Calling Elizabeth Warren….
The latest “you can’t make this stuff up” ruse on behalf of investors to hide from plunging asset prices is to run for the supposed cover of illiquid assets, where lax valuations allow fund managers to fudge valuations, meaning pretend things are less bad than they are.
Not only is choosing to prefer flattering and misleading accounting over economic reality not a wise idea, but virtually all of the illiquid asset classes, like real estate, infrastructure investing, and private equity, rely on the liberal use of borrowed money. That means they are riskier, in investment terms, than those embarrassing, loss-exposing asset types like stocks and bonds. In other words, if the objective were to be retreating from risk, rather than trying to camouflage it, this would be the last place you’d want to go. But Wolf Richter tells us investors are herding to the false cover of so-called “alts” (alternative investments):
BlackRock, the world’s largest asset manager, polled 174 of its largest institutional clients, including corporate pension funds (34%), public pension funds (25%), insurers (25%), endowments and foundations (7%), investment managers (6%), official institutions (1%), and others (4%). This might be an adequate sample of all institutional investors.
The poll, conducted in December, sought to find out about changes in their asset allocations for 2016. The results are not exactly a vote of confidence for this stock market.
“Institutional Investors to Embrace Illiquid Assets….” That’s how the headline of the announcement started out. And they would do so “to combat macro-economic trends, anticipated market volatility, and divergent monetary policy.”….
With reductions in equities and bonds, what are they going to buy?
“Long-dated illiquid strategies,” that’s where asset allocations are heading. In order of magnitude of the shift: private credit (“over half” plan to increase their portfolios), real assets (53% increase v. 4% decrease), real estate (47% increase v. 9% decrease), and private equity (39% increase v. 9% decrease).
The report offered two reasons why investors are fleeing into illiquid assets: to earn the higher return premia that illiquid assets offer, and most prominently, to escape the volatility of stocks and bonds.
Illiquid assets — because they aren’t regularly traded, there is no pricing data — have an advantage over stocks and bonds for institutional investors in these trying times: their losses don’t have to be booked every time a statement goes out. Losses aren’t known, and certainly aren’t disclosed, until years down the road.
And it’s not as if these investors aren’t aware of the fact that they are just playing accounting games. Consider this section from CalPERS’ private equity workshop last November:
In some ways, I hate singling out this workshop panelist, Bob Maynard, since he’s candid about the issue of the smoothing being questionable. But his remarks illustrate the point: that the investors know full well that this supposed advantage amounts to gaming of reporting systems and the larger political processes that are tied to them, and they embrace this gimmickry.
Allan Emkin, Pension Consulting Alliance: The next question is what do you individually and your boards see as the role of private equity in the portfolio?
Bob Maynard, Chief Investment Officer, Public Employees Retirement System of Idaho: We’re I think more skeptical of private equity than many and actually I’ve been quite surprised at the experience we’ve had, which has been dead solid on the average. Our time-weighted returns are almost exactly yours [turning to CalPERS’ head of private equity Réal Desrochers], that 1.34 above what you could put in the public markets is exactly our experience, so we’ve actually gotten average institutional experience, so it’s worked out better than we were expecting.
We knew we were entering an area where we would not have much influence over what we could do.
Ah, in fact, ah, we recognized however that we were going to get some pressure to look at local investments in private side, we did know that our actuaries and accountants would accept the smoothing that the accounting would do. It may be phony happiness, but we just want to think we are happy and they actually do have consequences for ah, ah, actual contribution rates we are going to be able to put in place. So we’re looking for it even if it just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks, as seen that way.
Once you get into the area, this is kind of a like a rental car return type investing. Once your front wheels are over the spikes, you can’t back up. You’ve got to keep kind of going forward. If we’re going to have a little bit, we’ve got to at least have enough to have a difference in the portfolio, which means get to at least 5 to 10%. And by the time we got to the 2000s, we had gotten to that point, so it did make an appropriate difference. So we’re there, it’s demonstrated benefits in the portfolio, we’re happy if it gives public market returns, anything extra, because of its effect having some smoothing of the risk as seen by the accountants and actuaries and, um, just don’t, you’ve got to keep going once you are there.
As you can see, this is an unusually straight-forward acknowledgment that what is driving the selection of private equity is accounting treatment that Maynard admits is “phony.” And he does not expect to get any other benefit from private equity.
Richter underscores that point:
This is not a strategy to reduce risk — some of these illiquid assets are very risky. It’s a strategy to reduce the requirement to book losses when asset prices head south.
But it’s even worse than that. First, this predisposition for risky, illiquid assets is the worst possible choice in a deflationary environment. The place to be is cash and cash equivalents, and high quality bonds.
Second, in the runup to the last crisis, investor appetite for illiquid assets not subject to mark to market discipline (as in unlike corporate bonds, the modeling allowed for particularly flattering valuations) led for them to be manufactured on a grand scale. From a 2010 post:
An incentive failures that has gotten a free pass in the crisis is the way money is managed in the Anglo Saxon world: annual time horizons and measurement against benchmarks. One of the factors that keeps pushing investors into greater risk taking is competitive pressure. If your performance lags, even it is because you are making better risk/return decisions, you will lose assets (and if you are at a big firm, you will be replaced). Yet we see remarkably little impetus to change a system which rewards the fund managers and gatekeepers (who have a particularly powerful role in keeping this system intact) since they earn….annual fees! A classic “And where are the customers’ yachts?” problem.
And too much risk is a no-no too, but the measurement of risk was volatility of returns. So what did we see in the crisis just past? A rise in popularity of strategies that used illiquid assets….which were therefore marked to model…which therefore did not show much (any) price volatility until their credit quality decayed.
Indeed, one of the features of the crisis was, just as the dot com era saw companies like Pets.com and boo.com being “manufactured” to meet investor appetite, so too were appealing-looking investment strategies ginned up this time around. From an extraordinarily prescient April 2007 paper, “Cracking the Credit Market Code,” by Henry Maxey of Ruffer and Company (no online version; more on this paper in future posts):
This leads us to the theoretical holy grail of hedge fund strategies: leveraged spread strategies in illiquid assets.
Illiquidity in the assets is essential. The danger with liquid assets is that market forces can change prices for both fundamental and haphazard reasons. Ordinarily holders of assets expecting a 20% return will accept commensurate volatility, but in a world demanding smoothed returns, this is unacceptable. Consequently, it becomes key that the capital value is not left to the vagaries of the market place.
Without a liquid market to price an asset, pricing is supplied by, for example, models. These frameworks tend to be self-serving because they are developed by players, such as ratings agencies and investment banks, who are more incentivised to give investors what they want than to ensure the price is an accurate reflection of the fundamentals. Prices, therefore, don’t change until the fundamentals, e.g., default rates, force a reassessment of the model inputs.
Everything hangs on default and downgrade. Actual default or downgrade become the critical events rather than markets’ forward looking pricing of that event, so problems are withheld until discontinuous pricing events occur rather than being anticipated in a continuously priced market. The capital prospects for the asset beyond 12 months are not of primary importance while the leverage yield spread provides the necessary return/volatility performance figures. Such a strategy is encouraged by a lack of visibility of the underlying portfolio (strategy secrecy), and a lack of regulation.
Yves here. This is a key point: it wasn’t just the demonized, presumed “dumb money” that took losses in this game. Hedge funds and prop trading desks were on the wrong side of many of these trades too.
In other words, perverse measurement incentives led investors to seek out precisely the sort of risks that were highly failure prone because they were not subject to market price discipline and investors would continue to demand them even as their fundamentals were decaying. For instance, in 2005, as the Fed was tightening, demand for prime mortgages fell, as you’d expect, while spreads for subprime mortgages tightened. That was the reverse of what had happened in any previous credit cycle (spreads on risky loans widen first, and more than those for more pristine borrowers). That was a reflection of the distortion created by CDO consisting of largely of credit default swaps, the perverse effect of the Magnetar trade which drove demand to the worst mortgages in the later part of 2005 through early 2007. And that resulted from investor appetite for safe-looking assets (the AAA tranches that proved to be anything but) and more venturesome investors thinking they could go long one tranche and short another, an idea so disastrous that at Morgan Stanley, it racked up the biggest losses of any trading strategy evah.
Now the entire point of illiquid investments is that they supposedly don’t go boom in such a dramatic way. But the crisis just past showed that they lead investors to underestimate the risks of those strategies and overdo them in a very big way. And the undue enthusiasm for investments with flattering valuations evident in the BlackRock survey suggests the odds of a recurrence of bad outcomes, meaning major losses, is high.