In “The Pension Dilemma,” I discussed some of the anomalies that occur in a zero-interest-rate investment climate. Several months ago, PIMCO’s Bill Gross said that investors are no longer living in the world described by Isaac Newton but are now inhabiting the world that Albert Einstein discovered. Newton, of course, explained the rules of classical physics, which are largely consistent with what we see every day. Einstein helped pioneer quantum physics, whose laws begin to take effect at subatomic levels where elementary particles behave like both particles and waves. The quantum universe is an invisible world whose laws often lead to behavior that seemingly defies logic.
That is also an apt description of the manner in which financial markets have behaved as interest rates have moved to their own subatomic levels. Bond yields are at near-microscopic levels, yet bond returns have been very strong. Equity valuations have been very reasonable in historical terms, yet equity returns have been largely disappointing.
Large pension funds and the promises they have made to their beneficiaries were designed for a classical universe. Unfortunately, they have been forced to live in a quantum world, which poses a host of challenges to which they and their advisers and investment managers now must adjust. In “The Pension Dilemma,” I suggested that these funds and their consultants need to improve their asset-allocation models in order to maximize their returns in this new environment. At Cumberland, we deal with all types of investment consultants. All of them work closely and conscientiously with their clients to design customized solutions to their funding needs. But the world has changed a great deal since 2008, and those of us who are charged with managing other people’s money must lift our games as well.
Most of the consultants with whom Cumberland works are focused on family offices, foundations, and high-net-worth individuals, rather than the very large state pension funds. Their mandates both require and allow for personalized service. Consultants serving much larger institutions have a different challenge, due to the fact that their clients are steering enormous amounts of money. Both sets of consultants play an important role, and both must adjust to changing market conditions.
There are limits to what consultants can recommend to very large pension fund clients. First, the funds and not their consultants are the ultimate decision makers with respect to asset allocation and manager selection. Large funds like CALPERS ($230 billion) or CalSTERS ($150 billion) have to invest enormous sums of money. This requires them to invest in large asset classes and multi-billion-dollar funds that can absorb such large sums. The larger the fund, however, the more difficult it is for it to outperform the market. This naturally leads to a tendency for large investors to follow consensus or politically correct thinking. That is why the largest hedge funds tend to attract the most money while tending to produce increasingly disappointing returns. It also tends to lead to dependence on quantitative methods of analysis and asset allocation used to rationalize investment decisions. That is where large funds and their consultants need to find a new approach.
Quantitative analysis must be tempered by changes in the context in which investments must be made and by shifts in non-quantitative factors such as market psychology. For example, long-term private equity returns are exaggerated by the monopoly profits that early practitioners and investors enjoyed; recent risk-adjusted performance has been mediocre to disappointing. Market psychology, which is as difficult as it is essential to understand and include in asset-allocation decisions, is particularly difficult for large investors to deal with for any number of reasons: it is decidedly irrational, can change without warning, and can produce unexpected results. Sudden changes in market psychology leave large investors unable to react or adjust their portfolios. Yet they occur all too often and can inflict untold damage, as in 2008.
It takes an enormous effort to introduce novel ideas into a large institutional portfolio, but it remains important to do so in order to optimize asset-allocation decisions. New ideas must overcome institutional resistance, fear of change, fear and misunderstanding of risk, and reliance on traditional ideas that remain deeply embedded in investment culture long after they have lost their utility and credibility. Such ideas may not always be welcomed, but they are essential in a quantum universe that is likely to keep surprising investors.
As a separate account manager, Cumberland works closely with consultants and their clients to fashion individual portfolios that meet their specific risk and return objectives. This is done with the assistance of Cumberland’s economists, Robert Eisenbeis and William Witherell, and through the prism of Cumberland’s team of experienced portfolio managers. Cumberland also calls on our colleagues at the Global Interdependence Center and NBEIC to help inform our views of the economy, individual industry sectors, and companies. This combination of economic research and practical portfolio management experience informs our work with the consultant community and enables them to deliver personalized solutions to their institutional and individual clients.