InvestingfortheLongRun

AndrewAngandKnutN.Kjaer 11November2011 Longhorizoninvestorshaveanedge.Theycanrideoutshorttermfluctuationsinrisk premiums,profitfromperiodsofelevatedriskaversionsandshorttermmispricing,andthey canpursueilliquidinvestmentopportunities.Theturmoilwehaveseeninthecapitalmarkets overthelastdecadehasincreasedthecompetitiveadvantageofalonginvestmenthorizon. Unfortunately,thetwobiggestmistakesoflonghorizoninvestorsprocyclicalinvestments andmisalignmentsbetweenassetownersandmanagersnegatethelonghorizon advantage.Longhorizoninvestorsshouldharvestmanysourcesoffactorriskpremiums,be activelycontrarian,andalignallstakeholderssothatlonghorizonstrategiescanbe successfullyimplemented.Illiquidassetscan,butdonotnecessarily,playaroleforlong horizoninvestors,butinvestorsshoulddemandhighpremiumstocompensateforbearing illiquidityriskandagencyissues. 1.Introduction Wedefinealonghorizoninvestorasaninvestorhavingnospecificshorttermliabilitiesor liquiditydemands,orthattheseshorttermcommitmentsorliquidityneedsaresmallin proportiontothetotalportfoliooftheinvestor.Longhorizoninvestors,therefore,have capturedcapitalthatwillbedrawndownonlyinthedistantfuture.Thelonghorizon confersanumberofadvantagesovershortterminvestors,including Theabilitytorideoutshorttermfluctuationsinreturns. Assetreturnsarenoisyintheshortterm.Furthermore,shorttermvolatilitytemporarily exacerbatesliquidityneeds,margincallsandfundingissues,makes(operational)risk managementmoredifficult,andfraystheworkingrelationshipsbetweenmanagers, boardmembersortrustees,theultimateassetowners,andotherstakeholders.Long runinvestorshavetheluxuryofknowingthattherearenoshorttermfundingissuesor liabilities,andcanearnriskpremiumsthatoftenmanifestreliablyonlyoverlong periods. Beingabletoprofitfromperiodsofelevatedriskaversionorshorttermmispricing. Inrationalassetpricingmodels,pricesarelowbecauseriskaversionishighand investorsbiddownpricesinordertoreceivehighfutureexpectedreturns.Ifalong
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Electronic copy available at: http://ssrn.com/abstract=1958258

horizoninvestorsriskaversionremainsconstant,hecantakeadvantageofthese periodswithlowprices.Inbehavioralmodels,pricescanbelowbecauseoftemporary periodsofmispricing.Again,alonghorizoninvestorcantakeadvantageofthesetimes knowingthatpriceswillreturntofairvaluesoverthelongrun. Takingadvantageofilliquidinvestmentopportunities. Clearlyshorthorizoninvestorscannotinvestinilliquidinvestmentsiftheywishtoaccess capitalbeforetheilliquidinvestmentcanberealized.So,alonghorizoninvestorcan takeadvantageofilliquidinvestmentopportunities.

Sadly,longhorizoninvestorstoooftensquandertheiradvantages.InSection2,wedescribe thetwobiggestinvestmentmistakesmadebyinvestorsthatcausethemtoforfeittheir longhorizonadvantage:procyclicalinvestingandmisalignmentsbetweenassetownersand delegatedmanagers.InSection3,welayoutaframeworkshowinghowinvestorscantake advantageoftheirlonghorizons.Section4concludes. 2.MissedOpportunities Webeginbyillustratingthemissedopportunitiesinducedbyprocyclicalinvestmentsand notadequatelyaddressingagencyissuesbetweenassetownersandmanagers.Todothis, weusetheexampleofaverylargeassetmanager,theCaliforniaPublicEmployees RetirementSystem(CalPERS),whichheld$240billioninassetsatJune30,2011.Thereare, ofcourse,manyareaswhereCalPERSisaleader,especiallyinactivistsocialandethical investing,butitsrecordoverthepastdecadeservesasacautionarytaleinnottakingfull advantageofitslonghorizon. 2.1ProcyclicalInvestments Duringtheturmoilin20082009,CalPERS,lost$70billion.1Manyinvestorsalsolostmoney. ThedifferencewithCalPERSisthatalotofthismoneydidnotcomebackduetoprocyclical investmentbehavior:CalPERSsoldequitieswhenequitypriceswerelow(andexpected futurereturnswerehigh).In2008,avarietyofcircumstancesledCalPERStosellequities exactlyatthewrongtime.Stocklendingblewupandasclientsredeemedloans,CalPERS soldequitiestoraisecash.CalPERShadsevereliquidityproblemsandsoldequitiestomeet

Robinson,E.,andM.Marois,CleaningUpCalPERS,Bloomberg,Sep9,2010.

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Electronic copy available at: http://ssrn.com/abstract=1958258

obligationsfromprivateequityandrealestatedeals.2TheBoardbecameskittish.3Before thefinancialcrisis,CalPERSequityweightwas60%atJune30,2007,asshowninFigure1. AtJune30,2008theequityweightshrankto52%asstockmarketsstartedtodecline. CalPERSdeliberatelysoldequitiesbringingtheequityweightdownto44%atJune30,2009 andmissingthereboundinpublicmarketreturnsinearly2009.4In2008,CalPERSsold2.3 millionsharesofAppleforapproximately$370million,astakethatwouldbeworth$920 millioninOctober2011.5 TheshortcomingsofCalPERSprocyclicalrealestateinvestmentswerealsomadeapparent inthefinancialcrisis.Figure1showsthatfroma5%lowinJune30,2005,CalPERS aggressivelyrampedupitsrealestateallocationreaching9.2%inJune30,2008rightwhen realestatewascrashing.Asrealestatesurgedduringthe2000s,CalPERSinternalcontrols onrealestateinvestmentwitheredandoutsideinvestmentadvisorsheldlargeswayand discretionarypowertoallocatebillionsincapitaltorealestatedeals.Theyusedit.In January2007CalPERSinvested$970millioninLandSource,whichheldresidentiallandinLA County.Itwasbankruptthenextyearasrealestatecrashed.InStuyvesantTownCooper VillageinNewYork,CalPERSlost$500millionafterlenderstookcontroloftheproperty. CalPERSusedleverageextensively,upto80%insomecases,initsrealestatedeals,inways thatwereusedbyitsrealestatepartnersthatwerehighlyopaqueeventoCalPERS managers.Theiruseofleveragepeakedjustastherealestatemarketpeaked.AtJune30, 2008,oneofCalPERSrealestateinvestmentshadavalueofnegative$305milliondueto leverage.6 Countercyclicalinvestingbuyslow,ratherthanCalPERSbuyingrealestateatitspeak,and sellshigh,ratherthanCalPERSsellingequityatitslow,andlonghorizoninvestorsshouldbe countercyclical. 2.2 MisalignmentbetweenAssetOwnersandManagers Theprincipalagentproblemhasbeenlongstudiedineconomics.Itisaseriousissuethat impedestakingadvantageofalonginvestmenthorizonandcanleadtoprocyclical investments,theinabilitytogeneratevalue,andpoorriskcontrols.

Karmin,C.,andLublin,J.S.,CalpersSellsStockAmidRouttoRaiseCashforObligations,WallStreetJournal, Oct25,2008. 3 PriortoFebruary2009,CalPERShadnoformalrebalancingprocess.SeeBurr,B.B.,CalPERSCreatesFormal RebalancingProcess,PensionandInvestments,Feb12,2009. 4 Partofthisdeclinewasduetotheshiftintoprivateequities,fundedbyreductioninpublicequities,during thisperiod(seeWayne,L.,CaliforniaPensionFundHopesRiskierBetsWillRestoreItsHealth,NewYorkTimes, Jul23,2009),butpublicequitiesreboundedmuchmoreduringthisperiodthanprivateequities.Thisactionof sellingpublicequitiesatlowprices,andbuyingprivateequities,isstillprocyclicalinvesting. 5 RobinsonandMarois,CleaningUpCalPERS. 6 Corkery,M.,C.Karmin,R.L.Rundle,andJ.S.Lublin,Risky,IllTimedLandDealsHitCalPERS,WallStreet Journal,17Dec,2008.
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Tocapitalizeonthelonghorizon,therehastobeconsistencyandbuyinfromboththe principal(theassetownerorthestakeholdersofthefund)andtheagent(thefund manager).Therearemanyprincipalagentproblemsinlargeorganizations,including internalandexternalmanagers,theboardversustheinternationalmanagementcompany, andtheultimatebeneficiariesofthefundversustheboardorthefundmanager.Successful longhorizoncountercyclicalinvestingcanbedoneonlywhentheprincipalandagent,in eachprincipalagentrelationship,cantolerateshorttermlosses.Theselossesaretransitory andtheproductofinvestmentstrategiesthatearnriskpremiumsthatcanonlybeverified overlonghorizons. CalPERSinvestmentperformancewashindered,especiallyin2008,byagencyissues. CalPERSwasaffectedbypaytoplayscandalsinvolvingplacementagentswhoreceived moneytohelpmanagerswininvestmentmandatesfromthefund.7Severalagentsinvolved inthescandalshavebeenjailed.Thesearecertainlyexamplesofconflictsofinterest,but theywerenotthebiggestagencyproblemsfacedbyCalPERS. Inrealestate,CalPERSfavoredjointventureagreementswhereithadlittleabilityto monitorandcontrolrisk.Itlargelyleftmanagementofrealestatetoitsoutsidepartners, eventhoughCalPERSborealmostalltherisk.Thesearrangementsmadeithardtomeasure thequalityoftheagent,seteffectiveriskboundaries,andcreatedtheworstpossible alignmentsbetweenCalPERSanditsrealestateinvestmentadvisors.CalPERSalsohadno systemstomeasurethecosteffectivenessofitsexternalmanagersuntilrecently.Toomuch complexityandhighcostsinthetotalportfolioobscuredtheunderlyingriskexposure.As RobinsonandMaoriswrite,Boardmemberskickedthemselvesforlosinggraspofthescale, andleverage,oftheirwagersduringthebubble.8 Alignmentsbetweenassetownersandmanagersareessentialtobeingabletofocusonthe longterm,whenriskpremiumswillbeultimatelyearned,andbeingabletorideoutperiods oftemporarylossesandvolatility.Indeed,ariskpremiumisearnedoverthelongrunto compensateinvestorsforperiodsofshorttermriskandlosses. Procyclicalinvesting,madeworsebymisalignmentsbetweenthemanystakeholders, causedCalPERStoreturn23%initsfiscalyearendedJune30,2009comparedtothe averagelargepublicpensionfundreturnof19%duringthissameperiod.9Itisnowonder thatgiventhisexperience,JosephDear,thenewCIOhassomehousecleaningtodoand stated,Icannotoverstateourdeterminationtomakethisanewdayhere.10

7 8

Seehttp://www.calpers.ca.gov/eipdocs/about/boardcalagenda/agendas/full/201103/srrr.pdf RobinsonandMaoris,CleaningUpCalPERS. 9 Economist,Investor,HealThyself,Sep2010. 10 Economist,Investor,HealThyself.

3.ExploitingtheLongHorizon
Werecommendfourbasicstepsforexploitingthelonghorizonedge:(1)Institutionalizecontrarian behavior,(2)Buildarobustfactorportfoliotoharvestmanysourcesoffactorriskpremiums, (3)Createclosealignmentbetweenassetownersandmanagers,and(4)Demandsufficient

riskpremiumsforilliquidinvestments.

3.1InstitutionalizeContrarianBehavior Investingcountercyclicallyishard.Itinvolvessellingassetsthathavedonewellwhen theseassetsarealltherageandbuyingassetsthathavedeclinedinprice,sometimes precipitously,whenthemajorityisshyingawayfromthem.Investingcountercyclicallygoes

againsthumanbehavioraltendencies.Itismucheasierjusttofollowthecrowdthantostandupas oneoffewcontrariansandloadupwithriskyassetsattimeswheneveryoneelseisdoingexactlythe opposite. Thebestwayofinvestingcountercyclicallyistoinstitutionalizecontrarianinvestmentbehavior.A strictrebalancingruleisarobustwayofdoingthis.Rebalancingcanbecarriedoutinmanydifferent ways,andwithmanydifferentschemes,butcommontoallofthemisitforcesinvestorstosell assetsthathaveriseninvalueandtobuyassetsthathavefalleninvalue,anddoingsobringsthose assetsbackinlinewithfixedportfolioweights.Rebalancingiscountercyclical.11

Manyinvestors,however,withrebalancingrulesfailedtorebalanceduringthefinancial crisis.Someinvestorsthoughtthistimeisdifferentandsimplyputtherulesaside.For otheritwasthelackofliquidityand/orriskcapacitythatcausedtherebalancingrulestobe breached.Theparadoxisthatitispreciselyduringsuchchallengingtimesyoumostneed therules.Theneedfordecisionrulesisafunctionofafundsgovernancestructure.For someinvestors,especiallythosewithmanystakeholdersthatinfluencekeyinvestment decisions,arulesbasedprocedurethatcannotbearbitrarilychangedduringtimesofstress isessential. OneexampleofsuccessfulapplicationofrebalancingrulesistheNorwegianGovernment PensionFundGlobal(theNorwegiansovereignwealthfund).Therulesaresetbythe ParliamentwhoistheowneroftheriskonbehalfofthecurrentandfutureNorwegian population.Norwaywasthelargestbuyerofequitiesgloballyduring20082009anditisthe disciplineimposedbytherebalancingrulethatallowedthefundtoincreaseitsequity holdingsasmanyotherswereselling. TheperformanceofJapaneseequitiessincethe1990sisanexamplewhererebalancing betweenJapanesebondsandJapaneseequitywouldhavebeenproducedlosses.Itistrue

BillSharpelabelsgoingwiththeflowandholdingmarketcapitalizationweightsasanadaptiveasset allocationpolicy.SeeSharpe,W.F.,2010,AdaptiveAssetAllocationPolicies,FinancialAnalystsJournal,66, May/June,4559.

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thataninvestorwouldhavebeenbetteroffholdingpurelyJapanesebondsduringthistime. However,investorswitharebalancingregimeinplacebeforetheJapanesebubblestarted wouldhavebeensellersduringthe1980swhenpriceswereelevatedandenduredfewer losses.Japanisalsoonlyonepartofaglobalportfolioandanimportantpartofrebalancing istorebalanceovermanydifferentsourcesofriskpremiums(seebelow). Theremaybescopeforimprovingrebalancingrulesbyincludingvaluationdependent metrics.Thiswouldhelpinvestorstoweightassetclassesorriskpremiumsmorethan predictedbyasimplerebalancingrule.Arebalancingrulewithfixedweightscertainlybuys whenanassethasdeclinedinprice,relativetootherassetsintheportfolio.Amore aggressiverebalancingrulewouldbuyevenmoreifthatassetsexpectedreturnishigh, relativetotheriskpremiumsofotherassets.Todothisrequiresembeddinganotionof valuationofthatassetclassintherebalancingrule.Thesevaluationbasedrebalancingrules mustbeconstructedrobustly.Theserulesneedtoredefineriskwhichisoftendefinedas volatilityandbasedonshorttermmeasurements.Timeswithlowvolatilityarecalledlow riskandoftencoincidewithhighprices,likethemid2000s,buttheseareactuallyperiods ofhighriskbecausefutureexpectedreturnsarelow.Usingvaluationruleswould incorporateonemeasureofriskasthepricepaidagainstthelongtermfairvalueofrisk premiums. Ontheotherhand,valuationmetricsareregimedependent.Inrarecases,valuation methodsarenolongervalidbecausearegimeshiftoccurs.Thistimeisdifferentperiods areextremelyrare.12Werecommendthatformalrebalancingprocessshouldincludesafety valvesfordealingwithcatastrophescenarioswhichmayincludehighlyinfrequentshiftsin regimes.Thekeyelementistohaveproceduresthatensuredisciplineinthedecision makingprocesssothatpotentialregimeshiftscanbediscussedinthefundswritten investmentbeliefs.Theriskofactingprocyclicallyshouldbewellunderstoodby stakeholdersanddecisionmakers.Anydecisionontakingriskoffthetablemustbemade togetherwithformalrulesforwhenriskshouldbetakenonagain.Takingoffriskisalways easy.Itistheabilitytoputonriskintroubledtimesthatmakesthedifferencebetween professionalandmediocreinvestors.Fundsthatlackclarityinthegovernancestructureand haveweakalignmentsbetweenassetownersandmanagersshouldhaveahighthreshold foraddingthistypeofsafetyvalveintotheirrebalancingrules.

Twoexamplesofthistimeisreallydifferentarepre1933wheretheaveragespreadbetweenthreemonth commercialpaperyieldsand10yearTreasuryyieldswaspositiveandpost1933wheretheaveragespreadhas beenpositiveandpre1987wheretherewasnodownsideskewnessinthesmilecurveacrossstrikesofimplied optionvolatilitiesandpost1987wherethereisnegativeskewnessinimpliedvolatilities.

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3.2BuildaRobustFactorPortfolio Factorriskexposuredrivesthebulkofexpectedriskandreturnforlarge,longhorizon investors.Unfortunatelythisisgenerallynotthewaymanyfundsorganizetheirinvestments andhowboardsandtopmanagementprioritizetheirtime.Toooften,investorsfocuson selectingmanagerswithalphaevenwhentheycontributeonlymarginallytototalfund performance.Thefinancialcrisesover20082009alsoexposedlimitationsinthecurrent paradigmofusingalternativeassetmanagementvehiclestoimproveonportfolio diversification.Theirbetasduringthesestressfultimeswerehigherthanforthenormal liquidassetclasses.Usingalternativesfordiversificationiscostlyandalsocontributesto complexitywhichmakesitdifficulttounderstandthetrue,underlyingriskcharacteristicsof thetotalportfolio. Abettermodelofdiversificationistodiversifyacrossfactors.Factorsgobeyondasset classes.Academicshaveknowntheimportanceofmultiplefactorsindeterminingasset returnssincethe1970s.13Ang(2010)usesananalogyofnutrientsandfoodtoillustratethe relationshipbetweenfactorsandreturns.14Individualseatfoodtosustainlife,butitisnot thefoodpersethatprovidessustenance;itistheunderlyingnutrientscontainedinfood (water,carbohydrates,protein,fiber,andfat)whichareessential.Factorsaretoassets whatnutrientsaretofood.Factortheoryisbasedontheprinciplethatfactorsarethe drivingforcebehindassetriskpremiums.Assetsarebundlesofdifferenttypesoffactors justasfoodscontaindifferentcombinationsofnutrients. Therearedifferenttypesoffactors.Examplesoffundamentalfactorsareinflation, economicgrowth,andpoliticalrisk.Certainassetclassesarefactorsthemselves,likeG10 sovereignbondsanddevelopedmarketequities.Otherassetclasses,however,arecertainly notfactorslikeprivateequityandhedgefunds,andinsteadbundleupdifferenttypesof factorriskpremiumsinsometimesexpensive,leveraged,andnontransparentinvestment vehicles.Therearealsoinvestment,orstylefactors,likevaluegrowthandmomentum whichtranscendassetclasses.Valuegrowth,forexampleisthenamegiventobuying assetswithhighyields(orlowprices)andsellingassetswithlowyields(orhighprices).In foreignexchange,thisstrategyiscalledcarrywhileinequitiesitisvalueinvesting.In fixedincome,itiscalledridingtheyieldcurveandincommoditiesitiscalledtherolland relatedtonormalizationorbackwardization.Figure2showspictoriallyhowfactorsdrive assetreturns,whichultimatelymakeupaportfoliostotalreturn. Theriskfactorapproachisasmarterwaytodiversifyaportfolioratherthanrelyingonasset classes.Justasabalanceddietconsistsoffoodsprovidingtheoptimalunderlyingblendof nutrients,aninvestorshouldholdacombinationofassetsbuttheseassetsserveto providetheoptimalexposureoffactorrisk.Lookingatassetclassescaneasilydouble

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Ross,S.A.,1976,TheArbitrageTheoryofCapitalAssetPricing,JournalofEconomicTheory,13,341360. Ang,A.,2010,TheFourBenchmarksofSovereignWealthFunds,workingpaper,ColumbiaUniversity.

countfactorsandleadtoinvestorsoverestimatingthetrueamountofdiversificationthey areachieving,whichthefinancialcrisismadeclear.Forexample,creditriskisincorporate bonds,creditderivatives,butalsoinequitiesandrealestate.Basinginvestingonfactors canresultinmorerobustportfoliosasinvestorsgainabetterandmoreintuitive understandingofthekeyperformancedriversofportfolios.Moreover,factorindicesare thebestwaytobenchmarkactiveportfoliomanagers:ifmomentumorvolatilityriskcanbe donecheaply,thenwhyshouldwepay220forahedgefundmanagertodoit? Therearecertainlymanychallengesinbuildingoptimalfactor,ratherthanassetclass based,portfolios.Someofthefactorsinvolvedynamicportfoliostrategiesthathavelong beenthepurviewof(oftenveryexpensive)activemanagement,likevaluegrowthinvesting, volatility,andmomentum.Someotherfactorshavemappingstoassetreturnsthatonly manifestthemselvesduringcertainperiods.Someleadingglobalinstitutionalinvestors,like CanadaPensionPlanInvestmentBoard,theDanishpensionfundATP,theNorwegianfund, andthesovereignwealthfundsofNewZealandandAlaska,amongothers,arepursuing researchinthisareaandgraduallymovingtowardstheriskfactorbasedapproach.Their ambitionistoharvestriskpremiumsinamoreefficientwaythanjustcombiningassetclass basedindexmanagementandtraditionalalternativeinvestmentvehicles. 3.3CreateCloseAlignmentbetweenAssetOwnersandManagers Lackofalignmentbetweentheassetowner(theprincipal)andthemanager(theagent) createsroomforagentstoservetheirowninterestsandnotthoseoftheprincipal.This problemofagencyiswellstudiedineconomics.Inthecontextofdelegatedasset management,misalignmentsbetweenassetownersandmanagersoftenresultin squanderingthebenefitsoftheownerslonghorizonadvantage. Thereareseveralagencyproblemswhichleadtotheassetownernotbeingableto capitalizeontheadvantagesofalongtermhorizon.First,agentsoftenhaveshorter horizonsthantheirclientsastheyfocusonshorttermperformancethroughthefeesthey generate.Investorsoftenchasereturns,soagentshaveincentivestomaximizeshortterm returnstogenerateflows.Managersnormallyknowmuchmoreabouttherisk characteristicsoftheirportfoliosthanassetowners.Thatasymmetricinformationgenerates opportunitiestofakeskillswheremanagerscanhiderisksotheyarepaidmorethantheir truevalueaddedrelativetothecorrectriskbenchmark.Whileperformanceinthelongrun isaseriesofshortrunreturns,thestrategiestakenbymanagerstomaximizeshortrun returnsoftentakeconcentratedriskthatisnotreadilyobservableexante,ortakeriskthat hasonlyasmallprobabilityofbeingrealizedovershortperiods,andwouldnotbeoptimal foralongrunhorizon.

Contractdesigncanmitigateagencyproblemstosomeextentbydefiningtheinvestment universepreciselyandsettingexplicittimehorizonsforperformancemeasurement. Perhapsamoreeffectivewaytocountertheinformationalandskilladvantagesof managers,however,istoupgradetheassetownersowninvestmentcompetence, increasingtheabilityofassetownerstoassess,monitor,andevaluatetheiragents.From Section3.2,athoroughunderstandingbytheassetownerofthekeyfactordriversofrisk andreturn,andknowinghowtoefficientlytapintothesefactordrivers,isthebestwayto counterthetraditionaldisadvantagesofassetownersrelativetomanagers. Suchunderstandingshouldbespelledoutexplicitlyintheassetownersinvestmentbeliefs, wheretheassetownerisrepresentedbyaBoardofTrustees,MinistryofFinance, Parliament,orsimilargoverningentity.15Theinvestmentbeliefsshouldincludethebasic reasonfortakingriskandtheperceivedlinkbetweenrisktakingandthepurposeand objectivesofthefund.Theboardshouldhaveaclearstanceonwhyandhowrisktakingis compensatedandtheexpectedrewardtoriskratiothatsuchrisktakingshouldproduce. Throughtime,thisshouldbetestedbyevaluatingrealizedreturnsagainstexante expectations.Finally,theboardshouldwritedownitsviewonownabilitytoselectand monitoragentsandhowitcanhandlepotentialagencyissues. Thisprocedurewillensurethattheboard,asrepresentativefortheultimateownerofthe fund,willownthebulkoftherisktakingofthefund.Crucialtothisprocessisan understandingwhylossescanoccurandformingappropriateresponses.Usingfactors certainlyhelpsinthisregardbylookingthroughassetstothefundamentalrisksofthe portfolio.Whenthefundishitbygeneralmarketturmoil,andthisdrawdownistheresult oftheboardseekingtotakefactorriskpremiumsthatwillberewardedinthelongrun,then theboardcannotjustblametheagentsandterminatethecontracts.Thisallowstheagent toavoidtimeinconsistentactions,especiallyinnotpanickingandtakingriskoffthetableat timeswhenperformancehasbeenbadwhicharetypicallytimesoflowpricesandfuture highexpectedreturns.Thestartingpointforthedelegationtothemanagershouldbewell specifiedfactorbenchmarks.Combinedwitharobustrebalancingruleforthefactor exposures,thislowerstheriskofprocyclicalinvestmentbehavior. Theboardcanbuildcompetenceinseveralways.Theycanselectboardmemberswhoare investmentprofessionals,startaboardeducationalprogram,orsetupateamofexperts closetothemasadvisorsorinvestmentcommittees.Recruitinginvestmentprofessionalsis notanobviousrecipeforsuccess.Theymayshifttheboardawayfromthefundsbase constituencyandweakenlegitimacyandtheabilitytocommunicateeffectivelywiththe

Weassumeinourdiscussionthattheboardfullyreflectstheinterestoftheconstituencies.Thatisoftennot thecaseandthereisanadditionalagencyproblembetweentheboardandtheconstituencies.Oneexample ofsuchanagencyissueiswithU.S.publicpensionfunds,whereboardshavetakenfarmorerisk,tolerated lowercontributions,andgivenmoregenerouspromisesthanwhattheresidualownersofthefunds taxpayerswouldhavepermittediftheyweredirectlyincludedinthedecisionmakingprocess.Thepotential agencyconflictsbetweenconstituenciesandtheirrepresentativescanbereducedbyhightransparency.

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fundsultimateassetowners.Investmentprofessionalswhoareespeciallyclosewith financialintermediariesmayinfactgeneratemoreagencyproblems,andhighercosts,in steeringbusinesstowardsthoseintermediaries. Somefundssolvethecompetenceissuebyhiringconsultants.Thataddsanotheragency dimension.Consultantsarepaidbyservicefeesandnotbylongtermresults.Often,advice givenbyconsultantssimplyaddscomplexitytothefundandmasksthetruefundamental factordrivers.Thebestconsultantsdoenabletheassetownertounderstandthe underlyingfactorrisksthefundistaking.Twomorecommonreasonstohireconsultants seemtobetheirfunctionasscapegoatwhenresultsarebadandforsignalingtheboardis doingitsfiduciaryduty. 3.4DemandSufficientRiskPremiumsforIlliquidInvestments Illiquidassetscanonlyberealizedbyinvestorswithamuchlongerhorizonthanthe expectedpayoffsoftheilliquidassets.Theseareilliquidinvestmentsthatshorthorizon investorscannotdo,solonghorizoninvestorshaveanedge.Buthavingalonghorizondoes notmeanthatthelonghorizoninvestorshouldautomaticallyinvestinilliquidassets. Investinginilliquidassetsmeansrelinquishingliquidityandthustheinabilitytorebalanceor tradewhendesired.Thisiscostlyandthelonghorizoninvestorshoulddemandan appropriateilliquiditypremiumtoinvestinilliquidassets.Thatis,investmentinilliquid assetsshouldnotbemadeatanycostandinvestors.Theappropriateilliquiditypremiumis investorspecificbecausethecosttoaninvestorforbearingilliquidityriskdependsonthe needforliquiditythroughliabilities,theabilitytotapfactorriskpremiums,thegovernance structureandskillsthatcansupportactivemanagementinilliquidinvestments,andthe considerableagencyissuesinvolvedinthemanagementofilliquidassets.Computingan investorspecificilliquidityriskpremiumentailsanassetallocationmodelwhereaninvestor canmeasuretheopportunitycostofholdingilliquidassets. Unfortunately,therearefewassetallocationmodelsthatdirectlyaccountforilliquidityrisk. Infact,theubiquitousstandardmeanvarianceoptimizationusedinindustrycompletely ignoresit.Ang,PapanikolaouandWesterfield(2011)explicitlyconsidertheeffectof illiquidityonassetallocation.16Intheirmodelofilliquidity,illiquidassetscanonlybe rebalancedwhenaPoissonarrivaloccurssignalingaliquidityevent.Whenthereisno liquidityevent,illiquidassetscannotberebalanced.Astheaverageperiodbetween liquidityeventsismadeverysmall,themodelneststhetraditionalassetallocationmodels whererebalancingisalwayspossible.Forilliquidassetslikerealestateorprivateequity,the averagetimebetweenrebalancingeventsmaybeonceeverytenyears.

16

Ang,A.,D.Papanikolaou,andM.M.Westerfield,2011,PortfolioChoicewithIlliquidAssets,workingpaper, ColumbiaUniversity.

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TherearethreeimportantfindingsinAng,PapanikolaouandWesterfield(2011).First, illiquiditycausestheinvestortobehaveinamoreriskaversemannerwithrespecttoboth liquidandilliquidassetinvestmentsandthiseffectiveriskaversionistimevarying.The intuitionissimple.Aninvestorcannoteatorconsumeoutofilliquidassets,onlyfrom liquidwealth.Ifyouarewealthy,butholdeverythinginilliquidassets,youcannoteat. Thus,theinvestorcaresabouttheratioofilliquidtoliquidwealth.Thatis,theinvestors assetallocationandconsumptiondependsonasolvencyratio.HarvardUniversityfoundthis outin2008whereithadtremendousneedforcash,butitsendowmentheldlargeamounts ofilliquidassetswhichcouldnotbeimmediatelyliquidatedtofundexpenses.17 Second,illiquidityriskmakesilliquidassetsmuchlesscompelling.Asabaselinecase, considerthefullliquiditycasewheretheoptimalallocationtotheilliquidassetis59%,close toatypical60%equityholdingformanyinstitutions.Now,supposetheriskyassetcanonly betraded,onaverage,onceperyear.Theoptimalholdingoftheilliquidassetwhenthe investorcanrebalanceisnow44%.Whentheilliquidassetcanberebalancedonlyoncein 10years,onaverage,theoptimalproportionisonly5%.Clearly,optimalholdingsofvery illiquidassetsshouldgenerallybeverymodest. Third,investorsshoulddemandsteeppremiumstobearilliquidityrisk.Whatincreaseinthe expectedreturnoftheilliquidassetisrequiredfortheinvestortohavethesameutility whenalltheassetsareliquid?Thisisthecompensationforbearingilliquidityrisk.The illiquiditypremiumsareshowninTable3.Asingleprivateequityfundthatcanbe rebalancedonceevery10years,onaverage,shouldhaveapremium(orhurdlerate)of6%. Illiquidassetsthataninvestorcanrebalanceeverytwoyearsrequirea2%premium. Thereisanotherreasonwhyinvestorsshoulddemandapremiumforinvestinginilliquid assets.Investinginilliquidassetsinvolvesconsiderableagencyproblems.Thetypical contractsareopaque,itishardtomonitorthefundmanagers,andmarketvaluesarenot observed.Typicalcontractsinvolvinginvestmentinilliquidassetsexacerbate,ratherthan solve,agencyissues. 4.Conclusion Longhorizoninvestorshaveanedge.Theyhavetheabilitytoreapriskpremiumsthatare noisyintheshortrunandonlymanifestoverthelongrun.Theycanacquiredistressed assetswheninvestorswithoverstretchedriskcapacityhavetosell.Theycanalsopursue opportunitiestoinvestinilliquidassets. Therearetwopitfallsthathinderlonghorizoninvestorsinfullyexploitingtheiradvantage: procyclicalinvestingandmisalignmentbetweenassetownersandmanagers.Theseare

17

SeethecaseLiquidatingHarvardfromColumbiaBusinessSchoolCaseWorks.

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intertwined.Countercyclicalinvestingrequiresstronggovernancestructurestowithstand thetemptationsofsellinginblindpanicswhenassetpricesdrop.Agencyconflictscontribute toprocyclicalinvestmentbehavior. Totakeadvantageofthelongrunadvantage,investorsshouldfirstinstitutionalize contrarianbehaviorbyadoptingarebalancingrule.Avoidingprocyclicalityalsorequires redefiningtheconceptofriskawayfromjustvolatility.Lowvolatilityoftencoincideswith lowexpectedriskpremiums,whichareamorerelevantconceptofriskforthelongrun investorwhocanwithstandshorttermfluctuations.Investorsshouldpracticefactor investingandbuildrobustfactorportfolios.Longterminvestorscanharvestmanysources offactorriskpremiums.Theyshouldgobeyondassetclassesandusetheunderlyingfactor riskpremiumdriversasthebasisforportfolioconstruction.Doingthisrequirescreating closealignmentbetweenassetownersandmanagers.Thedecisiontotakefactorrisk shouldbeatopdowndecisionandanchoredthroughouttheorganization.Infact,thetwo mostimportantdecisionsinfundmanagementshouldnotbedelegatedtoagents:thelevel ofrisktobetakenandthekeysourcesofriskpremiumstobeexploited.Finally,longterm investorscanpursueilliquidinvestments.But,acquiringilliquidassetscomesatacostin notbeingabletorebalanceandnothavingdrypowdertobuydistressedassetsduring badtimes.Investorsshouldchargesignificantpremiumsforbearingilliquidityrisk.

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Table1.OptimalIlliquidAssetHoldings AverageTimeBetween Rebalancings 10years 5years 2years 1year year ContinuousRebalancing

Source:Ang,PapanikolaouandWesterfield(2011).Optimalilliquidassetholdingsfordifferent averagetimesbetweenrebalancing.TherowforContinuousRebalancingcorrespondsto instantaneousrebalancing.

OptimalRebalanceValue 0.05 0.11 0.24 0.37 0.44 0.59

Table2IlliquidityPremiums AverageTurnover 10years 5years 2years 1year year

Source:Ang,PapanikolaouandWesterfield(2011).Thetablereportstheadditionalpremiumwhich theilliquidassetneedstobearinorderfortheinvestortobeindifferentbetweenanassetallocation problemwheretheilliquidassetcouldbecontinuouslyrebalanced.

IlliquidityPremium 0.060 0.043 0.020 0.009 0.007

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CalPERSEquityAssetAllocation
70.00% 65.00% 60.00% 55.00% 50.00% 45.00% 40.00% 35.00% 30.00% 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

CalPERSRealEstateAssetAllocation
10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Figure1:CalPERSAssetAllocation.WeplottheassetallocationofCalPERSinequities (domesticandinternational)andrealestateintermsofmarketvalue.Thefiscalyearends June30.Source:CalPERScomprehensiveannualreports.

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 Figure2:FactorsandAssets.Differenttypesoffactorriskpremiumsarereflectedinthe returnsofdifferentassetclasses.

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