Rethink the Notion of Risk-Free Assets?

Risk is, as many readers may have learnt, like fat. You cannot eliminate it from the financial system, you can only move it around. The truth of this statement is arguably starker today than at any point in living memory.

When even the world's most risk-free financial assets, US Treasury bonds, have been downgraded, and the very notion of risk-free assets debunked, according to some, what are investors to do?

Prepare for war is one startling piece of advice. Even if it is a war fought with numbers rather than with flying bullets or nuclear weapons, the very mention of the word pulls one up in one's tracks.

A second piece of advice, from Karl Dasher, head of fixed income globally at Schroder Investments, is to forget about benchmarking investment expectations on the real return experience of the past 30 years. He advocates taking a 150-year view stretching back to the American Civil War, and describes the past 30 years as something of a golden age in terms of returns from government bonds: “Everyone forgets the previous 120 years during which there were elongated periods of negative real returns in bond markets,” he says. Markets will eventually force yields back to the “right” level, he argues.

Investment professionals identify at least two other clear risks presented by the prevailing conditions of recent years. The first is the risk of inflation created by quantitative easing.

“If you are debasing your currency via quantitative easing, one day it will come home to roost,” says James Foster, fund manager and partner at Artemis Funds. Quantitative easing will lead to inflation, he says, and that will undermine government bonds in the long term.

By contrast, Paul Brain, head of fixed income at Newton Investment Management, does not see inflation arising from such central bank action.

If inflation provides an effective route to gradual default, the second clear risk is of outright default. Mr Foster says the chances of this in countries such as the US, UK and Germany are very low. The first two can always resort to the printing press, Zimbabwe-style if need be. Germany's well documented extreme fear of monetary disaster keeps it on the financial straight and narrow. With Greece, though, the chances of getting any money back seem to become slimmer by the day.

What exposure, then, should investors have to sovereign bonds? Arif Husain, who runs the European fixed income business at asset management house AllianceBernstein, tackles the question in two parts.

“You should first ask what you are using government bonds for,” he says. “It has become increasingly evident that government bonds do not all fit into the non-risky definition in the asset allocation process and investors are holding risky assets in the non-risky portion of their portfolios,” adds Mr Husain. “That transfer of risk is causing problems.”

His advice is to diversify and globalise, with the aim of mitigating risk while maximising yield, at a time when near-zero yields from the countries perceived to be safest severely limit the potential investment upside of government bonds.

Mr Husain identifies Mexico as one emerging market that returns a relatively high yield while having a low debt-to-GDP ratio, and Australia and New Zealand as two mid-developed countries offering the same combination.

Benno Weber, head of fixed income at Swisscanto, is advising his Swiss pension fund clients to cut their holdings of government debt “massively”, and to look instead for true diversification of interest rate, credit duration and currency rather than a debt-weighted collection of assets.

For Bill Street, global head, fixed income alpha, at State Street Global Advisors, there are four principal pillars of investment to consider when making a sovereign investment decision. Is there liquidity? Are dealing costs low? Does the issuer have integrity? Is there easy access to the market?

“But even when the answer is no, that doesn't necessarily mean you don't invest,” he says.

“You just invest in a different parameter set, perhaps sacrificing a degree of yield or liquidity, and accepting a bit of credit migration from one sovereign to another.”

Chris Lynas, head of fixed interest at Smith & Williamson Investment Management, says his firm likes US, UK and German government bonds, especially if index-linked. But these are likely to be in short supply. “No sane central bank or Treasury would issue index-linked in the current climate,” he concludes.

I read these articles and I cringe. First, go back to carefully read my weekend comment on how policy blunders might lead to a global meltdown. I don't know any serious economist and analyst -- at least not the ones I track -- that truly believes inflation is a big risk. In fact, as governments rush to implement austerity measures to avert a "Greek-style debt debacle," the real risk remains debt deflation, not inflation. This is why Treasuries continue to rally during these turbulent times as global investors seek refuge in the safest and most liquid bond market in the world.

Second, risk premiums on sovereign debt are rising following the Greek debacle because the CDS market was exposed as a pure scam which allowed big US banks and insurance companies to profit of unsuspecting clients who thought they were insured against sovereign debt default. My brother told me about a Bloomberg radio interview with John Mauldin who said that this was the reason Italian bond spreads widened last week as nervous investors cut their exposure realizing they can get screwed again because they're not able to hedge against sovereign credit risk via the CDS market.

I attended the IQPC pension risk conference last week in NYC and one presenter after another was saying how underfunded pensions should be de-risking their portfolios by going into bonds and adding alpha through various portable alpha strategies. The problem is that pensions are in no mood to de-risk their portfolios; in fact, underfunded pensions are making riskier bets and this could come back to haunt them as deleveraging/deflation continues to ravage risk assets.

In my presentation, I alluded to the fact that most pensions are repeating the same mistakes that got them into the mess they're in now - ie. they're focusing too much on alpha chasing after hedge funds and private equity funds and not focusing enough on beta and how they're navigating through these turbulent times. Arun Muralidhar of AlphaEngine Global Investment Solutions sent me his comment on dynamic beta: getting paid to manage risk., which I encourage all pension fund managers and their trustees to read carefully.

Leo de Bever, President and CEO at AIMCo, once told me that pension fund managers are first and foremost risk managers. Unfortunately I don't see it. In fact, from what I've seen, most pension funds typically cut risk at the worst possible time and take on risk at the worst time too. These pension fund managers are paid big bucks (at least here in Canada) to take risk intelligently and while some do, most don't. They keep chasing after alternative investments, erroneously believing these investments mitigate risk.

Diane Urquhart sent me an IPE article which clearly states that pension schemes are overpaying for alternatives:

Pension funds often pay too much for asset managers, particularly when it comes to alternative investments, industry experts have warned.

Speaking at the German pension fund association's (AbA) annual conference, Ueli Mettler – partner at Swiss consultancy c-alm, which the Swiss social ministry (BSV) commissioned to look into asset management costs in the second pillar – said: "Costs explain around one-fifth of difference in performance."

Invited as a guest speaker to the conference, Mettler presented details of the study and told delegates that c-alm had found "a definite correlation between higher costs and lower net return".

The consultancy identified alternatives as the main culprits, as they only made up around 7% of investments but 37.2% of costs, Mettler noted, updating preliminary figures issued by the BSV earlier this year.

Mettler also spoke out against further regulatory investment restrictions for Pensionskassen.

Investment decisions should reside with the trustee board, he said, as "these people are also responsible for the fund's performance".

However, he noted that regulators had the means to increase transparency of products and investments, as investors had "paid dearly" for "asymmetries in information" between them and the asset manager.

Mettler said funds should use the effects of scale by pooling mandates rather than over-diversifying, as this, together with re-negotiating mandates, could save as much as one-quarter in costs.

He added that performance fees were basically "options" emitted by the institutional investor and should be valued accordingly.

Also speaking at the conference, Paul Woolley – former chairman of GMO Woolley until 2006, after which he funded the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at the London School of Economics – largely agreed, saying that charges and fees were one element responsible for low returns in recent years.

"The main return of hedge funds went to their owners, not their clients, who were lucky to get anything," Woolley said.

Respecting private equity investments, he said "hidden costs" and commodity investments were "unethical".

Quoting from his 'Manifesto for Giant Funds', he slammed alternative investments and performance fees and urged institutional investors to transform their way of thinking.

"Performance fees just aggravate moral hazard, and if they are applied, then it should only be over a 3-5 year investment horizon," he said.

Similarly, he said mark-to-market valuation was "cyclical and damaging" because it "forces short-term views on investors who should be investing long".

As I stated at the conference last week, the majority of hedge funds and private equity funds are not worth paying any fees for as they deliver mediocre results, charging pensions 2&20 in fees (2% management fee and 20% performance fee) as they sell them beta as alpha. Even after the 2008 carnage, it never ceases to amaze me how stupid pension funds get conned into the marketing ploys of hedge fund and private equity fund managers. Always be skeptical and never rely on past performance. Even the Bridgewaters and TPGs of this world can get smoked in these markets so always be skeptical and think before jumping into alternatives.

Pension funds should be thinking a lot more like Leo de Bever, bringing alpha internally and only paying fees to funds that generate alpha that they can't generate internally. Moreover, I think it's time that all pension funds, endowment funds and insurance funds and family offices got together to discuss this 2&20 model for alternatives. Why should you be paying 2% management fee to a mufti-billion hedge fund for turning on the lights? After assets under management reach a certain level, it should be all about performance and there should be a hurdle rate over T-bills before any performance fee kicks in (just like PE funds have). The problem is that most of the big "brand name" hedge funds have become large asset gatherers, not aligning their interests with those of their clients, and yet stupid pension funds listening to their stupid consultants keep plowing billions into them. It's truly scandalous.

Let me end this comment by stating that La Dolce Beta is coming back and we are likely to see a massive year-end rally in markets after Greek Prime Minister George Papandreou and conservative opposition leader Antonis Samaras agreed on Sunday on a new coalition government to approve a euro zone bailout deal. It looks like Lucas Papademos, former vice-president of the European Central Bank (ECB) and former governor of the Greek central bank, is an early favorite to lead the transition government, but we'll see what is announced on Monday.

In any case, markets should react favorably to the latest developments, snapping up risk assets. I'm primarily trading Chinese solar shares but I also like shares in technology, energy, mining, metals and materials and think that pensions should be taking on risk in the near-term. Longer-term, I'm worried that policy blunders will come back to haunt markets. Tread carefully in this environment but don't be surprised if a melt-up materializes in the next few weeks.