Learning From Mistakes Made By Pension Funds

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By: Roger Nusbaum, AdvisorShares ETF Strategist

Forbes took a look at How Pension Funds Make Investing Too Complex. The issue was hedge funds and private equity funds that tend to be expensive, opaque or both. These types of direct investments also tend to be illiquid in terms of having long waiting periods before investors can get their money out.

The Iowa Public Employees’ Retirement System drew a lot of heat in the article for appearing to side with KKR on keeping fees confidential. CalPERS drew a lot of attention of course for its decision to get out of these types of funds over the next year. We made a little fun of this at the time in noting that they bought in after a run where these pools of capital did relatively well and now they are divesting after a run where these pools of capital have done relatively poorly.

This is a meaty subject with a lot of moving parts.

At a very high level these types of funds are alternatives designed to not look like the stock market and generally speaking they usually don’t look like the stock market. These funds were hot in the last decade when domestic equity stunk and now they pale next to the rocket ship returns of the S&P 500 for the last five and a half years. Years of poor equity performance as occurred in the last decade have happened other times in the past and should be expected in the future. This is not a prediction, this is normal market function.

The next time one of those periods comes along people will disparage index investing, seek out alternatives and suggest huge weightings to them. This repeats over and over with whatever is hot. As we’ve talked about quite a few times, how many articles did you read four years ago suggesting 20-25% in gold?

I’ve been writing about moderate allocations to alternatives for more than ten years and in that time the ETFs space has evolved to offer countless types of alternative strategies. Another evolving aspect to the conversation are models being built that are comprised of ETFs; some models include alternatives, many do not but I would bet that the next time alternatives become popular holdings more articles will suggest huge weightings to them and more investment models will be created that allocate to them.

The model business seems to have a couple of different applications. One is that this is what the robo advisors are doing. A client’s inputs determine a portfolio that the robo firm will then rebalance for the client. Another big one, but it is still very early days, is the outsourcing of portfolio management for financial professionals. This is absolutely a valid concept in that a small RIA with a couple of partners needs to handle customer service issues, planning issues, compliance and business development all of which leaves very little time for the task of portfolio management. You’ve likely already read a lot about them at ETF.com and they will become increasingly prevalent.

The difference between ETFs that target some alternative exposure and ETF models (whether they include alts or not) is that they do not take on the complexity that comes with targeting similar exposures through the hedge funds and private equity funds as discussed in the Forbes article.

The other issue to address is patience. If equities are the best performing asset over the long term and alternatives generally don’t look like equities then there should be no shock if your merger arbitrage fund (just one example) did not keep up with the S&P‘s 200% gain over the last five years, there’s a good chance that your managed futures fund (an example) did help offset some of the decline from six years ago. After many years of great stock market gains and often poor performance for alternatives investors may repeat the behavior of taking on more risk and volatility after the market moves up while becoming impatient with holding they bought when they thought they didn’t want full stock market volatility.

Patience and discipline are crucial elements to long term investing success. Investment models will be the answer for some folks to maintain patience and discipline.

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