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Friday, January 29, 2010 11:36 AM

Wisconsin's Pension Strategy Update: Disaster Looms Over "Free Lunch" Proposal

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Inquiring minds are digging deeper into the State of Wisconsin Investment Board (SWIB) ideas to rescue Wisconsin's deeply underwater pension plans. The plan is get the investments back on track using leverage starting out at 104% escalating up to 120%. The board even considered 200% leverage at one point.

Unbelievably Steven J. Foresti, head of the investment research group of Wilshire Associates Inc., Santa Monica, California, says "Using leverage to manage risk is a free lunch".

Please consider Wisconsin may pioneer leveraged approach to manage risk.

The State of Wisconsin Investment Board is considering leveraging its $67.8 billion core fund to achieve an asset allocation equivalent to 120% of total assets over the next three years.

The groundbreaking move — believed to the first effort to adopt an approach that a number of pension funds are weighing — would enable the board to reduce its equity exposure and increase allocations to lower-returning and lower-risk assets that offer greater diversification benefits while seeking to meet the board's expected actuarial return.

The recommendations call for potentially raising leverage to achieve a 112% allocation in 2011 and 120% allocation in 2012, when the allocation targets would be a combined 43% for U.S. and international equity; 35% for fixed income; 20%, TIPS; 7%, real estate; 7% for other alternatives; 4%, multiasset strategies; and 4% for active risk strategies.

SWIB, which is working with Strategic Investment Solutions Inc., San Francisco, its asset allocation consultant, is among a number of pension funds to consider boosting their effective allocation by leverage beyond 100%. At one point, the Wisconsin board even kicked around the idea of leveraging the fund to achieve an allocation of 200%, according to a staff report about the asset allocation study.

Wilshire's Mr. Foresti believes early adopters of the strategy would leverage their pension funds to achieve a 110% to 130% effective allocation, but he could see some going to 200% and higher.

“If you are using leverage to chase return, that's different” from the strategy Wilshire or SWIB is promoting, Mr. Foresti said. “But if the idea is to use leverage to manage risk and maintain diversification and current expected return levels, that is a free lunch.”
No Free Lunch

There is simply no beating around the bush with this. Anyone who believes in "free lunches" is a fool. So is anyone who thinks leverage reduces risk. Here is a simple rule to live by: If anyone, anywhere, ever promotes "free lunches", and you believe it, you are as big a fool as he is.

The problem with pension plans in general is that rate of return assumptions are too high. Anything that one does to stretch for those returns increases risk. That is a simple statement of fact.

Mr. Foresti is attempting to promote the idea that jumping off the Golden Gate Bridge is safer than shooting yourself in the head. Perhaps so, but it is ridiculous to propose either.

If the state of Wisconsin buys this nonsense, it will have a disaster, possibly at the worst possible time. The worst time would be with maximum leverage. If it sounds too good to be true, it is. Every "free lunch" idea in history has been too good to be true. This one is too.

Wisconsin's Asset Allocation Strategy

The above article was written on January 11. Since then, the SWIB has finalized its asset allocation strategy. Please consider Wisconsin gives nod to leveraging core fund.
January 26, 2010, 5:45 PM ET

State of Wisconsin Investment Board, Madison, today approved leveraging its $67.8 billion core fund to achieve an asset allocation of 104%, according to a statement from Vicki Hearing, public information officer.

Under the new asset allocation approved by the board, the allocation could range between 100% and 106%, depending on the leverage employed.

The new target allocation is 28% U.S. equities, 25% international equities, 26% fixed income, 7% TIPS, and 6% each private equity, real estate and multiasset.

28% U.S. equities
25% international equities
26% fixed income
6% private equity
6% real estate
6% multiasset

Risk Assessment

Add that up and it is a total of 104%. The allocation is 3% to TIPS (effectively 7% with leverage).

I am assuming those are all long allocations. I believe that US and foreign equities are going to take a huge haircut. For the sake of argument let's say 20% each although foreign equities have both market risk and currency risk.

Real estate returns are likely to be negative, perhaps hugely so.

TIPS are a bet on inflation, good luck with that because that trade is likely several years early. I do not know what durations the SWIB proposes but at over 100% leverage, the gains or losses will double. Somehow the board believes there will be no losses and this is the ultimate free lunch trade.

Returns on fixed income will vary huge by quality. Junk bonds and municipals are likely to get clobbered. High quality corporates held to maturity will be OK. However, corporate bonds in general are not a value play here as discussed in State of Wisconsin Goes Insane With Leverage; Corporate Bond Mad Rush Is On.

Not knowing exactly what SWIB is doing with fixed income makes it hard to make a precise assessment other than "risk is high".

However, assuming the strategy is an "all long" strategy, my bet is that it drops 15-20% minimum from here and after it does, recovery will be very slow, unlike the enormous bounce in 2009.

All In All The Time

Here's the deal. US equities are up 63% from the lows. Foreign equities are up as much as 100% or more. The odds of a huge correction is enormous. It makes absolutely no sense to be in equities at all, unless one is heavily hedged.

It makes no sense to be in junk bonds either. Although high quality corporates are likely to be OK, this is not a particularly good time to be in those either, especially if one is hoping for capital gains.

Instead of using leverage, I propose the state of Wisconsin go to 60% cash and wait for better opportunities. Alternatively, if the SWIB wants some risk, they should take a crack at shorting the market here.

But that is not the way that these guys think. They cannot stand cash. And they do not like treasuries. So when the S&P plunged to 666, they rode it down all the way. At the bottom, they had no cash to deploy. That is the foolishness of all in all the time.

Moreover, use of leverage means one is more than all in all the time. Somehow that is supposed to be a free lunch that reduces risk?! After a 63% rally off the lows? With Baa corporate bond yields looking like this?

Moody's Baa Corporate Bond Yields

click on any chart for sharper image

On Thursday, I chatted with Kathleen Gallagher at the Milwaukee Journal Sentinel. She could not get any hedge funds to speak on the record about what the SWIB was doing. I talked with her for an hour, all the time wondering why no one else would.

I found the answer in that first article above after we finished talking. Here goes:
A first-time allocation to hedge funds also is being recommended. The board could search for 25 hedge fund managers over the next 36 months under an allocation of up to 5% for absolute-return strategies, according to the SWIB report.

About 15 managers could be hired in 2010 for an initial 2% hedge fund allocation for the core fund, which would rise to an additional 10 managers and an allocation of 4% to 5% by mid-2011, the report said. The hedge fund allocation would be diversified among 25 managers by style, strategy and geography, according to the report.
Pie In The Sky

Hedge funds typically make 2% up front and 20% of returns.

No hedge fund wanted to be critical of the SWIB out of fear of losing a piece of the pie. Well so much for any chance we had for pie (probably slim anyway as we never approached them) but I cannot sit back and say nothing.

In my world, the way to produce above average returns over time is to take some chips off the table when risk is high, and put them back on the table when there is a good risk-return opportunity.

Those asset allocation strategies are the opposite. Their strategy is now attempting to juice gains using leverage after one of the biggest runups in history.

Zero percent in cash may not look good, but it is far better than -38.5% returns in the S&P (and bigger losses in foreign equity), in 2008.

Long Term Capital Management Yet Again

Foresti's proposal is nothing more than a revival of the strategy that did in Long Term Capital Management. I would advise any pension plans thinking there is a free lunch to read Genius Fails Again.
Let's consider a second review of When Genius Failed.

Roger Lowenstein explains how Long-Term became arrogant due to its success and eventually leveraged $4 billion into $100 billion in assets. This $100 billion became collateral for $1.2 trillion in derivatives exposure! With this kind of financial leverage even the most minute market move against you can wipe you out several times over. Talk about financial weapons of mass destruction! This risk did not deter Long-Term, though.

Finally in 1998, Russia defaulted on its bonds- many of which Long-Term owned. This default stirred up the world’s financial markets in a way that caused many additional losing trades for Long-Term.

By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.

By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.

Sowing Seeds Of Failure

Use of leverage self-sows seeds of its own failure. Even if the trade is a good one, leverage will eventually cause problems.

I know Foresti's rebuttal - He is only proposing up to 200% leverage, not the leverage used in the LTCM failure. The problem is, one needs multiply the size of the trade knowing every pension plan in the country, is doing the same thing, to the tune of hundreds of billions of dollars (or more).

“Over the next five or 10 years, we think this is the direction institutions will go,” said Foresti.

Let me ask: Who is on the other side of trade?
Let me ask it a different way: What happens to all those geniuses who believe in the "free lunch theory" when the trades start to go the other way?

I will tell you what happens - Goldman Sachs and hedged funds not involved will bet against it, in size. The system inherently takes advantage of leverage and weakness. That is what sunk Bear Stearns.

With all these geniuses "all in" to the tune of 120% to 200% some of them will decide to cut their losses in a downturn. Those who don't cut their losses will get crucified by those who do. Thus, these leveraged trades can fail for technical reasons in addition to fundamental reasons.

Even if the leveraged bets are fundamentally sound it will not matter. Moreover, there is a strong likelihood the trade is not fundamentally sound in the first place. With everyone betting the same way, the trade is always wrong eventually. History is replete with examples from tulip bulbs to the shoe shine boy in the great depression, to the housing bubble that just exploded.

Two Lost Decades

Fundamentally, the S&P 500 can easily fall to 500 or below, a massive crash from this point. Alternatively, stocks might languish for years.

click on chart for sharper image

The Japanese Stock Market is about 25% of what it was close to 20 years ago! Yes, I know, the US is not Japan, that deflation can't happen here, etc, etc. Of course deflation did happen here, so the question now is how long it lasts.

Bulls Dance On Edge Of Cliff

It's time to review Hussman on Valuation; Stocks Higher? Bulls Dance On Edge Of Cliff

John Hussman:

It's important to recognize that when I quote probabilities, I am generally using a form of Bayes' Rule. So when I say, for example, that I estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year, that figure is based on various combinations of historical evidence, and what has (and has not) happened afterward, and how often. As a side note, a “market plunge” in this context need not be a “crash.” In the context of a credit-driven crash and rebound (which is what I believe we've observed), a typical post-rebound correction would be about -28%, but even that would take stocks to less than 20% above the March lows.

That was Hussman's view. I think the probabilities look something like this:

  • 20% chance of a durable rally
  • 20% chance the market meanders nowhere for as long as 5 years
  • 30% chance of of a hard 25-30% correction
  • 30% chance the bottom is not even in

Unlike Hussman, I have not done any statistical analysis of my estimates. Certainly his "estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year" is reasonable enough.

[Note: those probabilities were written in December. The odds of a strong rally now, are less likely, perhaps 10-15% at best]

Note that Hussman's 80% probability of a plunge encompasses a plunge where the bottom holds and also where it doesn't.

The key for me is that on average it does not pay to be fully invested here, regardless of what the stampede of bulls say. Bear in mind, the bulls were saying exactly the same thing as they are now right at the October 2007 high. I received taunts for several months for my market top call late summer of 2007, about 3% and 3 months early.

Is the top in now? No one knows, but that is not even the right question to be asking. A far better question to be asking is "Is the bottom in?" Even if it is, a major test coming of that bottom down the road is highly likely and that will gore a lot of overly complacent bulls along the way.

Fundamental Thesis

The odds of another huge stock market dip in 2010 or 2011 are huge. The odds of another recession in the next 10 years are also huge. Heck, the odds of double-dip recession in 2010 or 2011 are very substantial.

Fundamentally, a huge wave of boomer retirement is coming up, and those retirees will be drawing down funds and lowering lifestyles, not contributing and consuming more. Moreover, global wage arbitrage still has not played out and there is huge downward pressure on wages and jobs.

Credit card defaults are still soaring, and banks are still sitting in hundreds of billions of dollars worth of assets held off the balance sheet. The S&P PE is over 20, a number associated with market tops, not bottoms.

Structurally, unemployment will remain high for a decade. And finally, consumer attitudes towards debt and risk have reached a secular peak and have turned.

That is not a backdrop for a huge bull market in equities or a massive bet on inflation either.

Pension plans better figure this out and act accordingly or they are going to dig themselves an even deeper hole.

Mike "Mish" Shedlock
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