Indeed pension funds of all sorts need to figure out something as poor returns and models that rely on unrealistic expectation create a big threat to anyone who collects a pension check. You can read more about this from the WSJ, Mish, David Merkel (a more general post) and Larry Weinman.
Aside from the burden of unrealistic expectations, pools of capital like this have a very difficult time reducing or increasing exposure to a particular asset class. I write a lot about reducing equity exposure when the S&P 500 goes below its 200 DMA as a way of potentially avoiding down a lot. While I am not sure about the SWIB specifically, the typical pension cannot do this.
The change in SWIB's investment policy to allow leverage has gone through an approval process that involved some sort of study and decision making at a speed that is slower than how markets move. Basically SWIB is going to lever up some small, for now, amount to buy fixed income. Embarking on this sort of a thing after a decade of lousy equity performance and three decades of great bond performance seems ludicrous as every article about this I've read says and yet they appear to be moving full steam ahead with the expectation of a "free lunch" and probably the belief that they will be able to de-lever at just the right time.
It looks like they will be starting with 4% leverage and if I read correctly they could increase it to as much as 20% down the road. Small numbers like 4, 5 or 6% will not, contrary to what some people think, bring about the demise of the SWIB. The Harvard Management Company has operated with 5% leverage for years without crashing down to zero. However the 5% leverage at HMC combined with the huge exposure to illiquid assets meaningfully impaired the Harvard Endowment and SWIB does face this potential as it will have the following allocations to potentially illiquid assets; 6% private equity, 6% real estate and 6% multiasset (whatever that means) in addition to 28% domestic equities, 25% international equities, 26% fixed income and 7% TIPS . It is also possible that their investments in private equity, real estate and multiasset (whatever that means) could be levered up making the overall leverage greater than 4%. Should the SWIB ever take the leverage up to 20% as apparently they could, well that could bankrupt it.
I do not know how long the people running the SWIB today have been there but the process that allowed them be over exposed to equities at the wrong time and that is allowing them to lever up on an asset class that is now at very high prices has been in place for a long time. Part of successful asset allocation and navigation of market cycles is learning from past mistakes. That appears to be absent here.
Mish recommends that the SWIB put 60% in cash in order to wait for a better opportunity. While strategically this could be correct it is not practical for a state retirement system. I did not find in any of the articles linked above how much of a gap the SWIB is trying to make up but if they have that much in cash they would have no shot of making it up while in that much cash and then could be wrong about when they sell or buy back in but of course they would not lose money from here is the stock market were to go down anywhere near as much as Mish thinks it will.
Mish is critical of the "all in all the time" nature of these funds which I obviously agree with in theory but I am not sure in practice how they could pull off taking defensive action without completely rewriting their policies and procedures.
I have no realistic solution other than abandoning the idea of leverage altogether (I am astounded that they or any state retirement system would do this). How do they not see that levering up because they "have" to has big problem written all over it is mind boggling. The behavior of believing "we can handle it" only to eventually get badly hurt is something that repeats over and over.
The only conclusion can be for us about what not to do. We should not lever up in our portfolios, if we do not get the longer term result we think we need then something else will have to give and we should keep our portfolios simple relative to the time we can spend on our portfolios.47 year old Herschel Walker won a mixed martial arts fight over the weekend that I think was aired on Showtime. The guys on PTI showed about ten seconds of his match. He looked ridiculously fit for a 25 year old. If you ever needed motivation to start exercising or a reminder about why you do exercise I'm sure you can find the video somewhere.
16 comments:
Leverage is dangerous.
One of the things that made it easier to live through the decline in early 2009 was no leverage and no debt. A couple of years worth of expenses in cash did not hurt either.
Leveraging after such a large run up, even though I expect a continued advance after this correction, is foolish IMO. Wisconsin's best course of action would be to fire themselves.
SEG
Roger, Appreciate the articles, just a note of correction here. Hershel is in his forties, not a 25 yr old. He is in amazing shape for any age. Thanks again for the insights, G.
you're misreading about HW. I note that he is 47, will be 48 in a month. my point is he is more fit than the typical 25 year old world class athlete despite being 22 years older than that.
I was born and raised in Wisconsin
....now you know why I left..LOL
Just kidding, it a wonderful
family (mostly) blue collar state.
The state pensions are huge..
Real Estate taxes are over $3,000
per each $100,000 cost of home!
I wish them luck.
I was in three leveraged CEF's last October when the auction-rate preferred market froze up. Needless to say, I got burned badly and have certainly learned my lesson. Odd that Wisconsin didn't.
Whoa, there. Did anyone notice that Wisconsin is using leverage to reduce stock exposure and increase safety? It sounds like they are implementing a "Risk Parity" style strategy.
The premise is that if you have a policy portfolio of say 40% stocks and 60% bonds for example then you implement that portfolio with leverage and use the extra purchasing power to buy more bonds. With 20% leverage you would be exposed to 40% stocks and 80% bonds. The extra income thrown off from the bond portfolio will smooth out the returns of the portfolio.
This approach does work, feel free to backtest it with whatever means you have available. That said I am sure Wisconsin and their consultants could loose tax payer money - theoretical finance is no guarantee against that! (For example the fact that the asset allocation consultants put the pension assets into TIPs is a red flag that they haven't done their homework IMHO.)
Here is an example of using an allocation to a high beta equity class to simulate leverage and reduce drawdowns.
Portfolio Allocation: 60.0% 5 Yr T , 40.0% MKT-TSM
Compound return = 9.13%
Worst year: 1974 -7.92%
Portfolio Allocation: 91.3% 5 Yr T , 8.7% EM
Compound return = 9.13%
Worst year: 1994 -4.90%
http://www.riskcog.com/portfolio.jsp#52hipyd
Here is a post about which states are in the most fiscal trouble wrt unemployment benefits:
http://www.zerohedge.com/articlex/majority-states-are-now-insolvent-quantifying-disastrous-unemployment-situation
i address your point i think, any backtesting would include the best 30 year period for bonds in history.
every implemented strategy like this backtests well, that is the whole point.
Roger is spot on.
Interest rates were sky high under Volker and bond prices have been rising over that 25+ year period. I do not know how much longer bonds have in the short run, but I would be willing to bet the proverbial farm they will be one of the worst long term investments going forward.
SEG
I usually agree with the likes of Roger, Mish, and SEG - but in this case I have to say that I think the analysis of Wisconsin's pension fund has been over-simplified. I'll just throw out a few observations which you can add to your analysis if you like.
1) The "risk parity" type approach works with T-bills too not just longer dated notes and bonds.
Portfolio Allocation: 60.0% TBILL , 40.0% MKT-TSM
Compound return = 7.70%
Worst year: 2008 -13.85%
Portfolio Allocation: 13.2% EM , 86.8% TBILL
Compound return = 7.70%
Worst year: 2008 -5.54%
2) The last 30 years have seen a significant bull market in long bonds. But if you go back 40 years then you see the preceding bear market, and this doesn't materially change the result.
3) Why do stocks have higher volatility than bonds? One of the reasons is that companies are levered by virtue of the debt on their balance sheets. If you think in relative terms Risk-parity type approaches effectively de-lever the stock portion of a portfolio to more closely match the beta of the bond holdings.
4) Consider this proposition: "Holding a $100 portfolio with $80 exposure to bonds and $40 exposure to stocks will under-perform a like portfolio with $60 in bonds and $40 in stocks."
There are three ways this prop can come true: 1) Stocks and bonds together both return negative or close to zero over the entire trial period, so as to not cover the cost of leverage on $20. 2) The act of buying the extra bonds causes the bond asset class to more closely correlate with the stock asset class (this could happen e.g. if all the money in the world followed risk-parity). 3) The act of buying the extra bonds causes the stock or bond asset classes to perform worse than they would have (see note on #2).
5) Roger's practice of choosing SDS over SH, or higher beta stocks over lower beta funds for exposure to a certain sector or country is basically the same thing Wisconsin is doing: same exposure using less capital.
Hopefully this is interesting to some...
Off-topic.....thought of you Roger as I read this. Perhaps a bit more extreme than the lifestyle you provide as example, but the basic concepts are there:
http://earlyretirementextreme.com/2007/12/how-i-became-financially-independent-in-5-years-part-i.html
Your daily postings are always a source of encouragement to me.
Matthew SWIB et al can't take the risk that this is 1978.
anon, TY for the link, i will give it a gander
for anyone so interested this might be easier; http://bit.ly/75m5PE
Not to sound too much like Mish, but adding leverage isn't the answer. The odds of this backfiring are just as great as it working out.
The government either needs to ask the taxpayers for more tax dollars to properly fund the pension, which would fly like a lead balloon, or tell the state workers that they shouldn't expect their full benefit - another lead balloon. Rather than make a difficult decision, they are gambling and hoping that they come out winners.
I think we will begin to see governments modify the cost of living adjustments for pensions and social security. I served at Coast Guard Headquarters and worked on the retiree affairs division. The CG routinely gave the retirees less of a COLA raise than CPI. Eventually, the retirees would raise a stink so the CG would give them a nice raise to quiet them. Then, the undercut would resume. I suspect we will see an invisible cut at all levels of government.
Of course, many claim CPI is rigged to understate the true inflation rate so we may already be doing this.
Everyone is worrying too much
If it blows up, they will be bailed out like everyone else. Why not try it, when you know there is no risk if things go wrong?
*sarcasm*
It is not clear Matthew's point is being understood: The issue is not leverage per se, it is what leverage is being used to accomplish (regulation of volatility in this case). Speculation that a particular asset such as bonds may be a poor investment at this or any other juncture is irrelevant, it is a question of variance and total return.
New to the blog...please be kind. Excuse my ignorance...I understand the MPT premise that increased individual security risk can decrease portfolio risk as put forth by RW, but the answer to risk-parity Wisc is choosing is to increase risk on the bond side via leverage. Why not decrease equity risk (via a covered call overlay, or some similar strategy) instead? Though it only gives mild protection on the downside, that protection combined, over time, with the increased yield produced by the option premium, should give the desired results.
The point that the last 30 years have been bull markets for bonds is a valid point; but, consider backtesting to 1926 using the CRSP data. During that period, PE multiples doubled and yields took a round trip. Clearly a period that would favor the 60/40 allocation, not risk parity with levered bonds. But, RP works even then.
You may find this piece by AQR interesting:
http://www.econ.yale.edu/~af227/pdf/Leverage%20Aversion%20and%20Risk%20Parity%20-%20Asness%20,%20Frazzini%20and%20Pedersen.pdf
Risk Parity is something that has a lot of merit.
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