Getting Reacquainted With Risk

Pfeifler: This is one of the few times when there are very, very smart people I respect on both sides of the recession -- bullish and bearish. But I have never seen anyone able to predict the economy on a consistent basis. So I typically don't try to make huge calls on the economy. My general view is that people tend to underestimate its resiliency, whether it's the U.S., Europe or emerging markets. I have found it isn't a good bet to bet against the resurgence of some type of economic growth. That has historically been the case, and I expect it to be the case going forward. Looking out two to five years, I think we will have at least moderate gross-domestic-product growth on a global basis. It may be driven more by emerging markets than it has been historically.

What kind of GDP growth?

Many of the estimates for next year are for 2% to 3.5% global GDP growth, which seems reasonable. In that context, longer-term equity-market performance perhaps won't be as strong as it has been historically, but it will be attractive for investors.

What are your thoughts about the stock market?

When the market bottomed in March, it really was the exact opposite of what we saw in late 1999 through early 2000, when valuation wasn't a concern among most investors. If you had a discussion about price/earnings multiples, they didn't want to hear about it. It was just, the market was going up, and they wanted to participate. Valuation did not matter.

At the beginning of March -- as the market bottomed -- for our clients and I think for most investors, it was not about valuation. Companies were cheap, but investors were pricing in negative growth and very poor economic data for years, and valuations were at very low levels. But people simply didn't care; they didn't want to talk about that. They just wanted to get out of the market. So it was a mirror image of what we saw in the late 1990s.

My sense is that we have kind of moved away from that as the market has rebounded. But I'm still of the belief that for the longer term, equity-market exposure and risk-asset exposure will provide the most attractive returns -- but not necessarily looking out just a year or so. Often, professional investors get very focused on the short term. But looking out three to five years, I still think that equities, credit, and certain alternative investments will provide the most attractive returns, and certainly better returns than one can get in cash or government bonds.

What concerns are you hearing from your clients about their portfolios?

People are still very scared, though there has been some wading back into the market. I read recently that there are net outflows for equity mutual funds this year. Our clients have exhibited a modest willingness to re-embrace risk. When I say risk, I mean equities, credit and hedge-fund strategies, which have steadily come back since March. People typically do invest by looking in the rearview mirror, and they want to at least see a pattern of stability on a historical basis -- and they are starting to see that now. But many people out there, both professionals and among our client base, believe that there are real problems in the economy -- and that we may see some type of pullback in equities. That is preventing people from committing more fully.

How is that caution manifesting itself in investors' portfolios?

More cash, and a willingness to allocate more money to bonds, versus pure equities. There is also a desire to keep greater liquidity in the portfolio. And there is less desire, at one extreme, for long-duration, private- equity vehicles that typically have 10- or 12-year lives. There is more interest in hedge funds. But when investors do allocate money to hedge funds, they are keenly focused on liquidity, whereas in the past there was more emphasis on having access to a good manager. Now it is about access to a good manager, but they want liquidity with that manager. Investors are also less focused on real estate, which is nonliquid.

Turning to fixed income, where do you see the best opportunities?

One theme is in the financial sector, where we have been buying a number of fixed-to-floating-rate securities. The issuers are high-quality financial institutions in the U.S. and Europe. Many of these securities were trading anywhere from 70 to 85 cents on the dollar; now many are between 80 cents and par. When they become callable in 2017 or 2018, for example, they convert from a fixed-rate to a floating-rate instrument, typically paying Libor [London interbank offered rate] plus 200 to 400 basis points [two to four percentage points]. The securities could be called at or prior to the call date, in part because a number of these banks lose the equity-capital designation of these securities when they become floating-rate instruments.

Should these securities be called, the capital appreciation could be between three and 15 points, depending on price at purchase. Earlier this year, when the securities were trading lower, capital appreciation represented the lion's share of the trade's potential return. Currently, as the securities' prices have moved closer to par, it is more of a current-yield play, as the coupon is still quite attractive.

The other area we like in fixed income is where we have a view on the company or on the industry and the security is trading at an attractive spread, based on historical levels. My view is that there will be continued normalization of credit markets looking out two to three years. Spreads probably won't move back to the tight levels that we saw in 2007, but they will tighten from where we are now. I think we are about three-quarters of the way through the spread-tightening we are going to see.

Where do you see equities opportunities?

Prior to the bounce that started in March, there was just no concern about valuation, as I mentioned. You had great franchises that were being priced for zero growth over the next three to five years, but many of these companies had very attractive dividend and cash-flow yields in the high single digits. Assuming any type of normalcy in the economy, high-quality names were priced far too inexpensively, and lower-quality names were being priced to go out of business. Basically, any company needing access to capital markets was being priced for potential bankruptcy. Then, all that changed. So it isn't surprising, given that exposure levels were very low in risk assets -- particularly higher-beta equities [those more volatile than the market], that the first thing to rally was those companies most leveraged to capital markets.

But that rally in lower-quality names, and even cyclicals, looks extended. So we are shifting to high-quality, large-cap names, typically global franchises with steady cash flows. A number of these companies are still trading at around 13 to 16 times earnings, with 5% to 8% free-cash-flow yields. Compare that to a U.S. government bond yielding around 3.5%, and it's a good risk-reward for individual investors.

What about emerging markets?

I am quite bullish on emerging markets and their long-term prospects. I wouldn't be surprised if emerging-market equities outperform developed-market equities by three to five percentage points a year over the next five to 10 years. So I'm inclined toward these global-franchise companies -- whether they are domiciled in the U.S., Europe or wherever -- that have high, or increasing, exposure to emerging markets.

Are you concerned about equities getting too frothy?

That brings up an interesting point, and it ties in with alternatives. Some of these cyclical names have rallied a lot, and are now pricing in quite robust economic growth looking out to even 2011. So there is an opportunity for a number of our long-short managers to make money by going long some of the higher-quality names or shorting some of the names that have run too far.

While we wouldn't short equities within our discretionary portfolios directly, we absolutely do look to put money with alternative managers who have that shorting component as part of their strategy.

What kinds of hedge funds do you invest in these days?

It could be long-short equity, global-macro or credit funds, typically with managers that hold publicly traded securities, versus private equity, venture capital or real estate. Some of the best talent continues to migrate to the alternative landscape.

On the whole, alternative managers probably do more in-depth research. Also, with the reduction of principal trading activities at the Wall Street firms, there are fewer dollars chasing the same situations. You see this in merger arbitrage; spreads have widened to attractive levels once again. So there are opportunities just because there is less money chasing any new deal.

Early this decade, as hedge funds boomed, there was much talk about absolute returns. After the market tanked, the emphasis was on relative returns since hedge funds on average lost less. Thoughts?

There were people who perhaps sold some of these products as absolute-return vehicles, but they shouldn't have. And they did that because the historical pattern was something that had decent absolute returns. At the same time, there were individuals who bought these products as absolute-return vehicles when they shouldn't have.

In a normalized equity environment, where returns for equities are between 7% and 12% in a given year, which has been the long-term average, alternative managers are likely to perform just as well as long-only indexes. In situations like this year, when equity-market performance year-to-date has exceeded long-term averages, hedge-fund performance should provide 75% of the upside. In years like 2008, when equities were down considerably, hedge funds, while negative on an absolute-return basis, did outperform on a relative basis, despite the perfect storm of investor withdrawals and funds' reduced ability to borrow from their prime brokers.

Are you putting money into bigger hedge funds with longer track records, or smaller funds with shorter tenures?

The majority of our exposure is long-short equity managers. We try to focus on certain sectors where we think there is good opportunity. For example, we allocated money toward long-short equity managers around the end of last year and the beginning of this year that had a specific expertise in financials. There was a lot of dislocation in that sector and, therefore, the people who knew that sector the best would be in a position to more effectively pick winners and losers.

We were a little too early in credit, which we started allocating to in the fall of 2008, but we continued to increase our exposure through 2009, and only recently started taking some money off the table. We found some attractive opportunities in distressed debt, starting in May and June of this year. We have less exposure to global macro and CTAs [commodity-trading advisors].

Why do you avoid those strategies?

It is hard for us to invest in black-box strategies. There needs to be a higher reward for the risk you are taking with illiquid investments and/or any type of strategy where you don't have a high degree of transparency. Most of our long-short equity managers give us that high degree of transparency. We know on a monthly basis what their exposures are, including their top holdings. We feel that we know what is going on, but that is less so with CTAs, global macro and some of the other strategies.

What about funds-of-funds, which have an extra layer of fees for investors?

If someone has less than $10 million to invest in alternatives specifically as an asset class, we typically go the funds-of-funds route. I view an alternatives portfolio like an equity portfolio. There is a minimum number of funds you need to invest in to gain sufficient diversification. You don't necessarily need to have exposure to 50 or 60 funds. But it's probably advisable to have at least 10 to 15 funds, given that the minimum requirement for most managers is $1 million.

Do you find that the best managers are upstarts or firms with, say, $5 billion or more under management?

The data would suggest that some of the larger funds have actually performed pretty well, even as they've gained assets. Having said that, I am a big fan of long-short equity funds whose size is around $1 billion to $3 billion. Even though a lot of managers will say that they have very liquid portfolios, it is much more difficult to manage a $5 billion long-short equity portfolio than a $1.5 billion portfolio. When you are at $1 billion or $1.5 billion, you typically have been doing it for a number of years, and you have a big team. You have best practices in place, unlike, perhaps, someone with $70 million or $80 million in assets. Yet, you are still at a level where you can be quite nimble.

My favorite fund would be someone who has been closed for a long period but who has been managing money for seven to 10 years. And maybe they've seen some redemptions because people are getting out of hedge funds; we saw that happening earlier this year, because the funds of funds were pulling money out. So we've tried to use openings at those funds to put money to work.

Are your hedge-fund investors adequately compensated for risks such as gating, which lets funds restrict redemptions?

We try to do a lot of work up front in terms of who we invest with and knowing the types of portfolios we are investing in. It is not surprising to me that a number of hedge-funds have gated, because you can tell a lot about people when you sit down and get to know them -- how they are going to manage their portfolio and what their focus is. We sit down with managers, and frequently we come away from those meetings thinking that the focus of the manager is not necessarily on the investors and their returns, but on growing and maintaining their business. That was reflected last year in a number of those managers who put up gates, because they're more concerned about the ongoing nature of their business than they were about the investors. We avoided a lot of that because we spent considerable time up front really trying to understand the motivation of the hedge funds and whether they value the investors.

So, yes, gating is another hurdle that you have to consider when investing in alternatives. But if you have a very high-quality group of managers, the advantages -- less volatility, an attractive return over time and access to strategies not readily achievable by going long stocks or bonds -- outweigh the negatives.

Thanks, Brian.