Take risk, seek alpha: that's the message for Asian insurance companies and central banks from Robert Litterman, the New York-based head of Goldman Sachs Asset Management's quantitative resources group, who is touring the region. His trip is to raise the firm's profile, highlight various active management strategies, and also promote a textbook he and his team recently published, a weighty tome titled Modern Investment Management: an equilibrium approach.
In the introduction to A Brief History of Time, physicist Stephen Hawking recalled being advised that sales would be halved for every equation he included. In the end, he included only one, e=mc2, and the book was a blockbuster. Based on that rule, the prospect of Litterman hitting the New York Times' bestseller list is slight. However, what he has produced is a comprehensive and updated guide to modern portfolio theory, and a reading of the first few chapters suggests it is reliable and pragmatic.
Moreover, the book is timely. Low interest rates and lousy equity markets have put institutional investors in a jam, and they are looking for solutions. GSAM's take is that Asian institutions need to increase the risks they take and go for alpha (perhaps via funds or services provided by GSAM).
The dotcom bust has led to a reassessment of the long-term returns equities provide. "We've determined a globally diversified equities portfolio's returns are pretty modest, around 3.5-4.0% over the risk-free rate," Litterman says. He argues that equities dominate an investor's exposure to the capital markets, because these reflect expectations about an economy's growth, and other asset classes must be considered in light of their beta with respect to the total equities universe. "In other words, what is the active risk?"
Despite headlines last year noting bonds outperformed equities since 1987, Litterman argues that in the long run (say 30 or 50 years), the market (equities) reliably produces a positive return. But that return is lower than previously believed, the return per unit of risk (the Sharpe ratio) is also low at 0.2-0.3, and volatility is high, 15-20%.
GSAM argues that for most portfolios this isn't enough, and that institutions need gains from uncorrelated risk - which means they need to take on active risk. The sum total of alpha across markets is zero (it's just the market), so achieving excess return requires skill, which costs investors money.
This raises the question of how worthwhile chasing alpha really is. For a long-term institution, active management requires performance that consistently is net not only fees, but the inevitable mistakes of choosing the wrong money manager - for studies consistently show that managers almost never remain in the top quartile over time.
Litterman concedes that passive management is a legitimate course, but notes that most investors still put the bulk of their assets into active strategies. That has changed over the past decade, which has seen passive mandates balloon - but recently, over the past two years, more passive funds are shifting into 'enhanced' mandates, a product that falls under Litterman's group.
This cycle varies in Asia, where fewer institutions have embraced passive investing as in the United States. That partly reflects the fact that in less efficient markets, active managers have more opportunities to exploit anomalies.
Philip Gardner, vice president and the regional head of GSAM in Singapore, says Asian clients may leapfrog instead. "We see clients going from active management straight to enhanced," he says.
GSAM doesn't argue that active monies should go to enhanced strategies, however; Litterman says investors should seek higher alpha and take on risk. This message is easier to get across in Asia, where investors are reasonably happy with active managers, unlike American pension funds or European insurers, which have gotten burned on large-cap equity positions.
"Central banks and insurance companies in Asia are more fixed-income orientated," Gardner says. "Equities are less meaningful." He notes that in the US, a typical pension fund has 40-60% of its assets in equities, versus 0-20% for Asian insurers, while Asian central banks are almost completely invested in fixed income. GSAM is suggesting to them that they need to boost alpha, but not necessarily via a traditional equities exposure.
Instead, the quant team is pitching other ideas, including overlay strategies and alternative investments such as hedge funds. Commodities are now hot, given their high returns and negative correlation to equities and bonds, and two or three of the region's savvier central banks are considering such investments.
"It's not about balance sheets, because Asian institutions are in surplus," Gardner says. "It's more about total returns, which is a similar conceptual framework to investing in hedge funds."
The product that GSAM talks the most about now, however, is global tactical asset allocation. TAA, much hyped in the 1980s, became a dirty word afterward when TAA managers were wrong-footed by the post-87 bull market.
Litterman says GTAA is more general, more flexible, more diversified, and less concerned about market timing. A GTAA overlay manager invests in a mix of global equities, bond and currency futures contracts, with a view to weight portfolios in those asset classes that are performing relatively better. GTAAs tend to use the most liquid, one-to-three month futures contracts to go long or short. The product can be packaged in a variety of ways, coupled with straight currency overlay, hedge funds, balanced mandates or enhanced cash mandates. The idea behind GTAA is akin to hedge funds, but GTAA doesn't require a prime broker or other infrastructure.
Currently GSAM manages about $20 billion worldwide in GTAA strategies. So far it claims one insurance company in Asia Pacific as a GTAA client, with a few others looking at it. Gardner expects the idea to catch on in Australia first.
GSAM also likes this concept because there are not that many serious competitors, unlike most other services. BGI, Bridgewater, Deutsche Bank, Mellon, Morgan Stanley, Mellon Financial and State Street are among the few players with this capacity.
