Spreading Risk has Spread Losses with Pension Funds: Jazelle Reed

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The idea behind diversification into new asset classes is to improve the trade-off risk and return in your portfolio, essentially, you will be making uncorrelated bets. Pension funds have diversified into new asset classes through buying emerging-market equities, corporate commodities and property, while giving money to hedge funds and private-equity managers. What they were trying to do was mimic the Yale endowment fund, which began to diversify into hedge funds and private equity funds in the 1980s. However, almost all of their diversified bets have lost money this year.

In hindsight, the strategy had a few flaws. First, all risky assets were boosted by the same factors (low interest rates and healthy global growth), which encouraged investors to use leverage (borrowed money) to create higher returns. This resulted in “the first truly global bubble”. As a result of unravelling confidence, investors have been forced to sell all those asset classes simultaneously, which drive down prices across the board. The second problem was that some of the asset classes were rather small. Initially, this illiquidity was attractive because it appeared to offer more appealing returns. Therefore, as more investors became involved, their liquidity duly improved. However, the downside is that when everyone attempts to exit the asset class at once, the prices dramatically fall. It is important to note that some of these asset classes were always likely to be driven by the same factors as stock markets. This means that private-equity funds, for example, give investors exposure to the same kinds of risks as quoted companies, but with added leverage. The third problem pension funds have experienced with diversification has been the cost. Because diversified assets cost more to trade and involve higher management fees, they have eroded most of the pension fund returns. Clearly, diversification has had perverse results for pension funds, which means fund managers need to come up with better ways to diversify their portfolio.