The Alchemy of Finance: Portfolio Construction Strategies

Panel Overview and Participants

• The "Alchemy of Finance" panel focused on portfolio construction strategies amidst uncharted market conditions.
• Participants included Steven Toy (Co-head, W.L. Ross), Brian Pellegrino (CIO, UPS), Hua Fan (CIC Fixed Income), Tim Hayward (GAM Fixed Income), and Jane Buchan (CEO, PAMCO).
• The panel represents investment perspectives from three continents with diverse mandates ranging from private equity to liability-driven investing.

UPS Portfolio Construction and Strategy (Brian Pellegrino)

• UPS manages $30 billion across four defined benefit trusts characterized by a young workforce and long-duration liabilities.
• Post-financial crisis, the strategy shifted from "vanilla" public equity/fixed income to a liability-matched portfolio.
• Equity Allocation: Focuses on custom beta strategies and high-conviction, benchmark-agnostic active managers.
  • Currently overweight in developed international and emerging markets relative to global benchmarks.
• Fixed Income Allocation:
  • The long-duration portfolio consists of 50% long-term corporates and 50% city strips.
  • Tactically moves between asset classes based on valuation and opportunity sets.
  • Added return-seeking assets including high yield, emerging market debt, and bank loans to diversify income and manage duration.
• Private Debt: Consolidated previously scattered private debt allocations (core fixed income, private equity, real estate, alternatives) into a single umbrella for better oversight.
• Liquidity Management: Maintains a higher cash allocation specifically to remain opportunistic and close deals quickly when partners present attractive opportunities.
• New Diversifiers: Exploring litigation finance as a non-correlated income stream.

W.L. Ross Private Equity and Distressed Opportunities (Steven Toy)

• W.L. Ross manages approximately $7 billion with four strategies: opportunistic buyouts, distressed/turnaround, real assets, and special situations.
• Market Valuations (2014-2015):
  • Private equity purchase prices averaged 10.7x EBITDA (well above pre-crisis levels) with 6.5x leverage.
  • In contrast, W.L. Ross acquired new investments at approximately 6x EBITDA.
• Capital Deployment: Liquidated over $2.2 billion of assets while reinvesting less than $1 billion, prioritizing quality over volume in a competitive market.
• Strategic Focus Areas:
  • Energy: Approaching the sector via credit opportunities with private equity-style diligence to understand capital structure and technical risks; expects future equity opportunities in distress.
  • Irish Real Estate: Launched an Irish mezzanine fund targeting 60-80% LTV with high single-digit current yields, filling the void left by retreating traditional banks.
  • Japan: Increasing activity in the Japanese market due to lower competition compared to the US and Europe.
  • Metals and Mining: Positioning for distress dislocations as commodity prices track oil markets downward.

Global Sovereign Wealth and Hedge Fund Strategies (Hua Fan & Jane Buchan)

• China Investment Corporation (CIC):
  • Manages a broad portfolio including public equity, fixed income, and alternatives; 12% allocated to F3 (hedge funds/multi-asset).
  • Target return is LIBOR + 6%.
  • Strategy utilizes risk parity as a baseline beta and hedge funds for alpha generation across equity long/short, relative value, event-driven credit, and CTA strategies.
  • China Market View: Sees alpha opportunities in China's fast-moving market with significant retail volume and a rapidly growing investor base.
  • Manager Count: Over 5,000 hedge fund managers registered with the CSRC in 2014.
• PAMCO (Jane Buchan):
  • Operates as a hedge fund of funds with complete asset control and full transparency to manage global risk.
  • Identifies "deadweight loss" from overlapping mandates (e.g., small-cap managers vs. cap-structure managers) and focuses on marginal trade-offs between managers.
  • Operational Alpha: Claims improved operations and risk management can generate alpha equivalent to or exceeding manager selection.
  • Europe View: Actively profiting from hedging strategies in Europe despite macro fears, specifically avoiding long-only bias.

Fixed Income Outlook and Macro Risks (Tim Hayward)

• Asset Class Assessment: Describes fixed income as "seriously troubled" following a 30-year bull run, citing high costs for quality income and low yields for risk.
• Strategic Shift:
  • Advocates for a "barbell strategy" shifting cash from overvalued European credit to undervalued U.S. long-term bonds.
  • Predicts U.S. government bonds will rally while European sovereign debt faces downside risk due to overcrowding and long duration.
  • Advises against "reach for yield" into CCC-rated credit (yielding ~17%) due to historical negative total returns (-22% in the prior 12 months).
• Hedging Techniques:
  • UPS (Pelligrino) noted that UPS takes the "payer" side of swaps while holding treasuries to offset funded status pain from rising rates.
  • Jane Buchan highlighted the use of swaptions to achieve positive duration exposure without symmetric losses if rates rise.
• Liquidity Concerns: Global wealth grew from ~$117 trillion in 2000 to $263 trillion in 2014, creating a saturation of capital that drives up asset prices and eliminates unloved opportunities.

Alignment of Interest and Structural Trends

• Fee Structures: Panelists agreed on the need to pay for performance rather than brand; investors should negotiate fees on drawn capital rather than committed capital in overvalued markets.
• In-House vs. External Management:
  • CIC runs a significant portion of its beta strategy internally to reduce costs and improve alignment while maintaining external managers for alpha.
  • PAMCO maintains full control over assets to avoid "product definition" traps and manage core competences directly.
• Co-Investments:
  • Co-investments are increasingly requested by LPs to reduce fees but require significant internal expertise and capacity to execute due diligence quickly.
  • W.L. Ross employs a flexible capital model capable of executing checks ranging from $25 million to $600 million to accommodate both co-investors and fund vehicles.
• Bank Prop Desks: Panelists expressed skepticism regarding risk-premium strategies marketed by bank proprietary desks, citing inconsistent teams and lack of compelling returns compared to dedicated hedge funds.

Forward-Looking Statements and Audience Sentiment

• 2015 Market Expectations:
  • Panelists and audience members anticipate a sustained repricing of risk rather than a simple volatility bounce.
  • Credit markets and liquidity pullbacks are identified as the primary drivers for the anticipated correction.
• Future Allocation:
  • Significant interest in increasing allocations to illiquid assets and tail hedges.
  • Expectation of negative or zero returns for 2015 is low, but returns are expected to be modest (0-5% range for many).
• Liquidity Dynamics:
  • The disintermediation of the financial system due to regulations (Basel, Dodd-Frank, Volcker) continues to create new niches for alternative capital in areas like real estate mezzanine financing.
  • The energy sector is viewed as a dislocated market with a wide forecast dispersion ($20-$90/barrel), necessitating flexible capital structures.