How to invest when inflation and deflation are possible

Institutional investors need to weigh extraordinary short-term opportunities against their strategic asset allocations, according to experts at sister publication Pensions & Investments’ round table on how the liquidity crisis has affected asset allocation.

“From our standpoint, it looks like there is a real tension between longer-term investment objectives and short-term liquidity needs,” said Hartley R. Rogers, chairman of Hamilton Lane in Bala Cynwyd, Pa.

“One thing that does keep investors awake at night” is whether there has been “such a tectonic shift in asset markets” to require changes in their strategic asset allocations, said Rumi Masih, managing director and head of the strategic investment advisory group at JPMorgan Asset Management in New York.

Still, short-term tactics can go too far, he said.

“When you think about what has happened and the gravity of it, the magnitude of it, you can fall into this trap of letting your tactical [bets] sway your strategic decisions,” Mr. Masih said. “Are we just shuffling the deck chairs on the Titanic here?”

However, pension fund officials on the panel predicted that most changes will be at the margins. Michael Travaglini, executive director of the $37.8 billion Massachusetts Pension Reserves Investment Management Board in Boston, said that fund officials intend to launch an asset liability study around midyear, but he doesn’t expect the changes to be “revolutionary.”

The round table was held Feb. 10 in New York. The other panelists were Nancy Everett, chief executive of General Motors Asset Management in New York, and Cynthia F. Steer, chief research strategist and managing director, fixed income, of Rogerscasey Inc. in Darien, Conn.

The problem for institutional investors is that the rules of the game changed during the economic meltdown. Standard tactics such as portfolio diversification struck out as seemingly uncorrelated asset classes fell in unison, with little relief expected from flagging alternative-investment strategies.

“We used to spend a lot of attention in our asset allocation exercise trying to understand the correlation between different asset classes, and we would always take some comfort that diversification would serve us, regardless of the broader capital market environment,” Mr. Travaglini said. “And, certainly, for the last part of 2008, that did not provide any comfort.”

But institutional investors believe in modern portfolio theory and thus expect returns from various asset classes will revert to the mean, Ms. Steer said.

TWIN THREATS

While asset allocation studies look 10 to 15 years out, Ms. Steer thinks that investing conditions will be very different for the next five years because of the threats of deflation and inflation occurring at the same time.

“I think you look at the glass half full as well as half empty. There are possibly more opportunities than we have seen in multiple generations, and we have to look both ways to make money for our constituents, as well as to provide new risk parameters if necessary,” Ms. Steer said.

Pension executives don’t expect dramatic changes in their portfolios.

“I think you have to separate the asset allocation from maybe a tactical, more strategic [investment],” Ms. Everett said.

Even so, Ms. Everett, who helps to oversee Detroit-based General Motors Corp.’s $84.2 billion pension fund, said that GM pension executives “don’t see a significant change in our [long-term] expectations for different asset classes.” She said that any changes would occur around the edges of the allocations.

For example, they could modify investment guidelines to allow debt managers to hold more mortgage-related securities, Ms. Everett said.

Still, pension executives find their plans much less funded than when the crisis started, and that will lead more pension funds to adopt liability-driven investing approaches, though perhaps not while interest rates remain so low.

“I think what has clearly changed, and I will be the broken record on this, is the awareness of the liability side,” Ms. Everett said. “When you think about the assets and the liabilities together, you do often get a different answer than you might have in just looking at the assets in isolation, or even in the traditional sense of an asset liability study.”

Pension fund assets are down significantly — as much as 25% or 30% — but liabilities haven’t changed, Mr. Rogers said.

“So, you have three choices: You can live underfunded for a while, you can make it up by raising taxes or getting corporate contributions, or you can earn your way out of it,” he said.

Round-table participants also suggested that the investment portfolios for different types of institutional investors will diverge going forward.

“I think the path for [endowments and foundations], for defined benefit plans, for defined contribution plans and high-net-worth individuals are very different because of the assets they hold and the mixes they hold in there,” Ms. Steer said. “And the liquidity crisis has really separated out the E and Fs from the DB plans for a long time, if not -forever.”

But a decade ago, pension plans were “getting a bad rap” because they weren’t following the endowments’ and foundations’ game plan. Pension plans were heavily invested in stocks, while endowments and foundations had exposure to alternative investments.

VARIED INVESTMENT GOALS

Although the asset allocations used by pension funds, and endowments and foundations did begin to resemble one another, the same investment model was never really the right answer for all institutions because their objectives differed, Ms. Everett said.

“There will be those investors like publics who are trying to replicate the Yale model, the endowment model. I think they will look under their magnifying glass a bit more now and say, ‘We really need to get our education right,’” Mr. Masih said.

Mr. Travaglini objected to the implication that pension funds — especially public pension funds — tried to replicate the so-called Yale model.

“The notion that a fund like MassPRIM is in alternatives because we want to look like Yale or Harvard or an endowment is just so presumptuous that it’s offensive,” he said.

“Nobody sat around our table in Boston and said, ‘We need to look like Yale’ or ‘We need to look like Harvard,’” Mr. Travaglini said. “We said 81/4 [%]; that’s a pretty aggressive total return to try to get year on year.”

Panelists differed as to whether investors should beef up their cash allocations to add greater liquidity to their portfolios.

Most opposed creating or beefing up a cash allocation. Ms. Everett said that cash is a “particularly unattractive thing to be holding in your portfolio” with interest rates effectively at zero.

However, investors could use derivatives to create more liquidity.

Ms. Steer held the minority position.

“I must be the only one in the room to think that cash is important,” she said, adding that even so, whether to have a cash allocation depends largely on whether the institution is “in the capital preservation mode or in the return-on-capital” mode.

“And I’m not sure we can answer that yet,” she said, adding that Rogerscasey is recommending a cash allocation of anywhere from zero to 20%, “depending on who you are.”

Within that, she has defined four tiers or subportfolios: “A bulletproof cash, which is really the highest level; then some of the [Troubled Asset Relief Program]; the commercial-paper programs; and there’s also a fourth level — many of us are holding assets that we need to restructure in the debt area, and that’s another form of cash.”

Mr. Travaglini said that while he doesn’t disagree with Ms. Steer, the key is to separate strategic allocations from liquidity needs.

“Rumi and Nancy talked about how the investment theory of holding cash makes no sense,” he said. “Cynthia’s made a great case for those plan sponsors that are going to have a need for liquidity that they haven’t historically had; [they] are going to have to think about melding the cash needs with the investment theory in ways they haven’t been forced to confront before.”

Arleen Jacobius is a reporter for sister publication Pensions & Investments.