Guest Post by Contributing Editor, Michael Lewitt, Vice President and Portfolio Manager, Cumberland Advisors. We thought this was an interesting article and thought our readers would too. Enjoy.
America’s largest pension fund, the California Public Employees Retirement System (CALPERS), reported a 1% return on its investments for the 12 months that ended June 30, 2012. This disappointing return fell woefully short of the plan’s target return of 7.5%. An analysis of the plan’s returns by asset class showed the following:
|Public Equity||– 7.2%|
|Private Equity||– 5.4%|
|Absolute Return Assets||– 2.0%|
While a single years’ performance should not be treated as dispositive, CALPERS’ experience is dispositive of a number of anomalies that arise in a zero interest rate environment.
CALPERS’ performance is a case study in the challenges facing large pension fund (and all investors) in a world without yield (see also, “Calpers Misses Big on Investment Target” from The Wall Steet Journal.) The fact that fixed income produced a double digit return while equities produced large losses unveils some of the fallacies that continue to govern institutional investment thinking. Conventional thinking has argued that equity is far more attractive than fixed income in an environment where bonds pay very low interest rates and stocks are trading at reasonable price/earnings multiples. Yet as CALPERS and other investors have discovered to their surprise, fixed income is producing stellar returns while public and private equity are not.
CALPERS attributed its stock market losses in part to poor manager selection, but many equity managers (including equity-oriented hedge funds) disappointed in 2011 and continue to do so in 2012. Such widespread under performance speaks to the asset class rather than the practitioners. In contrast, 10-year Treasuries have offered increasingly low yields for the privilege of loaning money to the spendthrift U.S. government. Nonetheless, the return on these instruments (which some have described as certificates of confiscation) have been extremely high over the past two years.
CALPERS’ returns do not tell us much about the risk-adjusted nature of the returns. Disappointing private equity returns are a case in point. Despite the fact that private equity lost less money than public equity, the private equity performance was arguably much worse once it was adjusted for the characteristics of private equity funds: egregiously high fees; high leverage; concentration risk; and illiquidity. And let us not forget how this asset class imploded in 2008 and is still digging out from that disaster. Institutions remain convinced that they must have large allocations to private equity. This is a result of the success of early investors in private equity such as the Yale University Endowment Fund led by David Swenson. But early investors participated in early private equity firms’ monopoly profits. The industry has since become overcrowded and risk-adjusted returns are now poor. Many institutions are increasing their allocations to private equity; it is time to rethink that approach.
The men and women managing large pension funds have a difficult task. But they need to revise their thinking about asset allocation. They rely too much on consultants, who in turn rely too much on conventional thinking that has proven time and again to be misguided. Traditional notions of asset allocation continue to lead institutions into traps such as excessive allocations to private equity that lead to unacceptably low returns. It is time for a new intellectual regime that recognizes that low interest rates are here to stay but neither assures low fixed income returns nor promise high equity returns.
About Michael Lewitt
Michael E. Lewitt joined Cumberland Advisors in January 2012 as a Vice President and the Portfolio Manager for the Opportunistic Credit Strategy. Mr. Lewitt has spent the last 25 years in the securities industry and the last 20 years in the investment business. In May 2010, Mr. Lewitt published The Death of Capital: How Creative Policy Can Restore Stability (John Wiley & Sons), which was included in the curriculum in economics and history courses at the University of Michigan and Brandeis University during the 2010-2011 academic year. For additional details regarding his biography, visit Cumberland Advisors.
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