A little over a week ago, CalPERS, the largest U.S. pension fund, with some $300 billion in assets under management and a formidable direct and indirect stamp on global economic development, revealed how it is now using a new mantra to evaluate the performance and risk across its complete portfolio.
The new measuring stick, according to CalPERS chief operating investment officer Wylie A. Tollette is “repeatable, predictable and scalable”. Eerily similar to the attributes of Renewable Economics™ , I have been stewing on and preaching for many years, and in its formative stages (2008-2010) have extensively communicated to former CalPERS board members, the former Chief Investment Officer (R.I.P. Joseph Dear) and members of his investment staff.
I never expected an immediate implementation of my discussions because it is hard for pension funds to be unconventional and nimble while carrying the awesome responsibility for pension payouts that shall not be jeopardized. And so I was pleased to now see new CalPERS CIO Ted Eliopoulos carry out a new mantra so closely aligned with mine and what appears to be some new standards of investment prudence.
The recent recalibration exercises at CalPERS tagged hedge funds as non-scalable and reduced private equity (including venture capital) investments to merely three new management firms (down from ten in 2001). The latter soon measured by lower (external) benchmarks as a result of lagging past performance.
Neither hedge nor private equity contributes to a significant stake in the overall asset management allocation of CalPERS. So, pension payouts are not in danger because of the poor performance of these relatively small and seemingly insignificant asset-classes.
Seemingly, as their failure is an ominous sign of financial engineering reaching the end of the asset management rope. Also, because private equity asset classes with risk deployed discriminately, drive a significant amount of renewable socioeconomic value upon which a thriving economy depends.
The challenge for CalPERS and other institutional investors is that – counter to popular perception – investment allocation performance is not at all tied to the propensity of investable assets as it should, but instead dangerously tied to a “religion” of asset management I refer to as the musical chairs of asset management. The absence of which allows Warren Buffet to outperform institutional asset managers hands down.
Asset managers dance to economic music in circles around asset-class chairs with a few too many asset managers eyeing to take an empty seat. Many will be unable to sit down (and make their assets work) when the music stops, and the tallies are counted. Another asset-class chair is removed before the music starts up again, with soon yet another group of asset managers unable to find a chair and unable to make its investment allocation to an asset-class workout.
Upon close examination, during my 5-year investigation with the world’s top asset managers, I discovered how asset management had become a game of financial escapism where the assessment of total risk, the risk of the full value-chain, is downright ignored. Wide in circumference yet shallow in depth is the prevailing risk model in the investment allocation business. For most risk is embedded in the asset management operating model, incurred way before the specific risk of the investable asset is even assessed.
With the benefit of an outsider looking in, I discovered the investment allocation in asset-classes from an institutional investor to an actual investable attribute (say a company) follows a “critical path” of no fewer than ten(!) levels of bottom-heavy diversification.
The equivalent of finding the fastest way to the beach with the nodes of possible travel intersecting at ten different times. A journey that requires deep insight into the congestion ahead to become predictable. An insight that is not bestowed on and not shared with institutional investors.
Even common sense dictates one ought not to expect to generate consistent outlier returns from ten levels of diversification of embedded risk. Additionally, the uniformity in embedded risk carried by all asset managers, each subscribing to the same prevailing religion of asset management, creates allocations carrying mostly the same risk, making it impossible for an institutional investor to stand out in the crowd. Uniform risk a.k.a. subprime risk as input to an investment thesis cannot consistently lead to prime returns as output.
Predictability is severely hampered, not by the intrinsic value of the underlying asset, but by the elaborate musical chair dance of escapism mounted on top.
Asset risk misunderstood
The built-in dysfunction in asset management does not stop there. How it deals with private equity, for example, signifies how asset management is not just steeped in a massive pile of self-induced risk but also in a fundamental misunderstanding and malfeasance of risk. A misconception that opens the door for so-called experts to sell their “snake oil” as purported domain expertise to the unsuspecting institutional investor.
For the uninitiated, let us briefly examine venture capital. A sector that, by its application to internet technology, has access to an eighty percent greenfield of buyers, an immediacy of low-cost distribution, and almost non-existent regulation. Why then, with all this wide-open opportunity, is the venture capital sector the “the most disappointing sector as far as returns”, according to CalPERS’ former CIO?
The answer is two-fold. Not only does venture capital inherit the fallacies of the aforementioned embedded risk incurred by every asset-class, but venture capital is also put in an investment allocation bucket where it does not belong. Most likely, because private equity and venture capital both constitute an investment in equity that is non-public, institutional investors have conveniently designated venture capital as a subclass of private equity even though private equity and venture capital are opposites in the risk spectrum.
Private equity is investing in hindsight, whereas venture capital is investing in foresight. Parlayed to Geoffrey Moore’s book “Crossing the chasm,” private equity is investing after the chasm, and venture capital is investing before the chasm. The difference in risk profiles could not be starker.
Asset allocation by institutional investors should not be evaluated based on the distribution mechanism of funds, but instead be evaluated based on the totality of risk carried by each asset, including the embedded risk induced by the asset management construct atop.
This kind of malfeasance of risk is not unique to private equity. Similar examples exist in other asset classes.
When arbitrage fails, so do assets
As I describe in my past article on soccer economics, no referee in soccer can make the game. Such is the prerogative of skilled soccer players. But a referee can break the game, especially when he misinterprets the rules of the game.
Like a referee, institutional investors must understand the rules of the game to which they deploy money. They must understand the criteria to which they hold their money-managers responsible. They must understand the total risk carried by the allocation to an asset, from top-to-bottom. Even when strong economic winds make turkeys fly, and temporarily deem that insight unnecessary. Because no investment in an asset class will retain value and thus be deemed repeatable if the public does not yield authentic socioeconomic value from it, and our evolution does not stand to benefit.
Back to soccer. If the referees of soccer consistently misinterpret the rules of the game, the audience watching from the bleachers will disappear. Not because soccer as the most popular sport in the world isn’t a great game to enjoy, but because it will no longer expose or attract the skills of great players. Save for the bottom feeders.
Conversely, if the investments in an asset class do not yield socioeconomic value the public can trust, the trust in the perceived value of those who produce erodes, the outliers will vanish, and innovation will be artificially stifled. “Renewability” and repeatability are severely hampered by institutional investors who failed to familiarize and align themselves with the macroeconomics of the asset in question.
The big question about CalPERS’ newly stated intent is less about the use of the compelling and responsible sounding mantra of “repeatable, predictable and scalable” but more about the quality of its actions.
The meaning of the words used in the mantra is a departure from the past, as those words each project a desire for more reliable foresight. And therein lies the rub of a schtick; no more in-depth evaluation or calibration of hindsight, especially those gleaned from an imperfect past, will lead to an extrapolation of yet unchartered foresight that redefines the norm.
Put differently, greater protection of the downside does not lead to a more responsible pursuit of upside. Reduce management fees all you want to protect the downside, but do not expect such tinkering to magically lead to the development of foresight and thus improved upside with its money-managers.
Simply put, a deepening of its hindsight cannot achieve the goals of foresight set forth by CalPERS’ new mantra.
Empower the societal life-cycle
Asset managers, in general, have an awesome responsibility to protect and grow the assets of monetary reserves under management. The fiduciary duty of pension funds as institutional asset managers is even more significant.
Pension funds must not only grow the monetary value of assets to pay for pension payouts to its members, but they must also make sure their asset allocations breed tangible socioeconomic value that increases pension memberships and contributions. Meaning, it better invest to secure the development of its membership base.
Allocation returns derived from assets earning temporal blowout valuations with highly dubious socioeconomic value will become the kiss of death to asset classes which produce them. For when the unknowing public, as the user and last investor in the chain of greater-fools has lost its hard-earned money, so has the trust in the asset class’ repeatability.
Institutional investors must establish new investment criteria. Criteria that – for the first time – include a complete review of total risk in asset management, top-to-bottom. Along with a new measuring stick by which not solely the absolute value of returns is made relevant, but more stringent socioeconomic directives of repeatability, predictability, and scalability apply to the health of its growing member base.