The Biggest Threats to a Pension Fund's Growth (w/ Jim Keohane)
ED HARRISON: Because you were talking about liability driven investing. And there were some other things that you talked about. I want to talk about what you are able to do that individuals aren't able to do. And in particular, I'm thinking about your asset allocation mix as well as some of the other things you were talking about. What, as you think about when you got into the business in '99 versus now, what's happened in terms of the asset allocation mix? And how is it different than, say, I, as an individual, would be able to invest? JIM KEOHANE: Well, just an example, we went through this exercise after the 2000 tech meltdown. And we went very quickly from having a surplus to a deficit. And when we unpacked that, we can see that first of all, there was way more risk in a portfolio than we thought. We had the traditional 60-40 equity plan at the time. And most of the risk came from mismatched between the assets and liabilities. So we had a situation there where interest rates went down, so our liabilities went up, and our assets went down. So it was a perfect storm. And that time, it was accepted that that's just a risk of being in the pension business. And we thought, well, surely, we can manage that more effectively. And so we started thinking about ways to better align our assets and liabilities to take away some of those major risks. And in our previous exposure with derivatives, it really allowed us to think about the portfolio in very different ways. And derivatives allow you to break the portfolio down of its component parts. So I think about the capital asset pricing model, which sells risk brief was beta plus alpha. So a risk brief for us is essentially long term bonds. Beta is whatever exposure risky assets you want to get, which you can achieve through the use of derivatives. And alpha is just management strategy. So the two biggest risks probably most pension funds have is actually, equity markets exposure and interest rate risk. And both things those scenes come from moving to having equities in your portfolio. So if you think about the least risk in a position we can have is owning bonds, right? But that doesn't produce enough income to actually-- the plan would be unaffordable if that's what you have. So if you don't use derivatives, the only way you can get exposure to equities is to actually to sell your bonds and to buy equities. So not only do you take on equity exposure, you actually create a big interest rate mismatch. So if you use derivatives, you actually do an overlay. So you can go leave your money in bonds and then just do equity overlay on top of that. So using equity futures swaps or options. So that's essentially what our portfolio structure is. We have a whole bunch of interest rate sensitive and inflation sensitive assets that hedge your liabilities much more effectively. And then we take on other risks in an incremental way using derivatives to gain those exposures. So that combination is actually less risky than if you had a traditional portfolio. So that's an example of things that we can do that you could not on your own. ED HARRISON: Right. And what about the alpha component of that mix? Because I know that that mix that you're talking about gives you less volatility. But I think you also said that there is more upside as well. You have almost the best of both worlds. JIM KEOHANE: In fact, what we've done is-- so there's three big risks which you're trying to hedge, which is inflation risk, interest rate risk, and equity market risk. So we're trying to control those risk more effectively. And we're trying to take other risks that are maybe more quantifiable and that if the worst case scenario plays out, it doesn't actually have a catastrophic impact on a plan. Whereas those other risks actually would. ED HARRISON: Right. JIM KEOHANE: So we entered into a whole bunch of absolute return strategies, which typically we would be used in a hedge fund world. So we'll do equity long shorts, credit long shorts, funding trades. We have a list of about 20 or 30 different things that we'll work on. And we may not have all the macro due at any point in time, but it's a diversified portfolio of absolute return strategies. So those strategies themselves actually produce enough return that then enables us to take our equity market risk down and still achieve the same level of return. So our equity market exposure is about 35% the portfolio while most people, it's more like 60% or 70%. ED HARRISON: Right. JIM KEOHANE: So if we had a big equity down market next year, we wouldn't lose anywhere near what our peers would lose. Now on a big up year, they're going to do better than us, but we're OK with that. ED HARRISON: Right. JIM KEOHANE: So it's intentionally making that trade off.