Several events have served as cairns on my career path: The opening of the corn option pit in 1984; learning about the power of alpha/beta separation from Tony Ryan (former Under Secretary of Domestic Finance in the U.S. Treasury) in 1994; and discussing environmental investing with Kerry Brick (Cargill’s Director of Pension Investments) in 2007. To this list I add another: Late last year, I discovered an asset owner that explicitly stated its target return in terms of a rate above future inflation. The asset owner is the City of Zurich Pension Fund (PKZH), a public-sector pension fund with total assets worth CHF 12.6 billion (as of June 2010), and its investment policy explicitly expresses its target return in terms of Swiss CPI plus about 3%.
Even before this discovery, I had been thinking about the incongruity of asset owners’ obsession with nominal return targets and their regular neglect of the real nature of their liabilities. In many cases, asset owners’ liabilities are particularly sensitive to inflation—and the loss of purchasing power due to inflation is the biggest threat to meeting these liabilities. Reading about PKZH revealed to me the folly and risk inherent in this obsession and confirmed that, in the end, real returns—not nominal or even absolute returns—are the benchmarks by which we should measure investment success (real returns net of fees, of course).
The current nominal-centric investment orientation might be attributed more to historical circumstances than to an intentional decision. For the past 30 years in the developed world, inflation has been perceived as a benign distraction, to be discussed—but not to be taken seriously. An entire generation of investment professionals has never experienced the pernicious impact of inflation on investment returns. The story of inflation in the U.S. from 1972-1982— when the 10-year inflation rate hit about 9%—is a part of our industry’s oral history, but few experienced the events directly. For the current generation of asset owners and managers, nominal returns are essentially real returns, but even this is a mere chimera. While inflation has been modest in most developed countries since 2000, its impact on investment returns has been quite meaningful. $100 invested in a typical U.S. 60/40 portfolio in 2000 would have had a nominal value of $143 in November 2010 yet be worth only $110 in real terms, an erosion in value of almost 24%.
Perhaps this sanguinity of many asset owners and managers will change as they are confronted with daily indications that inflation could be on the rise in the near term. Yet let me be clear. When I am talking about inflation and the need to focus on real returns, I am not talking about asset owners making pedestrian, temporary, tactical changes to their portfolios in response to specific inflationary outlooks by simply adding an inflation protection strategy. I’m not even talking about a strategic, long-term allocation to “real assets.” These tactical and strategic allocations still are undertaken within the confines of a nominal-centric investment approach. No, I’m talking about asset owners undertaking a fundamental shift in their orientation. This shift is founded on the premise that an asset owner’s genuine investment objective is to maximize real returns consistently—regardless of the current or forecasted inflationary environment. This permeates every strategic and tactical investment decision; all acts are guided by the goal of maximizing real returns (within specific risk parameters). Of course, given the singular nature of liabilities, each asset owner must determine what “maximizing real returns” means in terms of a return target relative to the appropriate inflation—not asset-based— benchmark, for example, CPI+3%. The choice of the inflation benchmark is critical because, while portfolios might be global, inflation is a particularly local phenomenon and is best measured by an inflation index that captures the impact of inflation on an asset owner’s specific liabilities. The profundity of the PKZH’s approach, I found, was the systemic embodiment—and not some one-off hedge—of this orientation.
Each one of my cairns marked a major turning point in the industry, and the City of Zurich Pension Fund discovery is no exception. Agricultural options revealed the possibilities of quantitative investing. Portable alpha demonstrated a more efficient way to construct portfolios and budget risk. Environmental investing exposed a secular change in how we think about externalities. The City of Zurich Pension Fund unveiled the archetype for measuring investment success while disclosing what Alex Orus, CIO of Blue Diamond Asset Management, calls the “real failure of traditional asset management.” I have seen the future. The future is real.
Angelo Calvello, PhD, is CEO of Impact Investment Partners.