One year ago, Lee Partridge left his position as deputy chief investment officer of the Teacher Retirement System of Texas (TRS) to form Integrity Capital, a consultancy dedicated to managing institutional investment portfolios. A month later, Integrity and Partridge signed on as portfolio strategists for the San Diego County Employees Retirement Association.
Partridge helped build TRS into one of the most successful and innovative public pension plans, overhauling the plan’s asset allocation. Futures talked to Partridge about his trading philosophy and approach to asset allocation.
Futures Magazine: Lee, you described yourself as a bond trader. Give us a little background on how you became involved in trading and how your career evolved.
Lee Partridge: When I finished my [MBA from Rice University], I ended up working for a wholesale bank in Overland, Kansas that served credit unions around the country and that wholesale bank had a trading and sales operation that I was involved in so I worked with them creating structured products as well as trading asset backed and other structured finance securities. I carried that over into the insurance world, then started trading rates for the Texas Teachers [Retirement Fund] in 2001. [I covered] everything from structured products and esoteric finance to clean sovereign rate trading and later took over all of the fixed income operations at Texas Teachers and that evolved into more tactical asset allocation and more of a global view of the portfolio.
FM: The Texas Teachers Retirement Fund has a reputation of being innovative. Did that shape your investment philosophy?
LP: Well, I helped shape that. When I came in to run fixed income, one of the things that I emphasized is not taking the low breadth bets like calling the direction of interest rates or allocating to credit or away from credit making those big sector decisions. Instead we would try and take relative value out of each market. All relative value, lots of different positions in the portfolio. In 2007, Britt Harris came in as the new CIO and he asked me to launch a new team that did strategic asset allocation: tactical asset allocation largely using futures and other liquid instruments, risk management and portfolio construction for the new fund. I took that effort on in 2007 and worked with Britt to redefine the asset allocation for the fund and that is when we went to a much higher allocation to alternatives. We looked at the portfolio in the same three categories that I am looking at this portfolio: equity or growth oriented assets, stable assets that are really bond like and real return assets that help mitigate inflation risks. Those are the three elements of the portfolio that we thought drove the returns of all of the underlying asset classes.
FM: I know you are much more involved in asset allocation and portfolio creation than simply trading today, but give us your philosophy as a trader. What lessons did you learn as a trader that still serves you in your current work?
LP: Don’t put all your eggs in one basket. Even if you really have high conviction on a particular idea, you still want to control how much risk you carry in that one idea and always have an exit in case it goes against you. The best traders are probably only dealing with a 60% probability of being right on any given trade so you don’t want to lose all of your capital if things are in the 40% criteria. And be aware that there are fat tails. It is very easy to get into trades where you make a little, make a little, make a little and then you lose a lot. I would definitely put credit in that category and I would put short options positions in that same category. Some of those are reasonable strategies but those do not evidence skill because most of the time they are making money but when they lose they lose all of the money that you made.
FM: You noted that most pension plans are underfunded and face political risk. How serious is the problem?
LP: It is difficult to quantify the exact dimensions of this problem within the United States but the one thing that people have observed is the sheer size of these plans compared to the output of local or state economies. [They] have become a very important part of those economies. What is critical is to manage the downside risk because if we get into a situation where across the table, pension plans lose 30% or underperform their targeted return by 30%, that puts a huge strain on the taxing base of these state and local economies. The important thing to think about is how much downside risk these plans [can] bare and that is what we are really focused on; not to have a devastating drawdown event at the plan.
Most public pension plans are underfunded right now. Most are 80% funded as they estimate their actuarial value but as losses come in from 2008 and that starts to roll into the averages the picture gets worse and worse even if we stay at current market levels. A lot of the cause for that was the heavy reliance on equities as an asset class to achieve intended income returns. That is why I felt that most public pension plans are under diversified. In 2008, the lack of diversification — really this whole decade — coupled with a high return objective has really caused the underfunding problem. If they had been adequately diversified they would not be underfunded today.
FM: Can you list four or five of the most important steps pension fund managers should take to improve the long-term outlook of pension plans?
LP: Diversify your investment portfolio, focus on downside risk, set attainable goals, resource the investment operation sufficiently and the last one is near and dear to my heart, consider cooperative structures to achieve these objectives so share resources with other plans, share due diligence, do joint ventures. There are a lot of opportunities to cooperate across public pension plans.
FM: Would a plan actually share an allocation with another plan if the minimum investment level was too high?
LP: That is a great example. If they didn’t have the required minimum, they could piggyback on larger order flow and get the diversification that would come from a larger portfolio without necessarily paying the full fees of a fund of fund manager that they would have access to.
FM: Everyone involved in investing will say diversification is very important, but how they define diversification can vary widely. How do you define it?
LP: Diversification really doesn’t come from the number of positions you have in the portfolio or the number of managers that you have. It really goes back to how many different return streams you have that are clustered together and how many of them are fundamentally different than one another. So we look at all of our traditional asset classes: our hedge fund assets classes and our private market asset classes side by side. We don’t think of alternatives as being one generic bucket and we don’t think of hedge funds being one generic bucket. We look at each distinct return stream and try and figure out how much volatility there is associated with that return stream and what fundamentally drives positive or negative returns in that return stream. And what we found is generally the three key drivers are the rate of growth in the global economy, the rate of inflation in the global economy and the level of investor risk aversion or appetite. Those three things seem to drive most of the asset classes or styles that we can identify and what we want to do is diversify within that whole queue of inflation, growth and investor sentiment or risk aversion.
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.
FM: I thought Mandelbrot proved that wrong 30 years ago.
LP: That’s true.
FM: Do you see that view of managed futures changing?
LP: It is changing. You are seeing some leadership in that direction. People are going back to some core principles of diversification. How we ever got to a 60/40, pushing 70/30, mix of stocks and bonds in the wake of everything that Markowitz and Bill Sharpe and Eugene Fama were doing in research 50 years ago is beyond me. It is really the hope that capitalism will be victorious over the long run and greed is good. That sort of drove everything from the first Wall Street movie until now.
FM: Break down your allocation in your current portfolio.
LP: We have a 40% allocation to equities: 20% to developed market equity, 5% to emerging market equity, 5% to high yield and 10% to private equity so it is only 40% of our overall allocation and I have a 35% levered position in Treasury futures on top of 5% unlevered. My 40% allocation to growth oriented basket comprises 68% of my risk budget and that huge allocation to these diversifying strategies which includes a 40% allocation to treasuries, a 10% allocation to emerging market debt, 10% to global macro and CTAs (divergent strategies) and 10% to relative value strategies. That 70% allocation of dollars only represents 18% of my risk budget. A 40% allocation can cannibalize two thirds of a portfolio and a 70% dollar allocation doesn’t even get up to a fifth.
FM: Are some of the risk measures used to analyze the appropriateness of certain investments, causing mistakes in allocation?
LP: Yes. The over reliance on more naïve optimization without thinking about what drove it and most of these things are not right or wrong. There is nothing wrong with standard deviation, there is nothing wrong with value at risk or estimated short fall. All of those are useful statistics but what is often not appreciated is that when you are looking over particular periods of time where a risk factor was not present then to expose the portfolio to that historical period without thinking about other periods of history that might not have been in your sample set is what causes bad decisions. For example, if we built our portfolio over the data set that we had ending in January of 2000 for the prior 10-year period, well we were in a particularly benign period that was marked by a soft spot in 1991 then from there we had a disinflationary period, high productivity, high credit creation, an overall increase in investor risk sentiment and positive government relation on a global economy (you had people globalizing and deemphasizing regulation).
If you had built your portfolio around that 10-year period you would come up with a result that was not at all diversified because it did not consider what would happen in a re-regulatory regime, or in a high inflation environment or a deflationary environment or an environment where credit creation was not the watch word of the day but credit contraction and debt deleveraging were the watch words of the day. That’s the fallacy more than anything else. People don’t really understand what is driving the results of these asset classes, these big moving global macro factors that are affecting the economy.
FM: Are some strategies designed to produce positive risk measures as opposed to providing diversification to an overall portfolio or positive results?
LP: Yes. Beware of high information ratio strategies. Credit is a perfect example, particularly higher grade floating rate credit. Bank loans were a perfect example of this and I like bank loans. The original concept of bank loans was a nice clean asset. Then people started levering them and then the underwriting got to be worse and worse as the banks quit retaining the risk and started syndicating 100% of the risk so the market changed. What historically looked like an efficient asset class with a high income relative to the volatility of the underlying no longer had those fundamentals as it evolved. Unlike that, I look at trading strategies that on their own only have an information ration of .2 but they have such a low correlation with everything else that when you collect 10, 15, 20 of these strategies and bring them into a portfolio and you can turn low information or Sharpe Ratios of 25% to Sharpe ratios of 1.5 times. That is what is attractive as opposed to being short this option… that makes credit look like an efficient asset class. …If you are going to use shorter term data series you have to look at something else other than the traditional statistics for credit strategies and convergent strategies. [For] divergent strategies, it is easier to use traditional measures.
FM: In our Markets piece, analysts are pretty split as to the direction of equities. They are even split in terms of defining the current markets environment. Are we in a bull or bear market and where do you see equities heading in the next six months?
LP: I don’t see a big rebound in six months. My five-year forecast is a pretty flat market even vs. where we are today. And it is because of several headwinds the global economy is experiencing. I think on a cyclical basis stocks are a little cheap just looking at cash yields and earnings yields. Long-term we are in a debt deflation economy where consumers are saving and not spending here. In Europe, countries are starting to save and not spend. You already have a lot [stagnancy] built into the economy and now through traditional measures the central banks are tapped out. I don’t think they can raise interest rates or get into a more aggressive position any time soon. There is tremendous slack in the economy, the output gap is massive. This is the worst trend deviation we have had in GDP since 1945, so post world War II this is it, we are more than two standard deviations off trend and you are in a re-regulatory environment so everything that fostered financial innovation, credit creation and leveraging of the consumer balance sheet is all working against you now because they want to recapitalize the banking system but put in tighter standards, which there are people that recognize that was part of the error of the Hoover administration in the 1930s so hopefully we are not going to go too far in that pendulum swing but it is a policy risk with some downside to it. I just see a lot of risk to the economy. The component of the economy that was built on finance, which was 30% to 40% of S&P earnings depending on how you treat homebuilders, most of that is not coming back so the earnings per share number we were experiencing in 2008, that is gone, that component of the economy is not coming back.
FM: What are the most important fundamental factors traders and investors should be watching right now?
LP: The unemployment statistic and the regional unemployment statistics — California had the highest marginal propensity to spend — that is pretty important because until you start taking the slack out of the labor market. I don’t think that you are going to have a meaningful sustained rebound in consumer spending. It is really the government stepping in and spending money and perpetuating consumer spending.
FM: Are we going to run out of money or see a real recovery come first?
LP: Well I am watching the dollar. I don’t think they are going to run out of money because they can print it. The problem is, the money multipliers are not increasing, they are decreasing, so bank reserves are still high and you have undercapitalized banks. You have to have an expansion of monetary policy and for velocity to stabilize. The Fed is not in the mode of increasing the monetary base and at the same time everything we have seen since the recession in 2008 is that velocity has offset all of the increase of money supply the Fed has put into the system and then you have this hording of bank reserves at the same time so there is no real expansion of the monetary base. It is not trickling through to consumers. Banks aren’t [returning] to the risk appetite that they had so all of those things have to get traction. You have to see unemployment go down and you have to see some real credit creation before this economy is going to have any sustained recovery. If it does, I’ll be the first person to come off of my bearish view. It is just that until I see some evidence of this turning, it is hard for me to buy into it.
FM: It is difficult for retail investors to get access to alternatives, particularly divergent strategies like CTAs. Should the retail investor have more access to those return streams?
LP: I think they should. I think that having commodity pool operators and CTAs should be more mainstream, just like a Fidelity, makes a lot of sense. Everybody should have some exposure, a minimum of 10%. Retail portfolios are far worse than institutional portfolios. Retail portfolios are almost 100% stocks.
