Using Multi Asset Solutions as a Diversification Tool
Multi Asset solutions are complete expressions of their designers macro views. Building a portfolio requires significant capital markets and risk expertise. Join us as our experts talk about how use this powerful investment tool.
Michael Schlachter - Managing Director, Multi-Asset Class Solutions Group at Prudential Investment Management
Michael Livian - Chief Financial Officer at Livian & Co.
Philip Brzenk - Associate Director of Index Research & Design at S&P Dow Jones Indices
Courtney: [00:00:12] Multi asset solutions can be considered a comprehensive asset allocation capability. By design, they’re complete expressions of the providers’ macro views spanning the entire asset class spectrum. Building a multi asset portfolio requires significant capital markets and risk management expertise. And often leverages, the experience of a global team of investment professionals, investors who do not have the necessary internal resources are therefore increasingly looking at multi asset solutions to help bridge the resource gap. Joining us today to discuss multi asset solutions are: Michael Schlanchter, Managing Director for Multi Asset Class Solutions, Prudential Investment Management; Michael Livian, Chief Executive Officer, Lehmann Company; Philip Brzenk, Associate Director of Global Research and Design, S&P Dow Jones Indices. Gentlemen, welcome to Asset TV’s Master Class and multi asset solutions. Michael, could you tell us your … Michael, what asset classes do you believe will outperform in the next five-ten years?
Michael: [00:01:16] Well, for a medium term period like that I think you have to go with the typical theory, right, stocks for the long run, stocks for the long haul. I think certainly right now everything seems relatively expensive; stocks are … maybe not in the past week or so, but near all time highs. Bonds are near all time highs. Commodities are down significantly. But right now, there aren’t a lot of glaring opportunities out there. If you’re taking a long term period, like again, five or ten years, I think you really need to stay with predominantly most of your assets in equities; that tends to work over long periods of time. If we’re talking shorter periods of time there’s certainly some great opportunities right now, high yield for example, among other fixed income sectors is especially cheap and has gotten significantly cheaper over the last few months and might be an opportunity for next year. But over the timeframe you’re suggesting I think hopefully investors are rewarded for the risk that they take in a portfolio.
Courtney: [00:02:07] Michael, what asset classes do you believe will outperform in the next five-ten years?
Michael: [00:02:10] Well, I tend to agree with Michael, I think equities for the long run, they always outperform comparing them to bonds or real estate, if you take a very long time horizon, they always outperform. Specifically I think that you do have areas in the market today that they look very attractive such as Asian equities or emerging market equities. They are considerably mispriced, they have been underperforming for a while and the market doesn’t really like them so much. And I think you can find a lot of opportunities there. Moreover I think also here in the US, shorter term, you have had a very big selloff in the MLP space and in high yield energy bonds. Those are attractive opportunities for the shorter term horizon.
Courtney: [00:02:58] Michael, what’s your approach to asset allocation?
Michael: [00:03:00] That really depends on, I think, the client and what they’re trying to accomplish. So if it’s someone who’s trying to truncate a left hill event for example, you really need to look at asset allocation, not just in the typical five 70% in stocks and that get me eight, and I have 30% in bonds and that gets me three, add them together I get five and that’s good enough, doesn’t work anymore. The whole reason why multi asset class solutions really is coming into its own I think as a valuable resource to clients is because we can think beyond that simple calculus. So looking at something like a stochastic projection of an overall outcome taking a variety of scenarios, a variety of asset combinations and trying to figure out at what level can you actually survive? It would be ideal if we got exactly what everyone expects and you get the magical six or seven or eight percent return. But we have to know that 20 or 30 or 10% of the time the worst can really happen. So are you comfortable living with that level? And if you can live with that type of return, that type of asset value then everything else really is hopefully gravy above that.
Courtney: [00:03:58] Michael, what’s your approach to asset allocation?
Michael: [00:04:01] Our approach to asset allocation is based on what we’ve studied and that is proven to work. So first of all we take a longer term horizon approach, so we don’t project one year, three year. Normally our projections are five-ten years. We have a robust methodology to formulate expected rates of return. And we tend to stick with strategic long term weights in our locations. However, shorter term to manage the risk, we look at some technical aspects in the market. And generally those are the only ones really that work. If you do have momentum in a big selloff in an asset class you may want to limit your exposure. But other than that it is really longer term strategic allocations based on expected rates of return.
Courtney: [00:04:49] Michael, how would you define multi asset solutions?
Michael: [00:04:52] Multi asset class solutions or multi asset solutions, I think in this day and age really means really anything to the eye of the beholder. It’s sort of like saying hedge funds. Hedge funds is a catch all for a wide variety of asset classes that don’t fall under simply just stocks or bonds or commodities or currencies or something like that. And multi asset class solutions is another one of these, again, generic catch all titles that really applies a wide variety of things. It can mean specific products that combine a variety of asset classes to generate one particular end. For some firms it might mean a software solution or an analytic solution which drives a different kind of outcome. For us, multi asset class solutions is engaging with clients, trying to figure out what really should be their strategic asset allocation, what kinds of risks are they most worried about in their portfolio? How can we mitigate those risks or truncate the outcome of those risks? How can we work long term with our clients really to achieve the kinds of return objectives and risk profiles that they’re trying to achieve in this market?
Courtney: [00:05:50] Philip, what role do benchmark or passive providers play in the multi asset space?
Philip: [00:05:55] Well, passive providers basically provide benchmarks or underlines for index related investments. And so really what we’re looking to do is provide clients with, you know, objective based transparent, low fee products that are easy to follow for investors. They’re not more black box in nature compared to more active based multi asset solutions.
Courtney: [00:06:24] And, Michael, why are plan sponsors shifting from individual portfolio investing to multi asset solutions?
Michael: [00:06:33] For the most part it’s a recognition that the world is a lot more complicated and a lot scarier than I think some of the capital market models would have us believe. Plan sponsors, especially plan sponsors in the pension fund space have really been through a rough 10-15 years. Funds were almost fully funded in the late 1990s, and obviously we had the NASDAQ bubble collapse, funds were turned almost or in many cases, above being fully funded in the early part of last decade and then we had the credit crisis. Over those 15 years many plan sponsors have gotten closer and closer and closer to the point of turning cash flow negative. The baby boomers are beginning to retire, so these losses, while losses back in the 70s or the 80s gave you 20 or 30 or 40 years to recover before that wave of cash flows came out of your plan, but time’s been compacted, cash flow or losses today are much more meaningful for clients who are again in that cash flow negative state. So for clients who are trying to hit the return objectives, simply just taking a long term perspective, Michael and I both agree that stocks [unclear 00:07:32] perform bonds for the long term, but in any given year who knows what’ll happen? So the ability to think across your various asset classes, to tactically weight asset classes, to put hedges in place to react to markets more quickly, can really help plans who are again, dealing with a much more time constrained asset allocation process or a risky perspective asset allocation, can help them engage with that and deal with that much more effectively than simply just taking the long term view all the time.
Courtney: [00:07:59] Michael.
Michael: [00:08:01] Well, I think that institution investors and pension funds are faced with a very difficult problem, probably the most difficult they’ve ever faced. They realize if they are acute observers of the market, that expected rates of return are much, much lower than what they historically enjoyed. And they really need to find a way to meet those return objectives. One way is to reduce their costs, so they’re shifting their investments towards passive investments. The other way is to actually tactively and actively managing their exposure in a holistic way. And that’s the multi asset solution. So they are still trying to figure out what is the right way. I think what is clear is that they’re moving away a lot from active management. I think that is somehow a mistake. I think there’s a place in a portfolio for active management and there’s a place for passive management. But what we’ve been observing is that a lot of the boards and the trustees, they are becoming very shy about taking active risks, they’re migrating towards cheaper solutions and managed solutions. And so we’ll see.
Courtney: [00:09:11] Philip, how does one go about constructing a multi asset portfolio?
Philip: [00:09:14] Well, it really depends on what the client is looking for. So there’s several different things, what we like to think of as multi asset solutions is really outcome oriented investing. And what that means is whether an investor is looking at a longer time horizon such as target date retirement or income generating assets. Now, typically in the past, for equity, fixed income split, 60/40, doesn’t always provide the diversification that an investor really needs. So if we start adding other alternative sources of income such as REITs, MLPs, market bonds, we see that adding those assets to a multi asset solution can provide superior return and risk profiles.
Courtney: [00:10:06] Michael, how does one go about constructing a multi asset portfolio?
Michael: [00:10:09] It really begins with a conversation with the clients, understanding what really is the client’s risk tolerance, what is their return objective, what kinds of constraints exist on the portfolio outside of simply just saying we’re happy with 20% bonds or not 20% bonds. And once you understand really where the client is trying to go then as Philip said, it’s adding the asset classes that hopefully can achieve that objective in the right kinds of combinations. The most important part I think though is understanding that these models are not static. The world changes, risk happens, understanding how assets can interact with each other, understanding when hedges must be used, when risks must be understood and understanding again what the client’s tolerance is for risk and the kinds of loss that they’re willing to bear. I think should be the single most important deciding factor in deciding your asset allocation. It’s too easy to pick some mix which ideally on paper should return seven, eight, nine percent. But unless you understand the kind of risk you’re taking to get there, you may find yourself in a very different position a few years down the road than you’re hoping to be in. So hopefully you can express that to your advisor and your advisor can find something which actually fits your risk tolerance and can be realistic about what kind of return you can expect with that risk tolerance.
Courtney: [00:11:25] Michael, how do you go about constructing a multi asset portfolio?
Michael: [00:11:28] Well, we start, I think, with the most important thing and often private investors don’t really know about this, institution investors they’re much clearer about what their goals are. But we determine to expect the target rate of return for the client. And this target rate of return should be net of inflation and net of taxes, these are important if it’s a taxable investor. And there’s some calculations that you can do with your clients. You determine the rate of return. You determine the risk profile by doing a thorough due diligence and asking questionnaires. You determine the amount of draw downs that they can withstand because markets will correct and you want to make sure that the clients have the ability to tolerate certain risk. And you determine the time horizon. Based on these metrics then you construct a portfolio that achieves the best rate of return that you can achieve with the lowest possible level of risk. And there are different techniques that you can utilize. I think the most used is the mean variance approach, we don’t really subscribe to that because we do believe that often the assumptions about the recent history, they weight too much in those models and the future may be different than the recent past, so volatility tends to grow in clusters and they’re reducing clusters. So we have our own modeling and we build portfolios, we formalize the goals in investment policy statement and we work with the clients to make sure they achieve those goals.
Courtney: [00:13:00] Michael, how does the approach towards solution vary among plan sponsors? I want to start with corporates first.
Michael: [00:13:08] The corporate side I think is very focused on risk tolerance these days and I’ve bought risk several times now. But corporate plans obviously are not in the business of managing a pension system. Unfortunately in many cases the liability itself for the pension might exceed the market value of the company. And companies are finding that the cash flow to support the plan is highly variable and often dwarfs the earnings for the company. So the more you can actually control for that, the more you can manage your portfolio in such a way that you can stabilize those kinds of ups and downs in your funded status and in your contribution volatility. That’s incredibly important to corporate plan sponsors. Now, it’s been made easier, obviously the shift several years ago to a corporate bond discount rate made it significantly easier for corporate plan sponsors to select an asset allocation that can realistically achieve that required rate of return. And so the asset allocation we typically would look at for a corporate plan sponsor is one which really gets you from here to the finish line. Many corporate plans have a terminal date in mind, they’re closed, they’re frozen, there aren’t new entrants, the plan is considering shifting to a defined contribution plan, considering shifting to a cash balance plan, in many cases they already have. So a corporate plan sponsor knows this is the remaining liability, this is how many years I have left to deal with this remaining liability and the entire management process of that is trying to get again, the last five or ten yards to the goal line without taking any major losses or any major risks that really imperil the rest of the corporate balance sheet.
Courtney: [00:14:40] And what about a public?
Michael: [00:14:41] It’s entirely different for public plans. Public plans in most cases are infinite in nature, very; very few have closed the new entrants, if any have closed the new entrants. And public pension plans still have very high discount rates. The average discount rate for public pension plans in the US among the 134, I believe it is, state systems, is somewhere in the range of seven and a half to seven and three-quarter percent. Now if … and Michael, you can correct me if I’m wrong, but most people these days estimate … if you were to take a survey of consultants and investment banks and those kinds of things, and asset managers, most folks think stocks are going to get six, seven, eight percent over the next five or ten years. Bonds are probably three or four percent over the next five or ten years. So if you’re lucky, what combination of stocks at seven and bonds and three gets me to seven seventy-five. It’s very difficult for public plan sponsors to achieve those return goals given what really is going forward a constrained return environment. So public plans are thinking much more as far as how can they really get there from here? Where can they add alpha in their portfolio? Should they consider things like private equity as an alternative, hedge funds where they can add a lot of value somewhere else in the portfolio because just trying to use the old ways of doing things may not get them really to the promised land of higher returns.
Courtney: [00:15:55] And what about endowments and foundations?
Michael: [00:15:57] Well, they have to some extent a similar view to public plans. Most endowments and foundations are trying to return somewhere in the neighborhood of CPI plus five or so. Well, if you assume inflation is around two percent, that gives you a return target of seven. Well, certainly is in the ballpark of the public plans. Endowments and foundations however, have a very different risk tolerance than public pension plans, hence you see many of the large universities having half or more of their assets in illiquid asset classes that a public pension plan would never even consider. They can invest for the very, very, very long term, when they underperform in many cases the larger endowments can turn to their donors to make up the shortfall. Or they can simply cut the use of that endowment whether it be building on campus or they don’t give money to this cause or that cause, your endowments have a lot of flexibility to survive the lean years, a kind of flexibility that quite frankly public pension plans don’t have. Those cash flows must be made, the benefit checks must be paid and public pension plans have to live with the risk where endowments and foundations have a bit more of an ability to tolerate it.
Courtney: [00:17:02] And sovereign wealth funds?
Michael: [00:17:04] The sovereign wealth funds vary so much, it depends on the nature of the fund, where the assets are coming from, what they’re doing with those assets. In the vast majority of cases the sovereign wealth fund exists really as a store of the nation’s wealth. The first concern is we have some asset whether it be oil, think in the case of Alaska Permanent Fund, we have an oil resource; the money from that oil goes into a fund which will benefit the citizens of Alaska for all time. And every year the citizens of Alaska receive a large dividend check from the state. The first concern of a fund like that needs really to be risk control and not taking large losses, many of the residents of that state or many residents of foreign countries who also rely on their sovereign wealth funds, depend on those resources really to persist. So taking large amounts of risk in an unconstrained fashion can be very dangerous to funds like that. So in many cases you’ll find those funds to be far more weighted towards fixed income investments, lower risk equity investments, a lot lower rated than the alternative say than endowments and foundations would be. Again, simply because stability and aversion to loss, really needs to be paramount in the minds of a client like that.
Courtney: [00:18:14] And, Philip, through the lens of a benchmark provider, how does the approach towards solutions vary among plan sponsors?
Philip: [00:18:21] Yeah. You know it really depends on the type of sponsor that we’re looking at. And I agree with a lot of comments that Michael made. Public pensions, corporate pensions, especially at this time where baby boomers are starting to retire, these would be more considered like liability driven investments. They need to be focused on more current income streams, so there is a less risk tolerance for these types of sponsors. Where you look at endowments, these really are longer term so they have a higher risk tolerance. They can invest in, you know, more volatile asset classes such as private equity or hedge funds because they’re willing to accept that risk for the potential benefit that they provide.
Courtney: [00:19:07] Michael.
Michael: [00:19:09] Well, I’m a little bit concerned because from what I hear I think pension plans, a lot of the foundation endowments, they are projecting rates of return that are not realistic. I mean if you utilize the tools that historically have been able to forecast returns, if you use [unclear 00:19:27] in the US and abroad, if you look at the real interest rates now, if you look at the level of the yields, the spreads, there is no way you’re going to get that three/four percent on fixed income and you’re going to get six/seven percent in equities, it’s very unlikely. So I’m concerned. I’m concerned, I think that there is this movement escaping, you know, active management and that is probably one of the few ways we can try to supplement the returns that the market itself is offering with some alpha. But I think we will or not us, but I think many plan sponsors will be surprised, you know, over the next decade and there may be some shortfalls and there maybe some problems. Hopefully not, but that’s my concern.
Courtney: [00:20:19] Michael, does solutions providers tread on ground historically covered by investment consultants?
Michael: [00:20:27] To some extent, yes, certainly we’re all giving similar kinds of advice, what asset classes should you be in, where’s the outlook for one asset class versus another. Certainly Michael’s outlook for, I’m sure expected return for various asset classes differs than ours, differs from various consulting firms. But that’s part of the reason why you want the multi asset class solutions providers to be involved. Who says your consulting firm is absolutely correct in their expectation of stock returns? When a client engages with a consultant or in many cases, two or three or four consultants for a large asset allocation project, and they also include the work of a handful of solutions providers, you can arrive at a much more robust consensus for what might happen in the world. Relying on a single advisor can be very dangerous and it might make you myopic to simply that one advisor’s concerns or perspective. So consultants and multi asset class solutions providers really exist … they can coexist quite well in the industry as long as we respect the boundaries that either operates in.
Courtney: [00:21:33] How do multi asset solutions … what is their approach to risk and volatility, Michael?
Michael: [00:21:38] Well, I think that in our specific case, we look at the risk in different ways. I mean there’s the conventional standard way and that is used by the [unclear 00:21:52] which is volatility, the variability of returns. That is, I think, important, but … so we use that when we look at the multiple asset classes. But the truth is that the intrinsic risk of an asset class or an investment may be very different from what the volatility’s suggesting. In fact you do have for periods of time, volatility is very, very low in an asset class and normally the asset class becomes more richly priced and in fact the fundamentals of the asset class deteriorates. And then you have a bout of volatility for the following years. So we tend to look more at fundamental metrics of the asset class, you know, such as leverage, exposure, the underlying risks. And we kind of determine what the risk is. Now, we do have technical measures, the maximum risk that an investor should take within an asset class and the total maximum risk that they would take. And we do some probabilistic, stochastic assumptions to determine what is the optimum composition of a portfolio.
Courtney: [00:23:00] Michael, how do multi asset solutions manage risk and volatility?
Michael: [00:23:05] By really considering the wide variety of assets you’re combining together into one framework, understanding how those assets might perform in various environments, whether it be macroeconomic environments, stress events, future scenarios both rosy and sad scenarios and poor scenarios. But managing risk really needs to be a holistic consideration of a plan. And assuming that the past is always indicative of what will happen in the future, the correlations are static, the risk levels are static, can be very, very dangerous, so we rely… Well, we do, do projections based on expected return and expected risk numbers based on kind of metric projections like everyone else does. Using much broader assimilation sets and stress tests in your portfolio management to understand really what is the worst case. We’re in an environment right now where many assets really have been on a one-way [unclear 00:24:00] for the last five or ten years.
And while we hope that they keep on going in that direction, it’s increasingly likely that they might go one way in the other direction. So if and when that ever happens, what happens in your portfolio, because simply relying on the trend of five or ten years can be very, very dangerous. So you really need to take a much broader, again a more holistic view of your portfolio and engage with your clients. What are the biggest risks that you face? What are the biggest concerns you have about your portfolio in today’s environment, is it a rebound on oil prices? Is it a collapse in emerging markets? Is it an interest rate shock or rapid increase in interest rates? Is it overseas economies falling deeper into recession? What is the biggest risk that you’re concerned about? What is the biggest risk that has an impact on your underlying business? And which of those risks really is … can be managed in the portfolio?
Courtney: [00:24:50] Philip, through the lens of benchmarking, how do multi asset solutions manage risk in volatility?
Philip: [00:24:55] Well there’s several ways that passive investments can approach that. One major thing that we can do is look at a volatility target investment which dynamically allocates based on prior historical returns and risk volatility, dynamically allocates between cash and equities. And what this does is … what we’ve seen is this dynamic allocation will see that a stable volatility target of maybe eight percent, ten percent, twelve percent, that all depends on the client’s willingness to accept a certain level of risk. That’s one investment vehicle that can be used by investors to meet their needs for a risk perspective.
Courtney: [00:25:44] Michael, how do multi asset solutions improve transparency for investors?
00:25:49: [00:25:50] Well, to the extent that a solution is developed in conjunction with the client, the client has a much better understanding of what’s happening in that portfolio. Now, obviously clients can have custom guidelines for portfolios throughout their entire total fund. But if you’re creating something which again is custom to a client’s needs, especially if it’s been designed to prosper in certain environments, to mitigate risk in other environments, the client really understand exactly what the intention of that portfolio is. In other cases multi asset class solutions are being used as a surrogate for hedge fund investing. So clients in many cases have shifted out of hedge fund portfolios or funds of hedge fund portfolios and into multi asset class solutions. If your goal was to invest in hedge funds hoping to get five or six percent fairly consistently and now you’re going to a multi asset class solutions provider who Michael’s pessimistic asset class return assumptions notwithstanding, might hopefully get you five or six percent. You’re doing so in liquid assets and you’re doing so in a portfolio which you can get full transparency on. And again, which was developed in conjunction with your particular portfolio and needs. So the multi asset class solution itself compared to many other asset classes in which we’re investing, which wrapped together many disparate assets, really hopefully is custom tailored to your needs and therefore a lot more transparent to the client.
Courtney: [00:27:09] Michael, what’s your approach to providing transparency?
Michael: [00:27:12] Well, we manage money for investors and we give full transparency. So I think that they see all the positions in the reports online, they can call us if they have any questions. So we individually construct these portfolios with securities. So they see everything and we report quarterly. We’re trying to keep a frequency that is correct in our opinion to incentivize investors, not to focus too much on the short term. And we provide, you know comparisons with other investments and benchmarks and compare mostly on an annual basis, we compare our return and our risks to the goals that we set for the clients, that’s our transparency.
Courtney: [00:28:00] How do multi asset solutions improve costs for plan sponsors?
Michael: [00:28:05] Well, if you’re shifting from a hedge fund portfolio, again, to a multi asset class solution, I think the costs are pretty obvious, certainly the costs of a variety of long only asset classes are significantly cheaper than a hedge fund portfolio. Secondly, you have the question of scale, if you’re a client who’s putting together three or four or five different equity portfolios, a handful of fixed income portfolios, hiring staff to manage that or hiring a team of consultants to manage that, some kind of a tactical framework, you’ve a lot of small portfolios and in our business typically smaller is more expensive per dollar invested, than larger portfolios. So to the extent that you are partnering with the large institution and you’re handing over a large share of your assets, or large amount of assets for a single portfolio managed to a single purpose, the economy of scale really begins to kick in. You can draw heavily on that provider’s resources, draw heavily on that provider’s people and talents and at the same time given the size of that portfolio and the relative simplicity of having a single relationship versus several relationships should by definition be a less expensive proposition for you.
Courtney: [00:29:07] And, Phil, through the lens of passive providers, how do you reduce costs for plan sponsors?
Philip: [00:29:12] Well, passive investments in general have lower fee structures. There’s less decision making needed by the plan sponsors if they use a passive investment vehicle, these are all transparent based investments or indices. And what that leads to is just lower cost compared to more active based investing which requires more staff, more decision making, more market time and skills by these managers.
Courtney: [00:29:42] Michael, what approach do you take to reduce costs for your clients?
Michael: [00:29:47] Well, multiple approaches, you know, on the transaction side we use a prime broker services, so we seek best execution and reduce costs for investors. When we’re investing parties in products that have been provided by third parties, we are very, very focused and identify the best products with the lowest cost. And also for taxable accounts I think that a significant saving on the tax can be pursued by wisely timing your decisions of buying and selling securities and purchasing securities that are taxed more efficiently in taxable accounts. So there are multiple layers that go into reducing the cost for a client.
Courtney: [00:30:36] In five years, what do you think the role will be of consultants, portfolio managers and multi asset solution providers, Michael?
Michael: [00:30:44] I think there’s a big convergence coming between especially consultants and multi asset class solutions providers and obviously portfolio products in part of that conversation. Many of the consulting organizations and until recently I worked for one of them, are shifting towards the outsourced CIO business. It is more scalable than traditional consulting. And in addition, honestly, the consulting industry while you have excellent people there, the client base is generally speaking flat to declining. It’s a difficult industry to operate in given there has not been the creation of a new client really in the past few decades. So as a result the business has simply gotten more and more competitive and many firms really have shifted again, much more to the outsourced CIO model. At the same time you have now virtually all of the top 25 or even 50 asset managers have created some kind of a solutions business, in many cases it’s an advisory solutions business or at least a solutions business with advisory components which again treads on the same ground that traditional consulting firms were occupying. So again you’re seeing, I think, a very large convergence between the two while asset managers try to take on more and more of the client needs as part of a large partnership. And consultants are finding that quite frankly the asset management space might be more valuable as a future of their industry.
Courtney: [00:32:00] Michael, in five years what do you view the roles being of consultants, single portfolio managers and solution providers?
Michael: [00:32:07] It’s a tough one, tough questions. I think that the role of consultants will stay there. I don’t think it’s going to change. Maybe it’s going to be a little bit diminished, I think that the consulting world is especially within the institutional space, is necessary. I think that a lot of people would like to have a second opinion. Maybe it’s going to be the role of the consultant is going to be taken over slightly by solution providers. So I would say the borders between those two functions will kind of disappear a little bit. But you always will have a sort of external consultant CIO, or provider of solution that will work as a sounding board for the trustees and the board of whatever institution is making investment decisions. And portfolio managers, I think that they will … the ones that will remain they will keep on providing their expertise within specific asset classes. So I would say to summarize the big dynamic and change is probably the role of the solution provider and the consultant may become one or more similar over the years.
Michael: [00:33:30] If I can add to Michael’s answer, many public plan sponsors have the role of a general pension consultant written in the statute. So for them there will always be the need for that trusted fiduciary advisor. The overall business plan of the consulting firm as I discussed, as Michael discussed, may evolve more towards solution space and may converge again somewhere in the middle. But certainly at least to some level that traditional consulting role will remain.
Courtney: [00:33:53] And, Michael, I also wanted to ask you, do clients who are used to just working with a few consultants or maybe they’re used to working with a couple of portfolio managers, how will they embrace the multi asset solution providers? Will they just broke with one or many?
Michael: [00:34:07] It depends a lot on client size. If you’re a relatively small fund you probably don’t have the scale to engage with multiple solutions providers. And you may not have the sophistication at the staff and the board level to incorporate to the different perspectives and make use, to take advantage of honestly, the different perspectives that you’re getting in some kind of a tactical framework or a rather aggressive action by your portfolio. But the larger plan sponsors are already engaging with multiple perspectives. So think of a client who might have an asset allocation staff or a Chief Investment Officer and in a large a team below the Chief Investment Officer, those kinds of folks are looking for more input. It can be difficult. I mentioned a few minutes ago, there are 134 state systems in the US and there are hundreds certainly of city and county systems. But all of those various entities to have a complete robust staff that’s efficient to every need is difficult. It’s difficult to staff all these public pension plans to the level that many boards of trustees would like. The solutions providers as a result really fill that gap. The consultants obviously play a role as additional staff or adjunct staff and the solutions providers do as well, whether it be through the people or the providers. Or in many cases their asset allocation modeling, their risk modeling, their credit analysis, whatever it is, whatever unique skill set that the solutions provider has, they can bring to the table and really contribute overall to the client’s workflow process.
Courtney: [00:35:33] Michael, what’s your process for developing investment solutions that are tailored to clients’ unique needs and constraints in their pursuit of alpha?
Michael: [00:35:43] Okay. So the process as we discussed before is we identify the goals in terms of expected rates of return. We identify the tolerance for risk. We identify unique circumstances. We identify the tax status. We tailor a portfolio and the alpha historically has been added through security selection. And that’s not our interpretation. There is a lot of academic evidence. The alpha, it’s very difficult to add alpha by time in the market or peaking sectors. If you select the right securities that are very underpriced you can deliver exceptional returns. And you may add, you know, some shorting in your portfolio also of securities. So that’s the process for us, through a concentrated portfolio of securities that have the ability to outperform benchmarks with possibly lower risks.
Courtney: [00:36:43] Michael, what’s your approach to developing investment solutions tailored to clients’ unique needs and constraints in their pursuit of alpha?
Michael: [00:36:51] I think clients need to understand really what asset classes that they want to be in and what the risk tolerance is for those asset classes, and certainly understand their construction that they have of their [unclear 00:37:01] portfolio managers. The thing you want to avoid obviously is multiple portfolio manager overlap. For very large plan sponsors the kinds of plan sponsors that the Prudential tends to deal with on the solution space, if you have many, say equity managers for example, dozens of equity managers, the overlap can be rather counterproductive. So pick active managers where you think you have a real opportunity and not just equity managers, pick equity managers in any space, where you think you have real potential for consistent alpha and where the managers themselves have a unique skill set from the other managers in their space. So be selective in the managers that you choose, don’t assume that if you have 100 portfolio managers, you’re guaranteed of alpha across the entire portfolio, rather be selective. And that places the less efficient asset classes or the asset classes where again you think you’ve found some unique skill or unique niche, that’s the place really where you should be empowering your asset managers to find the alpha for you. In places where, through a question of scale or manager overlap where there really is far less ability to [unclear 00:38:06] consistent performance, then indexation makes sense. Reduce costs wherever you can and seek out returns wherever it’s most appropriate.
Courtney: [00:38:14] Philip, with passive investing, what is your role in helping shape the process to help develop investment solutions tailored to clients’ unique needs and constraints in their pursuit of alpha?
Philip: [00:38:24] Well, what we see as passive investments, we see that they’re a good building block to multi asset solutions. So if you want better exposure you can invest in a market based benchmark such as the SMP500. The next step up from that would be gaining exposure to risk premium factors such as low volatility, value, momentum. And the next step from that would be looking at multi asset strategy indices. This is one way to gain some sort of alpha based on rules based objective decision making skills. We see that persistence for active managers over time is not there, it’s very rare for an active fund manager to outperform the benchmark over time. That’s just one way to avoid, you know, the tendency to … and its objective decision making skills of you know, past performance really doesn’t necessitate that they’ll outperform in the future.
Courtney: [00:39:27] Michael, do multi asset solutions typically take an open architecture approach and include both passive and active investing?
Michael: [00:39:34] It depends on the firm. So if you’re talking about some of the larger firms that have a large index house owned within them, I’ll give some, I guess, competitor names, if you’re talking to State Street or to a BGI or someone like that who had a large index capability, their solutions products often will. If you’re talking to someone who does not have that ability, Goldman Sachs for example recently was hired to run an external equity manager portfolio for a large plan sponsor, that was solely active. So I think it really depends a lot on who you’re talking to and what kind of capabilities that they have. In many cases clients want exposure solely to what that manager can provide. If they wanted to hire external managers they already have a consultant in place and they would go out and they would hire five external managers. What they’re turning to their solutions provider for really is the unique expertise house within that single organization. And so in many cases it’s a captive discussion. Again, it varies from provider to provider, certainly from a compliance standpoint, from a transparency standpoint it is far easier for a solutions provider to invest in their own products or products over which they have complete control than it is to invest in the products of competitors over which they may have transparency issues, certainly compliance issues, overlap issues that make it very difficult to have as effective a portfolio of construction.
Courtney: [00:41:04] Michael, do you typically take an open architecture approach and how do you view active versus passive investing?
Michael: [00:41:11] Absolutely, we take, I think, that is the way to go. I think that in this day and age investors should get the best instrument that is out there to get exposed. The active and passive approaches we have a combination of both. In areas where markets are very, very efficient or the cost would not justify an active manager we would just go with a passive instrument. In areas of the market where historically you have had inefficiencies and inefficiencies you also have to put them in context of a time period, because over the long horizon markets are efficient. Over the short term they are also efficient but you have an intermediate window where markets may not be efficient. And that you want in those type of markets to use active manager. So it requires a lot of analytical work to identify where you want to place your active managers and where you want to be passive. But the combination of both is ideal for investors.
Courtney: [00:42:16] And, Philip, with passive investing, what role do you take with active managers, can you explain a little bit more about how that works?
Philip: [00:42:23] Well we really don’t play a role with the active managers in itself. You know, as far as that goes, you know, we publish reports, doing studies based on fund managers and how they perform versus certain market benchmarks. One of these reports would be SPIVA, and what we do is we look at certain time horizons, one year, three year, five years, and what we do is we group active fund managers and see how they perform against a benchmark. And what we see is they typically underperform, the majority, underperform over a long time horizon.
Courtney: [00:43:01] Can you elaborate on that, some examples?
Philip: [00:43:04] What I can say is, you know, the majority, especially in the US which is … this is a very prominent report that we put out, what we see is, you know, active fund managers just underperform the benchmark over a long time horizon. You know, what they say is the majority of portfolio return; almost 90% just comes from the market return. And that access return that active managers are trying to pursue, sometimes they take unnecessary risk to justify their increased expenses compared to a passive vehicle.
Michael: [00:43:41] If I may respectfully disagree. I think that obviously the figures that he’s quoting are absolutely correct. I mean particularly this year. This year is one of the years on record where you have the highest percentage of active managers in the US underperforming the market. It’s about 90% this year, is very, very high. The reasons for that in this particular year are that there’s been a huge discrepancy between the performance of large cap stocks and small cap stocks. In fact the small caps are negative for the year and large caps are positive. And a lot of active managers, they kind of invested … their best ideas are smaller medium cap companies. So they could not really beat the SMP which is normally their benchmark. And you have had very low volatility. So in years where you don’t have a lot of volatility there’s not a lot of dispersion of returns of individual oppositions. And these are the explanations for this year. In general his figures are correct, there’s some qualifiers.
And I would invite everybody to go and read the work of Antti Petajisto, an academic from Yale, he was at Yale when he published, I think he may have moved now. And that what he demonstrates is that the majority of active managers that underperform in reality, they’re closet indexers. You know, you have unfortunately a lot of incentives for portfolio managers, especially larger portfolio managers, institute of strong portfolio managers, not to deviate significantly from your benchmark because you have a lot of career risk. If you do very well nobody’s going to really recognize anything, so if you do bad you lose your job and you don’t find another job. But if you kind of study a subset of active managers, that they’re really trying to be active, but they’re not really looking at the benchmark, they’re bottom up looking at the individual securities that have exceptional risk return profiles. Those active managers, and he measures this level of active management through what he calls Active Share Petajisto. Those active managers on average, they outperform the markets. And on average the good ones, they outperform by a big margin and consistently. So I think that there are a few managers, there are very few, not too many that can. And I think the job of investment professionals is to identify those people. They will be maybe a little more volatile. They will be a little bit more outside the box in terms of how they invest. But I think there are some active managers, the minority of the active managers.
Michael: [00:46:27] If I can add to that with an analogy. I’ve seen many of these studies. I’ve been involved certainly with some of these studies in the past as well that showed just how hard it is. It’s also very, very hard to hit a 95 mile an hour fast ball. And the vast majority of people, certainly myself included, can’t hit a 95 mile an hour fast ball. But the mere fact that I can’t and very few people can, doesn’t mean that no one can, and that no one can consistently. So while, yes, the population of a given asset class, 70 or 80 or 90 or 60% of managers might quite consistently underperform doesn’t mean that there aren’t a few who can outperform. I also would argue that some asset classes are 95 mile an hour fast balls and some are 60 mile an hour fast balls. So you need to be very careful in painting with a broad brush that active management always works or it never works. There are certain places, especially outside the US, especially in some debt asset classes where one could argue the benchmarks are poor, no offence to SMP. But the benchmarks may not be all encompassing; there are sector biases, things like that which allow for more consistent outperformance and certainly the asset classes themselves have [unclear 00:47:31] advantages. So I think to find a middle ground between both folks here, there certainly can be a role for active management if you have confidence that you have the ability really to find those who can hit that 95 mile an hour fast ball more days than not.
Courtney: [00:47:46] And how pervasive do you believe the closet indexing that Michael mentioned, is?
Michael: [00:47:53] It’s fairly common, a lot of managers will have a large overlap with the index, especially in places … in larger cap portfolios you’ll see a lot often in the industry. I’ve seen numbers from investment managers showing 70, 80, 90% overlapped indexes at times. The real value can come from picking either manager who has very little overlap. So a 40, 50, 60 stock portfolio who really is trying to find unique sources of value in the marketplace, or if you like the closet index then you go to an enhance index manager. There are plenty of quantitative managers who do an excellent job finding small bits of value outside of the index. And there are 80 or 90% overlapping by definition. But if you were to go out and hire a portfolio of five or six hundred stock active portfolio managers and hope that in aggregate they’re going to outperform, you’re going to be sadly mistaken. So really again, find those that are truly unique and truly trained to add value or find those that admit that they’re closet indexing or enhanced indexing produces some unique skill set hopefully to add small amounts of value at the margin.
Courtney: [00:49:06] Michael, what role do alternatives play private equity, hedge funds in multi asset solutions?
Michael: [00:49:11] They play a role but they play a decreased role relative to the overall portfolio. So if some multi asset class solutions providers do have some alternatives available within them, it really depends on the firm itself. Now, in Michael’s case he was talking about the ability to have external relationships. And you have more opportunities there. For other firms, for a closed firm you are often depending on what they have in-house. So private equity requires a very specific skill set, hedge funds requires a very specific skill set and long only investing requires a very specific skill set. So hoping to seek all of those things from a single provider is going to be very difficult. Quite frankly I think you’re better off turning to your multi asset class solutions provider for thinking big picture, thinking about the 80 or 90% of your asset class that has market exposure that you can control those exposures in, help them assist you with overall asset allocation, help them assist you with overall risk mitigation. And if you want to add some value through a truly unique alternative at the margin, find a real dedicated firm that has true excellence and that ability as opposed to simply trying to squeeze it in with the rest of your assets into a single firm.
Courtney: [00:50:23] And do you believe that that would then go to the role of the consultant?
Michael: [00:50:27] It does.
Courtney: [00:50:28] In picking a great manager?
Michael: [00:50:29] It does. And that’s really what a consultant’s role is, is finding your external managers. And whether it’s your traditional consultant or it’s your alternative consultant, that’s their job, is to help you find the right private equity manager for you, the right venture capital manager. And in many cases like that, or in hedge funds, get you access to those managers as well. That can often be 90% of the battle is once you’ve found them actually trying to have them take your assets.
Courtney: [00:50:56] Michael, what role do private equity hedge funds, alternatives play within your asset allocation framework?
Michael: [00:51:03] They play a relatively small role. I think they do have a role, but it’s relatively small. I think. I do not really have much to add to what Michael has said, I agree with him a lot. I think that in the past 10 or 20 years a lot of the players in the alternative space, they have delivered results that were somehow correlated with the credit markets and equity markets. They promised to be de-correlated, they were not. And the returns, they were in the past higher because of leverage. Now that, you know, leverage has become a little bit less … not less common but less used and portfolio managers are a bit more prudent. They lever up their portfolio a little bit less. Those returns have kind of become a lot more meager and people are shying away. The truth is that you need to really find very specific good managers. It’s not, the alternative space as a whole is not a panacea to market volatility. I mean the investor needs to understand that.
Courtney: [00:52:09] Philip, what tend do you believe we’ll see in the next five-ten years with the role of passive investments with multi asset solutions?
Philip: [00:52:17] Sure. You know, I think as more and more investors become aware of what passive investments offer, they will see it as being more attractive, mainly because of the transparency, and also the lower cost structure, at least for a base core portfolio of multi asset solutions. So they can build, it’s basically a building block and then if they want to add some active exposure to their portfolio then they can go down that road as well. But we see that, you know, passive benchmarks can either be used as a benchmark for these active multi asset solutions or they can be used as a building block for a total portfolio.
Courtney: [00:53:00] Michael, what trends do you think that you’ll be seeing in the next five years in multi asset solutions?
Michael: [00:53:05] I think overall, passive investing, I don’t want to say it’s at a peak, because a peak implies it will decline. But at this stage you don’t really need to convince plan sponsors to invest passively. Those that have had a bad experience with active management are passive, and those that believe they want to reduce costs are passive. It sounds as if there’s an unsold marketplace out there full of folks who aren’t aware of the benefits of or the opportunity of passive management. So passive management has its role, certainly it has its role for clients who are seeking things like alternative beta solutions. They want exposure to a market factor, but they want to get so cheaply and they don’t trust active management. But I don’t believe that the role of passive is going to increase significantly as it’s already there. If anything you’re engaging with your multi asset class solutions provider to get something more. How do I, in the seven and three percent return environment, how do I get to seven seventy-five, what combination of assets gets me to that seven seventy-five, as I discussed public plan sponsors a few minutes ago. You don’t get there through passive investments. You get there through your multi asset class solutions provider finding you unique sources of alpha or finding you a way to hedge or tail risks so that the overall distribution skews towards the positive direction.
Courtney: [00:54:19] And, Michael, what trends do you think we’ll be seeing in the next five years with both passive investing and multi asset solutions?
Michael: [00:54:27] Well, I think that as Michael just said, the passive space has been exploding, you know, it started as just index instruments. Now you have smart beta, you know, you have quantitative models that rotate around an index and try to outperform. What we do know is that when an algorithm or a system becomes known to the market participants, the whole alpha that can be generated, disappears because everybody knows what it is, they’re going to mimic it. So you have these liquid alternatives in the form of indices. So you have all sorts of things that are coming to the market. I think the providers of these solutions, if they don’t achieve a certain scale they cannot maintain these instruments because that, you know, 10, 20, 30 basis points with a small ETF that is very niche in particular, it’s just not economically feasible. So I do think that a lot of the new names and new participants and new instruments at some point will disappear. They will be kind of consolidated into other products. And so a kind of rationalization of the industry, so the good ones will stay in … they will have their place in the portfolios, but a lot of the names will disappear in the next five years. At the same time, I do believe that thanks to the Federal Reserve and the European Central Bank we’ve experienced an incredible period of low volatility. During periods of low volatility it’s very difficult for a good manager to shine. I mean it’s not … everything goes up and they cannot really do their work. I do think though over the next five years we will start to see more volatility as you know, the monetary policies change around the world. And you may have some crises. And I think there may be a return to some active managers, that they can prove themselves over the next five years to deliver a certain type of results.
Courtney: [00:56:28] Michael, do you have any comments on the central bank divergence and any of the macro trends that we’re seeing and how that will shape multi asset solutions in the next years to come?
Michael: [00:56:40] I think it’s where to encourage clients to engage with more points of advice. I’m not going to say it’s going to be a driver of just the multi asset class solutions business itself, as the head of one of those groups, it’s a little self-serving. But it does [unclear 00:56:54] clients to get more points of advice just in general from the consultants, from the other advisors, from single product managers, from multi asset class managers. The world is no longer operating as a truly free market in many cases. I’m thinking about what’s happened with bonds over the last several years, the central banks have really controlled interest rates within a certain band, for an extended period of time, far more so than in the typical recession. So understanding how you deal with that environment, understanding what things are going to look like when these policies begin to unwind or if these policies exacerbate as we might see overseas over the next few years, means that plan sponsors who are trying to position their portfolio around these issues or time their movements around these issues, need to seek as many points of view as they possibly can. So to the extent the multi asset class solutions providers have a broad perspective, I can talk about more than just one asset class, may actually have the ability to offer alternate ideas into a portfolio, other asset classes you hadn’t thought of, other ways of hedging risk, of gaining or reducing exposure to a particular risk factor in the industry. That’s a great role that multi asset class solutions providers can play as again, just another knowledgeable voice in the room, to hopefully lend some perspective to what large plan sponsors can accomplish.
Courtney: [00:58:13] Michael, your final takeaways?
Michael: [00:58:15] The multi asset class solution space really is a way for plan sponsors to think about their entire portfolio. For so many years now it’s been a relatively easy ride, stocks have had a tremendous run for the last few decades, obviously twin crises of the past 10 years notwithstanding. But those crises have opened plan sponsors eyes to the fact that the run of the 70s and 80s and 90s doesn’t persist forever. And we’ve a far more difficult cash flow situation now where obviously it seems like a different set of risks arising every day. The ability to engage with a trusted advisor who can think about a lot more than just a single portfolio or a single product, who can think across your entire portfolio, who can help you see things in a different light and can lend a different voice to the conversation. As well as possibly the ability to hedge particular risks or hedge or minimize or exacerbate given exposures in your portfolio can be an incredibly valuable part of the investment conversation. So multi asset class solutions in our opinion is a tremendous growth opportunity in the industry as plan sponsors again seek more voices in the conversation, not fewer. Those voices really are going to have to come from people who have that global perspective that can actually add to the conversation.
Courtney: [00:59:21] Michael, your final takeaways?
Michael: [00:59:24] My final takeaway is that at the beginning of the year if you ask any person, any investor what the 30 year treasury would do this year, they would never have thought it would be one of the best performing asset classes. So good investors know the importance of diversifying, of being exposed to different asset classes, so if this year if you did have the 30 year treasury in your portfolio along with equities, along with other assets classes y