategies long the economy?
LP: We have a correlation matrix that I like to show people. When we look at the different hedge fund strategies, when we look at long-short equity, distressed, event driven, those strategies are all very correlated with the equity market. It is almost an equity substitute. High yield bonds are very correlated with the equity market. Most real-estate, particularly the zestier flavors of real estate like opportunistic and value added, are correlated with equity market. There are only a couple of asset classes that we have identified that have a zero or negative correlation fundamentally and if you really think about it, the divergent strategies are very similar to being long volatility so when things go wrong and volatility spikes there are very few asset classes that hold up in those scenarios and CTAs (commodity trading advisors) are one of them. The nice thing about CTAs is when they are not working they generally don’t generate tremendously negative returns. They are generally flat. When they do work they tend to offset the risk of equity markets quite affectively. The other bucket that we found does that are interest rates.
This goes back to my fixed income trading. This is all the discipline that I learned. Everything in fixed income encourages you to sell an option either on the value of a firm or some other enterprise where you’re basically short a put to the equity holders of the organization so if things go wrong you as the credit holder end up with the assets of the firm. The only things that we can find in the fixed income portfolio that were diversifying are Treasuries and financing currencies. Back in the mid 2000s, we would systematically [hold] yen positions at a negative carry because during periods of uncertainty yen would do very well. A good friend of mine said the road to hell is paved with positive carry and I think that is absolutely right.
FM: You recommend a smaller allocation to equities than most investment advisors and a higher allocation to Treasuries. What is the reason for this?
LP: It really just comes down to the volatility of equities compared to the volatility of other asset classes. Equities and Treasuries tend to have stable negative correlations particularly during episodes of downside risk to the equity market. So when equities are generating a negative return, the correlation to Treasuries not only holds up but actually seems to fall further and goes to a negative number but the volatility of equities is about four times as great as the volatility of the 10-year Treasury so to, if we think they are negatively correlated, get any diversification benefit out of the Treasury exposure we have to increase the volatility to offset the volatility of equities. That is all it comes down to. Equities are just a volatile asset class that can easily dominate the portfolio.
FM: On the equity side do you allocate to active managers or are you simply in index funds?
LP: Right now we are all index. There are some hedge funds that we really like on the equity side because we think they have tremendous skill in picking stocks and managing portfolios both on the long and short side. The problem I run into with those strategies is that the incentive fees are not calibrated to what our objectives are. If I could make those incentive fess based on the performance of the market as opposed to a positive return or even a cash rate or small hurdle it would be much more palatable to bring those into our portfolio.
FM: You have advocated for greater use of alternative investments in portfolios for years. Despite a great deal of evidence to support this view, many traditional investment advisors are suspicious of alternatives. Why is this?
LP: People treat them as a homogenous asset class and they really are not. Even though they are not homogeneous, there is probably a roll in the portfolio for every component but I don’t think people have taken the time to dissect them. An event driven manager vs. a distressed manager vs. a multi strat or a CTA; people tend to lump them all together and they are very different. They are not well understood. Secondly, the headline of compensation, the opaqueness, some misalignment of interest with certain funds. And it is hard to find managers who really do have skills that align with the interests of investors but when you do, when we find managers who have true skill in their investment process, we find that to be very valuable. The funny thing is that the optical fee structure for a skill based hedge fund manager per unit of skill employed is much lower than the fee structure for a traditional manager who gives you mostly market exposure with a little slice of decision making on top of it. The optics of it make it look like the fees are significantly higher for a hedge fund but if you think about the fees in terms of the active risk that is uncorrelated with the market the right hedge funds are actually a bargain for what they deliver.
FM: Amid alternatives, managed futures are often left out of portfolios. This despite overwhelming evidence that it is the best alternative in terms of liquidity, transparency and non-correlation to traditional investments. Why is this?
LP: Part of it is that convergence/divergence story that most people don’t understand. There are certain strategies that should be consistent performers but then have a major hiccup in times of stress and then there are other strategies that are steady low performers until you get a big move. That is one of the fundamental reasons. The other, the efficient market hypothesis that says that you really shouldn’t be able to make money off of past price patterns, is somewhat the enemy of CTAs. Business schools teach that we are working in an orderly world where all of the information available to investors is comprised of the current price. It has only been the last 10 or 15 years where this notion of behavioral finance has come up and even infiltrated the University of Chicago that people have been thinking about that differently.