Wednesday, October 12, 2011

Target return of 7.75% very challenging in the near-term

Joseph Dear, the CIO of CALPERS, appeared on CNBC yesterday to discuss the near and long term outlook for the markets. His comments are highly instructive for other investors in formulating an investment policy, either for themselves or on behalf of a pension or endowment fund. Here is the key quote about CALPERS' return expectations [emphasis added]:

In the short-term, it's a little more nervous making. You look at 2% interest rates, your equity markets aren't going to do a great job, I don't think. So our target return is 7 3/4 becomes challenging in the near term.
They are projecting a 7.75% return on assets??? 10-year Treasuries are yielding around 2% and so are stocks. As I wrote before in my post "A stock market bottom at the end of this decade", equity returns are likely to be relatively flat for another decade or so. If capital returns from stocks are near zero, then any way you combine stock and bond returns, you aren't likely to get a return expectation above 3%.

To reiterate my point from my previous post, this long-term chart of the Dow tells the story, the markets has undergone a series of bull markets, followed by range-bound markets.

Zooming in to the period starting in 1950, this chart of market cap to GDP shows that the market goes through periods of exuberance and overvaluation, following by corrections in valuation as measured by market cap to GDP. The range-bound periods coincide with the corrective periods. The current trajectory of the slope in market cap to GDP suggests a valuation bottom some time around the end of this decade.

Hedge funds no panacea
CALPERS knows this. So what are they doing to raise returns? "Hedge funds" is their main answer.

Back in November 2007, I wrote in my very first post on this blog that hedge fund returns were highly correlated with equity returns and it was unclear why investors were paying 2-and-20 fees to achieve such a return stream. That assessment hasn't changed. In today's risk-on/risk-off world, buying hedge funds can be considered to be buying risk. Risky returns are highly correlated with equity returns. Therefore an investment policy of buying hedge funds could be construed as buying a return stream that is expected to correlated to risky assets, i.e. stocks.
Joseph Dear may be right in the very long term. However, my former experience as a portfolio manager for institutions tell me that pension fund staff turn over every 3-7 years. In many cases, pension fund officers are incentivized on the performances of the funds that they oversee. In effect, 3-7 years is a reasonable estimate of the maximum time horizon that an investment manager can expect with a pension fund officer.

Tactical asset allocation a better answer
I continue to believe that a better answer is to diversify into tactical asset allocation strategies. My version happens to be the Asset Inflation-Deflation Timer Model, but there are other approaches for other investors. In a volatile but range-bound market, investors can capitalize on the alpha of capturing the swings in the market and such returns have the benefits of:
  • Higher returns than traditional 60/40 buy and hold strategies; and
  • Diversification, as the return stream from such strategies are relatively uncorrelated with traditional buy-and-hold strategies.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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