Cambridge Associates to Investors: Stray Away From Long-Only Equities to Mitigate Risk of Another Perfect Storm

(August 3, 2011) — Pension funds must focus on asset-liability risk to mitigate the likelihood of another perfect storm, a report by Cambridge Associates asserts.

“The last perfect storms were 2001-2003 and 2007-2009,” report author David Druley, a Managing Director at Cambridge Associates, told aiCIO. During those periods, interest rates decreased causing liabilities to spike, coinciding with drops in equities.

Consequently, pensions are increasing their allocations to fixed-income to hedge against declining interest rates. “The hedging portfolio is the primary area of focus for many pension funds that implement liability-driven investment strategies,” said Druley. “This approach actually only allows for a portion of the total risk reduction that could be achieved by using a total-portfolio risk-budgeting framework. For one thing, ‘de-risking’ by primarily increasing the allocation to the hedging portfolio unnecessarily reduces long-term expected returns,” he said.

The report asserts that investors should focus more on asset classes that aren’t fully exposed to equity markets.  For instance, an institution could create a long-short equity program that has only 30% exposure to the equity markets but still has attractive return potential if the managers are adding significant value through active management.

“To implement this strategy, you need to use active management, and the most talented active managers are in the hedge fund space,” Druley told aiCIO, adding that while he believes there are some areas where it’s harder to add value through active management, there are robust opportunities to add value to plans and reduce risk through the use of active management. “With regards to active versus passive, investors must be selective,” he said.

Among the issues for pension funds that the report explores:

• What a “smarter” growth portfolio might do.
• What might comprise a “smarter” growth portfolio. Strategies for diversifying the growth portfolio across various betas and active exposures can include passive and active long-only equity strategies; long/short equity hedge funds; arbitrage-related hedge funds; excess return-oriented credit strategies; public and private real estate; natural resources investments; and private equity.
• How to manage risk inherent in a “smarter” growth portfolio. A strategy that allocates a significant amount of risk to active exposures must extensively diversify sources of active risk