A pension fund losing money is the last thing the retirees want to hear. But with the pension funds losing money in USA, golden times are getting trickier. The Fund managers assumed that they understood the asset classes they were investing in when markets surprised them. According to NASR (National Association of State Retirement Administrators) Public funds increasingly don’t have enough money to pay future benefits. The conservatism of yester years has lead to a vicious cycle which has made pension funds more like high risk funds. The Pension funds have deteriorated from a $20 billion surplus in 2001 to a $381 billion deficit.
Market risk, has moved beyond local rationales as poor portfolio performance has forced stock pickers and fund managers to employ new analytical tools to understand market risk. Unlike bottoms up approach of stock picking, the top down approach times market risk. However, top down approach needs thorough understanding of the macro picture, sector rotation, inter-market linkages, inter-market cyclicality and relative strength.
According to Ian Notely, the legendary time cyclist, playing with an asset trend and against it can seriously determine your chances of success. The odds can move up from 3/1 to 20/1 if you are against the trend. This simple logic of playing counter trend can determine the success of any investment strategy. Markets are changing so fast that by the time you realize that your understanding of the “familiar” asset class is limited and incomplete, it might be too late. This is what bottom up stock pickers are facing now with recurring market risk, which they don’t know how to diversify out off. The parameters influencing local valuations have just increased multifold. This is why any pure regional bottom up approach of stock picking is like playing against the trend with huge odds.
However, its all not gloom, there are always outperformers. Jim Simons, world’s best Hedge Fund manager has produced net annual returns of 37% since 1989. While some funds were cracking under the subprime crises, some of these high fee charging funds were already short on the ABX Sub Prime Index. Looking for negative correlation and acting on it in time pushed up the profitability for the respective fund.
But it’s not easy to find negative correlation or understand correlation in the first place. In times of contagion correlation are found to be high. But according to Invesdex, an alternative investment firm, correlations are not just high in period of panic but are generally positive. And barring dedicated short bias strategies and managed futures all other strategies viz emerging market, equity market neutral, event driven, global macro, long short equity have a correlation between 0.6 and 0.1, clearly positive. So finding negative correlation to reduce risk is not easy. However, strategy styles like pattern recognition, mean reversion and short term momentum can help reduce portfolio risk.
Sam Stovall’s sectoral rotation has an inbuilt risk mitigation factor. Sam linked the stock market or economic cycle with relative sectors explaining when a sector leads and lags. Why Energy sectors are leaders in the late expansion stage? And why when the market in early contraction of the economic cycle consumer staples and utilities take over? He also explains how technology and financials are late economic contraction and early economic expansion sectors.
The current market situation in India clearly exhibits where technology, energy and staples stand today versus the broad market Index. Technology and staples underperformed in 2007. Playing with or against emerging sectors can be a key profitability differentiator for a fund. And since sectoral underperformance can not last forever, knowing when the cycle is turning can really push the fund up in relative rankings.
Macro economic trends can also assist in sector selection. According to the recent IMF report the rising food costs impact headline inflation to as much as 55.9% for developing Asia. Rising food can have a direct impact on the staples sector. And Indian companies featuring in Business Week Asia’s top 50 today might change tomorrow with performers still coming from pharma, alternative energy and consumer companies like Cipla, Sun, Suzlon, and ITC rather than the banking, auto and tech majors like HDFC, Tata Motors, Hero Honda and TCS that also feature in the list.
Above sectoral cyclicality we have the asset cyclicality, which illustrate the intermarket relationship between commodities, bonds, currencies and stocks. Why bonds generally go up with stocks? Why commodity prices generally move opposite to the stock prices? Why value of cash is cyclical too? And why deflation or stagnation risk is a part of the credit cycle? Asset cycles are larger than sectoral cycles. The commodity cycles turned down in 1980s for nearly 20 years as equity cycles rose during the same period. The commodity cycles turned up in 2000 and we witnessed the equity market turbulence. The healthy disinflation and high saving rates in Asia might have delayed the deflationary effects. But as baby boomers retire and inflationary pressures increase, the sectoral cycles and existing assets trends will change. And if the interest rates cycles end, as they are anticipated to do so around 2009, top down investment approach might come a lot handy to find assets for capital conservation and growth.
And then we have the Climate cycles, which are linked with economic cycles just like wheat cycles. Institutions are already waking up to this link of environment, carbon and economics which they are redefining as green finance. Stock picking without understanding long term climate change on economics is another under utilized strategy, which is not only negatively correlated to traditional assets but is also extremely profitable. According to Nicholas Stern, the author of the famous report on economics of climate change, the benefits of strong and early action far outweigh the economic costs of not acting. The Review estimates that if we don’t act, the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP each year, now and forever. The author even mentions of major disruption to economic and social activity, on a scale similar to those associated with the great wars and the economic depression of the first half of the 20th century.
Capital markets have already started acting. We have a whole new suite of products designed to finance projects such as green buildings, clean energy, plants or low emission means of transport, capex in large alternative energy projects have enabled investors to participate in green finance. This has lead to the new green stock picking. The climate awareness is reshaping industries as Virgin gets into fuels, green grids define which auto company is better than the other. Barring Nissan and Toyota a majority of car manufactures are still far away from a cleaner technology focus.
After 10 years weather derivatives are picking up and playing a bigger role. The urgency in essentials like water and energy is visible. Markets don’t see 1 billion people in the world with no access to electricity and 2 billion people with no access to clean water as a crisis, but as a price inefficiency which will eventually correct as players jostle for 1% of the planet’s fresh water. The cost of drinking water is expected to increase 5 to 10 times in the next 15 years.
There are long only funds for alternative energy, healthcare, environmental services, finance, micro finance and water mgmt. And there are funds shorting the non environmentalists something like long a solar energy stock and short a company selling coal fired generation equipment. Markets are changing the way we look at energy, the way we look at banking, the way we look at cars, the way we look at correlation and the way we look at equity. By the time nuclear energy companies list in the global exchanges, Uranium would go through the roof and by the time we look away from the rising Oil, John O Donnel, CEO Ausra might have changed the world with his solar mirrors. Wealth creation is easy if we come out of the extreme short termism and all that bottom up mirage.