PAAMCO Perspectives

An Endless Waiting Room: How should pension investors manage a world of low yields, tight spreads and high valuations?

06/11/2018

As markets remain close to record levels, pension investors have a hard choice in front of them: should they 1) hedge liabilities and lock in low returns, 2) aim for their return target and take their chances regarding the liabilities or 3) do a bit of both?

While they are increasingly expensive, markets are cooperating in one big way: the cost of insurance has collapsed in interest rates (and stayed low). By implementing a nonlinear hedge with interest rate options, investors can be hedged in scenarios where protection is vital and be less impacted by losses in scenarios where a hedge is a hindrance – always an attractive position, but all the more so at these low price levels.

Furthermore, at current spreads, investors should seriously consider diversifying away from credit risk in their portfolios. Right now a portfolio that is focused solely on the various flavors of the credit risk factor is receiving historically low levels of return. Credit has had a fair wind for several years now and there is little headroom remaining. Diversifying away from this makes sense.

Therefore, our recommendations include:

1.  Using low levels of implied volatility to help the portfolio as a whole
The current level of implied volatility in long-dated swaptions, which has not been seen in over 10 years (and is 25% less expensive than at the start of 2017), makes these instruments a cost-effective choice to protect the portfolio.

2.  Diversifying away from credit risk
Tight spreads and low yields for high grade credit continue to be a headwind for investors, forcing a dilemma of accepting poor returns in exchange for hedging liabilities. A singular focus on credit for Liability Driven Investing (LDI) implementation makes achieving return targets and overcoming index slippage a very tall order.

3.  Moving from passive to active; macro to micro
Until recently, many investors have focused on making the right macro decisions and selecting passive strategies to implement their views. This is an approach that has certainly borne fruit in the recent one-way markets. The current historically high valuations of so many asset classes mean that making the right macro decision is increasingly difficult (as shorting in a pension fund can be challenging). Pension investors should resist the temptation to lash themselves to the mast of low yields and tight spreads. Rather, they should try to operate in a much more micro fashion and accentuate a more active role.

Macroeconomic trends are hard to call regardless of the amount of due diligence done. For microeconomic trades, however, the amount of due diligence meaningfully improves the odds of success. Rather than looking for asset class value, investors should re-focus on sub-asset class and individual trade value. In other words, invest actively rather than passively.

The start of the year saw some rediscovery of the truism that investing is hard and that markets go two ways. Whichever scenario we end up in, there is value in flexibility, opportunism and diversification. Being positioned for this sort of transition is never free but, remarkably, it is cheaper now than it has ever been.

Uncertain Times

Pension investors have a series of hard and possibly irreconcilable choices in front of them: should they hedge liabilities and lock in low returns or should they invest for high returns and not hedge liabilities, or should they do a bit of both?

Uncertainty remains high and investing in this environment may feel like being in an endless waiting room with no resolution. Looking at three potential future scenarios: normalization, a Japan-like scenario in the U.S., and the return of volatility (the bad sort), helps frame the issues. There are also non-symmetric choices for hedging rates such as using currently historically cheap swaptions that, when utilized, offer significant flexibility to investors in managing their overall portfolios. The other component worthy of consideration is that investors should pay heed to the tightness of credit spreads. Investors would be wise to remain engaged in credit risk replacement as a matter of urgency regardless of views on rates.

What are People Saying?

Recent talk (and actions) from the Fed and other central banks regarding an increase in inflation and rate rises has substantially influenced views among commentators and pundits. The strong global economy, and the slow withdrawal of monetary stimulus have bolstered hawkish rate views. Despite these factors, long bond rates still remain firmly within the range of the past five years.

Over the past few years, investors have seen almost every risk market move from significantly undervalued (2009) to priced for perfection (2017/2018). Today’s choice seems to be between a rock and a hard place: take your pick of one overpriced asset class over the other. This investment conundrum is further compounded by the requirement of pension investors to address their liability hedge ratio. What can be done? Well, there is one thing that continues to get cheaper even as everything else gets expensive: rate insurance. The cost of rate insurance has declined by nearly 30% over the past 12 months and — even after the shock to volatility at the start of February — remains at very low levels. This is demonstrated by the following chart which shows the relative change in implied volatility for VIX and for long-dated swaptions since the start of the year:

Swaption Implied Volatility (Level at 1/1/18 = 1)

Source: Bloomberg
As of May 31, 2018

 

What’s Been Going On?

We all know the headlines and the trends but stepping back and reconciling where we are today versus expectations of even a few years ago is quite enlightening. The past five years or so have caught the investing world in a one-way trip: according to pundits, long rates have been on the verge of “normalizing” for the entire period but have instead stayed within a range; meanwhile equities have been on a trip skyward (until the recent high in early 2018) and credit has steadily ground tighter. If, in 2012, you said that in 2018 the S&P 500 would have nearly doubled from 1400, unemployment would be at 4%, and the Fed would be shrinking its balance sheet with the end of Quantitative Easing (QE), but despite all of this, the 30-year rate would be close to 3%, there would have been some funny looks and probably laughter. Further, your counterpart, who was laughing at you, would have maintained their positions in preparation for a take-off in both rates and inflation (neither of which happened). Finally, if you told them that the cost of insuring against such a take-off of rates would be about 30% cheaper than it was then, they would have thought you were crazy. And yet here we are.

Cost of Swaption Insurance is the lowest since 2007

 

Source: JP Morgan Markets
As of May 31, 2018
Note: The 11-year date range was chosen in order to include the period leading to the 2008 financial crisis.

Meanwhile, the term premium in the rate curve has gone away: the difference between the 2 year and the 30-year yield is less than 1% as the short end has crept higher. This is despite the Fed’s signaling to the market both a continuing increase in the short-term rate level as well as the slow shrinking of current holdings of other duration bonds. There is a continuous bid for the long end of the curve, as suggested by the 2.41 bid to cover ratio of the recent 30-year auction in April. This was in line with January’s ratio of 2.74 which was the highest such ratio since 2014.¹ Fixed income investors are in an endless waiting room, stuck there for an indefinite period for judgement and eventual consignment to an appropriate fate. While there, they are caught between requirements to be long duration and unsustainable return targets.

Collapse in Term Premium

Source: JPMorgan Markets
As of May 31, 2018
Note: The 11-year date range was chosen in order to include the period leading to the 2008 financial crisis.

So Where Do We Go From Here?

Taking an agnostic view of the motivations behind a flat yield curve, what does it tell us about the future? First off, the markets are saying that there is more capital than opportunity. In the long term the markets think that the appropriate risk-free rate of return for investing for 30 years is somewhere around 3%. Second, there is a lot of talk of the future and how this situation in rates may or may not change. Assuming we don’t revert to the waiting room of the past few years of low volatility markets, let’s look at three possible scenarios that could play out in the short-medium term that merit consideration by investors.

Scenario 1: Normalization – at last!

• Economic growth is strong
• The bond market sells off, driven by central bank removing QE
• Everything is stable and steady

In this scenario, the term premium should increase, partially driven by the central banks of the world unwinding their QE balance sheets. Investors sell out of bonds and reinvest in better opportunities. This reduces the demand for long-duration bonds, raises yields and funds productivity-enhancing investments, increasing the “pie” for all.

But might this actually happen? This could be a sort of hell for the holders of long-duration assets as a new rate regime consistent with what was previously considered normal reasserts itself. However, given that there is a large set of pension investors following a glide path that requires them to sell their risk assets and buy the required long-duration bonds, a rising equity market has the side impact of also providing a steady bid for duration. This occurs despite rising yields at the short end. In other words, pension investors are forced to buy into a bond market depressing yields below where they would otherwise be, maintaining the current flat yield curve.

In this scenario, the economy lives up to the hype implied by equities. Normally we would expect that the curve should start to steepen as bond investors are attracted to other asset classes, but LDI glide paths don’t account for this. They will either cause yields to stay stubbornly static or force investors into a losing trade. This would replicate the situation in the UK gilt market, where a limited issuance of long-dated gilts has been eagerly snapped up by a set of constrained investors.

Scenario 2: Japan-like Scenario in the U.S.

• Stagnant Growth
• Deflation
• All investments perform poorly

In this scenario, the economy does not grow and inflation is not the problem — deflation is. Yields keep going down and the curve is basically flat, meaning no term premium at all. Holding long duration assets produces capital gains but the yield is derisory. Equities perform poorly over the long term as growth is in line with what has been predicted by the low and flat yield curve. This will hurt investors who choose to remain unhedged to rates as well as those who focus on a passive approach to risk assets.

Scenario 3: Something Happens – Volatility!

• Exogenous shock
• Positive or negative development draws capital from bonds
• Yields increase

In this scenario, an exogenous shock forces markets to adapt to a new economic equilibrium causing real change to the long-term calculus embedded in current markets. Such a change can be positive or negative. A positive change brings a set of transformative technologies and investments that pull capital from safe assets to reinvest in productivity-enhancing assets. Such a shortage of capital for bonds will drive yields up. The withdrawal of QE is also meant to have a similar effect.

On the negative side, an event that causes a large destruction of economic capital, such as a natural or manmade disaster, attracts large amounts of financial capital away from other uses in order to rebuild and regenerate. In other words, volatility! We had a little bit of a taste of what volatility is at the start of February; market participants that had grown complacent riding market trends suddenly experienced real uncertainty and actual losses. In the event of real uncertainty around future prospects, bond investors will get hit by both rising rates and widening spreads.

Pension Investors’ Dilemma

The weight of glide paths on the long-duration bond market is critical; pension plans betting that rising long rates will bail them out of poor funded-status by keeping the hedge ratio low may be very disappointed. Similarly, fully hedged plans hoping that a rise in risky assets will bail them out of the gap between current yields and the expected return on assets may also be disappointed. There is no simple solution to this other than the hard work of investing beneath the macro level and staying open to opportunities, diversifying away from tight credit spreads and finding cheapness where possible, both for hedging and for return-seeking parts of the portfolio.

 

 

1    Source Department of Treasury, Bureau of the Fiscal Service 30 Year Auctions of Jan 11, 2018 and April 12, 2018.
www.treasurydirect.gov

 

 

 

Ronan Cosgrave, CFA, CQF is a Managing Director and is Portfolio Manager for PAAMCO’s LDI and Long Duration solutions. He serves also as the main point of contact for certain institutional investor relationships. Prior to joining PAAMCO, Ronan worked as a Process Engineer at IBM’s Storage Technology Division sites in Silicon Valley, Germany and Ireland. He also did chemical engineering design and commissioning for ProsCon, an Irish engineering and process control consultancy. Ronan received his MBA from Columbia Business School, and B. Eng. in Chemical and Process Engineering (Honors) from Cork Institute of Technology. </span>

 

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Miren Portföy Yönetimi A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.

This document contains the current, good faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements.

Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.

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PAAMCO is a Core Supporter of the Standards Board for Alternative Investments.

©2018 Pacific Alternative Asset Management Company, LLC

 

Volatility Has Returned (and is here to stay)

04/27/2018

Overview

What a difference a quarter makes! After a prolonged period of suppressed volatility, equity market volatility spiked meaningfully in early February. A number of short volatility strategies (including several popular ETFs) exposed their downside risk during the volatility spike, forcing many of these strategies to reduce risk or unwind. As a result, many retail and institutional investors alike experienced large losses.

Since those events, the level of volatility in markets has remained elevated. It is a challenge to pinpoint the specific cause of the equity market trade-off in late January and the subsequent volatility spike. At the end of 2017, many forecasters, including us, noted several risks to be wary of going into 2018: the impending end of a long period of global accommodative monetary stimulus, signs of acceleration in inflation, deficit spending, and lofty credit and equity valuations. Identifying the primary culprit in Q1 is not simple; more important is recognizing that we have entered a higher volatility regime that has investors finally waking up to the reality of tighter financial conditions, increased geopolitical uncertainty, expanding deficits and a U.S. economy in the late stages of expansion.

Portfolio Implications

We expect the following three primary investment themes to characterize the balance of the year:

1. Hedged relative value and trading-oriented strategies will likely outperform directional strategies.

a. The prospects for a continued equity bull run seem to have diminished for a number of reasons. PE multiples are re-rating lower. The FAANG (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) stocks’ overwhelming success is spurring an increased regulatory focus. “Trade war” rhetoric is capturing headlines well in advance of any concrete negotiations, obscuring the economic impact on specific industries. These phenomena are contributing to an increased risk premium for equities, more than offsetting the positive impact tax cuts are expected to have on future earnings. All of the above is creating a “sawtooth” pattern for equity prices as investors react to positive or negative headlines. This has resulted in a lot of directionless market volatility.

b. Higher short-term interest rates and a reduction in global monetary stimulus will likely create a headwind for credit markets. Over the past few months, credit spreads have widened, but in the absence of increased default fears. If the economy slows, higher interest rates and revenue compression will start to squeeze weaker credits. The volume of BBB debt is particularly significant, which could mean a downgrade to HY territory for a notable amount of formerly investment grade paper. A pickup in downgrades in conjunction with rising defaults would add pressure to credit markets and cause HY spreads to widen.

c. The pace and path of removal of monetary accommodation will vary from country to country, but as long as the general economy doesn’t show signs of rolling over, a move toward more restrictive monetary policy appears clear. This shift will create a less accommodative environment for credit trading. The world is still flush with cash and the debt markets remain open, buvt we are wary that the psychology of bond investors can switch from buy mode to hold or sell mode in an instant. This may create a choppy backdrop for credit trading with risk biased to wider spreads.

 

2. Macro-focused strategies that can position for trends in the USD and yield curves will benefit, while long-biased strategies face headwinds.

a. We expect the U.S. fiscal deficit to evolve into a bigger problem than is currently anticipated. The Trump administration has shown no spending restraint while also passing one of the largest budgets in U.S. history; at the same time, recently approved tax reform will reduce government revenue.

b. The continued spending spree in the U.S. becomes even more concerning as we approach the end of the economic cycle. The U.S. should instead be using the long period of economic growth to pay down debt and shore up the country’s balance sheet.

c. Short-dated bonds that were issued at near-zero interest rates are getting rolled over at rates in excess of 2%. Short-term rates will likely continue to rise, further adding to the deficit.

d. We expect these profligate policies to cause an increase in the term risk premium and a bearish dollar policy.

 

3. The market volatility witnessed in Q1 will likely become the norm and not the exception.

a. Coordinated, accommodative central bank policies around the world have suppressed risk for years. With this backdrop of central bank support, investors have moved into riskier assets in search of higher returns.

b. We have been warned that this party will come to an end in Q3 of this year. As central banks slow QE-related purchases, assets will once again re-price to a fair risk-adjusted value (rather than the inflated value caused by QE). We are in the very early innings of this asset re-pricing. As monetary policy becomes increasingly restrictive, the repositioning of this risk will weigh on markets.

c. The inconsistency of the pricing of volatility within and across asset classes will provide a viable and profitable investment opportunity for volatility trading strategies. Increased volatility should also provide a favorable environment for various risk premia strategies, as a higher volatility regime typically bolsters returns earned from harvesting risk premia.

 

Overall, we expect 2018 to be a more challenging investing year than 2017 or 2016. With a less stable macroeconomic backdrop and historically rich asset valuations, the key to earning reliable returns this year is focusing on hedged relative value and trading-oriented strategies. The newly volatile market environment will create a rich opportunity set for investment managers that extract return by understanding relative value or technical dislocations. On the other hand, investment managers that rely on a stable environment to earn consistent carry or ride a positive equity trend will likely be more challenged this year.

 
 

Basil Williams is a Managing Director and Head of Portfolio Management at PAAMCO. He is responsible for the firm’s completeAlpha approach to hedge fund investing and is the Chief Investment Officer of Horizons, the firm’s fixed-income investment solution. Basil is also a member of the firm’s Investment Oversight and Management Committees. During his career, he has built and led teams in institutional investment management including equity and fixed income trading, research, risk management, and business development. Most recently, Basil was the Co-Chief Investment Officer at Mariner Investment Group, where he managed internal trading teams, led three of Mariner’s multi-strategy mandates, spearheaded the firm’s incubation and seeding business, co-authored Mariner’s Quarterly Investment Views publication and helped set the firm’s business strategy. Prior to Mariner, he spent nineteen years with Concordia Advisors and held the role of CEO for the last six of those years. Basil started his career at Merrill Lynch in 1980 and played a key role in the development of its financial futures and options business. Basil received his MBA from New York University and his BA in Applied Math from Brown University.

PAAMCO senior analyst Vanessa Welsh made significant contributions to this paper.

Tailored and Transparent: The Key to Absolute Return Funds Under Solvency II

09/24/2016

 

Introduction
In the search for attractive and diversified returns, European insurance companies have generally dismissed absolute return funds as potential investments due to lack of familiarity, the complexity of understanding risk and return drivers, implementation hurdles, and the potential for a skeptical regulator particularly in the context of Solvency II. According to a recent Preqin study1 of more than 5,000 global institutional investors, insurers represent just 4% of all institutions invested in absolute return funds. Moreover, those that do invest in absolute return funds allocate only a small portion of their assets into such funds, an average of 3.3%. For Europe specifically, these figures are likely to be lower.

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Assessing Risk of Private Equity – What’s the Proxy?

04/24/2016

 

Asset allocation is perhaps the most important choice facing CIOs. It involves evaluating the risk/return profile of various asset classes and is usually based on a combination of forward-looking expected returns and risk measures derived from historical data. In this context, the traditional modeling of private equity is subject to significant drawbacks. Available index data for private equity is lagged, smoothed, and understated with respect to the beta, volatility, and correlation with public equities. These drawbacks can have a significant impact on portfolio allocation decisions when a large share of a portfolio is allocated to private equity. The purpose of this paper is to evaluate alternative methods to proxy private equity investments in the context of portfolio allocation. This assessment draws on PAAMCO’s experience in managing hedge fund portfolios, which may contain private equity positions.

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The Upside of Transparency and Control

03/28/2015

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This paper examines how institutional investors can most effectively take advantage of hedge fund transparency and investor control structures. It is written in three parts. The first part of the paper traces the evolution of improved hedge fund transparency and control structures, particularly in the wake of 2008, initially as a defensive mechanism and, later, as a potential toolkit to generate upside. The second part addresses practical issues: now that the toolkit of transparency and control structures is in place, what are some of the “levers” that can actually be pulled to generate benefits for a hedge fund portfolio? The third part looks at how institutional investors make partnerships with hedge funds work.

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Funding Gap-Driven Investing (FGDI)

06/02/2014

 

Summary

Market participants have generally come to interpret the concept of Liability Driven Investing (LDI) as being equivalent to Liability Matching Investing (LMI). This interpretation is one that is forcing more and more pension plans to make decisions that do not make economic sense – decisions that may damage the ability of ostensibly well-funded pension schemes to deal with future events with respect to liability valuation or a downturn in markets. In addition, the total value of U.S. defined benefit pension assets is about 3.5 times the USD investment-grade long duration bond market making execution of LDI or LMI initiatives difficult. This article proposes an alternative to the LDI approach: investing not with a view to match liabilities, but with a view to explicitly minimize a funding gap (or maximize a surplus). This approach, which we call Funding Gap-Driven Investing (FGDI), also incorporates the use of assets other than long duration fixed income securities. The aim here is that diversification of return opportunities should lead to greater stability in long term returns as well as greater scope for active management to add alpha in order to provide greater absolute return.

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’40 Act Daily Liquidity Hedge Funds: Considerations for Institutional Investors

05/02/2014

 

With the mounting hype surrounding the growth of the ’40 Act1 hedge fund industry, many institutional hedge fund investors are evaluating whether to utilize a ’40 Act structure for their hedge fund investments or to stay with the traditional private placement structure.2 To assist the institutional investor in making this decision, this paper assesses the risk and return profile of the ’40 Act structure that has daily liquidity, also known as the mutual fund structure, relative to the traditional private placement structure. The paper also discusses the relevance of other features of the ’40 Act mutual fund structure for institutional hedge fund investors to consider.

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Under the Hood of Hedge Fund Leverage

04/28/2014

 

One of the key differentiators between hedge funds and other investment vehicles is the use of leverage. Leverage can be your best friend one day, and your worst enemy the next. Everyone knows that leverage will accentuate both gains and losses. However, less is known about how hedge funds actually obtain and incorporate leverage into their portfolios and how investors should monitor a hedge fund’s use of it.

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