The Invisible Hands

1. Real Money's Crisis: Size, Impact, and Taxpayer Risk

Real money funds are in crisis and are “too big to fail.”

Massive Scale. Real money funds, including pensions, endowments, and foundations, manage trillions of dollars globally, with U.S. pensions alone accounting for a quarter of total managed assets. This immense size makes their performance critical to the stability of the financial system.

• Pensions: $24 trillion globally, $15 trillion in the U.S.
• Total managed assets: $62 trillion globally (end of 2008)

Societal Impact. These funds are the backbone of modern society, providing retirement benefits, supporting education, and funding charitable activities. Their performance directly affects the lives of millions, and their failures can have far-reaching consequences.

• Pensions: Ensure basic societal functions are populated by competent people
• Endowments: Support universities and research
• Foundations: Fund charitable activities

Taxpayer Backstop. Many real money funds, particularly public pensions, are ultimately backstopped by the taxpayer. Underfunded pensions create a potential cost to society that is too great to ignore, making their management a matter of public concern.

• PBGC (Pension Benefit Guaranty Corp.) deficit: $33.5 billion (mid-2009)
• Underfunded pensions: Can lead to cuts in public services and increased taxes

2. The Evolution of Real Money: From Bonds to the Endowment Model

The shift into stocks, and corresponding increase in risk, occurred in lock step with Federal Reserve Chairman Paul Volcker’s famous battle with inflation.

Early Conservatism. Initially, real money funds were managed conservatively, primarily investing in bonds to match fixed liabilities. However, the high inflation of the 1970s eroded bond portfolios, prompting a shift towards equities.

• 1949: U.S. pension assets were $15.7 billion, mostly in bonds
• 1970s: Inflation eroded bond portfolios, leading to a shift to equities

The 60-40 Model. The 1980s and 1990s saw a move towards the 60-40 policy portfolio (60% stocks, 40% bonds), which became the standard benchmark. This shift coincided with falling inflation and declining interest rates, creating a favorable environment for both stocks and bonds.

• 1980s-1990s: Shift to 60-40 model
• Great Moderation: Falling inflation and declining interest rates

The Endowment Model. After the dot-com crash, the success of the Harvard and Yale endowments led to the adoption of the Endowment Model, which emphasized diversification into illiquid, equity-like investments.

• Post-2000: Shift to Endowment Model
• Emphasis on illiquid alternatives: private equity, real estate, venture capital, etc.

3. The Crash of '08: Flaws in the Endowment Model Exposed

The crash of ‘08 highlighted flaws in the Endowment Model, namely: (1) diversification with a high equity orientation is not really diversification; (2) valuation matters, whether it applies to equities, real estate, or liquidity; (3) investing in certain limited partnerships is a form of leverage; and (4) time horizons are not as long as previously envisioned for investors with annual liquidity needs.

Equity Concentration. The Endowment Model, despite its emphasis on diversification, remained heavily concentrated in equity and equity-like investments, leading to massive losses during the 2008 crash.

• High correlation: Equity-like assets moved in tandem
• Yale Endowment: 99.9% in equity and equity-like assets in 2008

Valuation Matters. The success of early adopters of the Endowment Model was partly due to the cheap valuations of illiquid assets at the time. As more investors piled in, valuations became stretched, and the crash exposed the dangers of ignoring valuation.

• Early entrants: Benefited from cheap illiquids
• Later entrants: Overpaid for illiquids

Implicit Leverage. Real money portfolios often attained leverage through allocations to external managers, particularly in private equity and venture capital, which required advanced commitments. This implicit leverage amplified losses during the crisis.

• Over-commitment: Up to two times the target allocation
• Capital calls: Increased exposure during the crisis

Time Horizon Misconception. The assumption that real money investors have extremely long time horizons was challenged by the crisis, as many institutions faced short-term cash obligations that they could not meet due to the illiquidity of their portfolios.

• Illiquidity: Made cash obligations difficult to meet
• Short-term needs: Exposed the fallacy of long-term time horizons

4. Rethinking Real Money: Macro Principles for a New Paradigm

It is time to rethink real money management, and a good place to start is with portfolio managers who fared well in 2008, either by posting strong performance or by preserving capital.

Global Macro Resilience. Global macro hedge funds, in aggregate, managed risk effectively during the 2008 crisis, either by posting strong performance or by preserving capital. This highlights the importance of risk management and liquidity.

• HFRI Macro Index: +4.83% in 2008, +4.03% in 2009
• Risk management: Key differentiator during crises

Avoid Large Drawdowns. The most powerful force in the world is compound interest, but avoiding large drawdowns is an important implicit part of this phenomenon. Large losses can wipe out years of performance.

• Negative compounding: Losses are harder to recover from
• Siegel's Paradox: Losses require disproportionately larger gains to break even

New Model for Real Money. Real money management needs to be rethought, incorporating elements of the global macro approach, such as a focus on risk management, liquidity, and a forward-looking perspective.

• Risk-adjusted returns: Prioritize risk management over return targets
• Forward-looking: Focus on the macro environment, not historical data
• Liquidity: Value liquidity and avoid over-committing to illiquid assets

5. The Researcher's View: Debt, Stimulus, and the Great Macro Experiment

The Great Macro Experiment, therefore, is an attempt to use aggressive reflationary policies to overcome the effects of debt deflation after the equity bubble burst.

Private Sector Debt. The real problem is private sector debt, not government debt. Private sector debt just kept growing and growing, and the government can almost always fund its debt if it decides to print money; the private sector cannot.

• Private sector debt: The real problem
• Government debt: Can be funded by printing money

The Great Macro Experiment. The aggressive monetary and fiscal stimulus following the dot-com bust and the 2008 crisis is an attempt to avoid a depression by overcoming the effects of debt deflation.

• Aggressive reflationary policies: To overcome debt deflation
• Quantitative easing and bailouts: Part of the hyper-experiment

Fiscal Policy Matters. Fiscal policy, particularly tax cuts for higher income earners, played a role in fueling asset bubbles. Fiscal tightening, combined with monetary tightening, can lead to deeper downturns.

• Bush tax cuts: Fueled the housing bubble
• Hoover's tax hikes: Worsened the Great Depression

Adjustment Underway. Although excess debt remains, it is falling as households pay back debt or default. This adjustment process, coupled with policy responses, increases the probability of inflation rather than deflation.

• Debtors deleveraging: Reducing private sector debt
• Creditors spending more: Narrowing trade imbalances

6. The Family Office Manager's Perspective: Cash, Risk, and Opportunity

To an absolute return investor, cash is an essential asset.

Cash is Not Trash. Unlike the Endowment Model, which views cash as a drag on returns, absolute return investors see cash as an essential asset that provides flexibility and the ability to capitalize on opportunities.

• Endowment Model: Cash is "trash"
• Absolute return: Cash is an essential asset

Dynamic Value of Cash. The value of cash is not static; it increases during periods of market stress, providing the ability to buy assets at bargain prices.

• Opportunity cost: Cash provides flexibility
• 2008: Cash enabled investors to buy trashed assets

Illiquidity Costs. The Endowment Model's focus on illiquid assets can make it difficult to capitalize on opportunities during crises, as these assets cannot be easily sold to raise cash.

• Illiquid assets: Difficult to sell during crises
• Redemption issues: Can take time to access capital

Risk Management. Real money managers need to focus more on managing downside risk and less on chasing returns. The goal should be to avoid large drawdowns that can wipe out years of performance.

• Risk-adjusted returns: Prioritize risk management
• Drawdown control: Avoid large losses

7. The House's Approach: Liquidity, Risk, and the Long Game

The lesson of the importance of liquidity will be remembered by the survivors and will likely not be forgotten for a generation.

Liquidity is Key. The most important lesson of 2008 was the value of liquidity. Having liquid positions allows you to avoid making bad decisions in a crisis and provides funding potential to take advantage of extreme prices.

• Liquid positions: Essential for flexibility
• Illiquid assets: Can become unsellable during crises

Value of Liquidity. The value of cash is not just its return, but also the opportunity cost of not having it. Cash allows you to take advantage of unique opportunities when they arise.

• Cash: Provides flexibility and opportunity
• Illiquidity: Limits ability to capitalize on opportunities

Risk Management. Good risk management is essential for long-term success. It involves understanding how much you can lose in your portfolio at any given time and structuring your portfolio to limit downside risk.

• Risk-based approach: Anchor portfolio construction in risk
• Downside protection: Limit potential losses

Long-Term Perspective. Real money managers should use their inherent strengths, such as their long-term investment horizon and credit worthiness, to pick up extra return from activities where they provide some kind of risk-free liquidity.

• Long-term horizon: Advantage for real money
• Risk-free liquidity: Opportunity for extra return

8. The Philosopher's Insights: Probabilities, Psychology, and the Long View

Views sometimes count very little, whereas good risk management always counts a lot.

Probabilistic Thinking. The Philosopher focuses on probabilities and the range of potential outcomes, rather than trying to predict a single, certain future. He seeks to identify mispricings in the market based on these probabilities.

• Hypothesis testing: Focus on what is more fit, not what is true
• Probabilistic approach: Consider a range of outcomes

Market Psychology. Understanding market psychology is crucial. Markets are driven by human expectations, beliefs, hopes, and fears, which can lead to mispricings and opportunities.

• Market sentiment: Driven by human psychology
• Mispricings: Result from flawed expectations

Risk Management. Good risk management is essential for long-term success. It involves understanding how much you can lose in your portfolio at any given time and structuring your portfolio to limit downside risk.

• Risk-based approach: Anchor portfolio construction in risk
• Downside protection: Limit potential losses

Adaptability. The ability to change your views as facts change is crucial for success. Persistently holding on to views, regardless of changing reality, is a recipe for failure.

• Flexibility: Change views as facts change
• Avoid rigidity: Adapt to new information

9. The Commodity Trader's Edge: Asymmetric Bets and Market Cycles

The most successful made substantial gains, in large part due to tactical risk management techniques.

Tactical Risk Management. The Commodity Trader emphasizes tactical risk management techniques, focusing on liquidity and asymmetric bets. He seeks to capitalize on market inefficiencies and dislocations.

• Tactical approach: Focus on risk management
• Asymmetric bets: Limit downside, maximize upside

Commodity Super Cycle. The Commodity Trader believes in the commodity super cycle, driven by emerging market demand. However, he recognizes the importance of managing risk and liquidity during volatile periods.

• Emerging market demand: Driving commodity prices
• Volatility: Requires tactical risk management

Liquidity and Flexibility. The Commodity Trader values liquidity and flexibility, allowing him to capitalize on opportunities and avoid getting trapped in illiquid positions.

• Liquid positions: Essential for flexibility
• Illiquidity: Can limit ability to capitalize on opportunities

Valuation Matters. The Commodity Trader emphasizes the importance of valuation, seeking to buy assets when they are cheap and sell them when they are expensive. He also recognizes the importance of understanding the macro environment.

• Valuation: Key to identifying opportunities
• Macro environment: Important for understanding demand

10. The Commodity Investor's Thesis: Long-Term Trends and Real Assets

The path to hyperinflation may well involve an initial period of healthy-looking recovery.

Long-Term Structural Bull. The Commodity Investor is a long-term structural bull on commodities, driven by the increasing demand from emerging markets and the limited supply of many resources.

• Emerging market demand: Driving commodity prices
• Limited supply: Creates upward pressure on prices

Real Assets as a Hedge. Real assets, such as commodities and farmland, are a good hedge against inflation and currency debasement. They also offer a way to diversify away from traditional financial assets.

• Real assets: Hedge against inflation
• Diversification: Away from traditional financial assets

Importance of Fiscal Policy. Fiscal policy is often underestimated, but it plays a crucial role in shaping the economy. The Commodity Investor emphasizes the importance of maintaining expansionary fiscal policy for long enough.

• Fiscal policy: Underestimated but crucial
• Monetary policy: Less effective without fiscal stimulus

TIPS as a Core Holding. Treasury Inflation-Protected Securities (TIPS) are a good way to protect against inflation, offering a positive yield over inflation and a principal guarantee in the event of deflation.

• TIPS: Protection against inflation and deflation
• Positive yield: Over inflation

11. The Equity Trader's Adaptability: From Technicals to Fundamentals

The key is finding cheap things that will go up in scenarios where everything else is going down.

Adaptable Style. The Equity Trader has evolved from a price-based, technical trader to a more fundamental, theme-based trader, demonstrating the importance of adaptability in the markets.

• Technical trading: Initial focus on price action
• Fundamental analysis: Evolved to incorporate macro themes

Importance of Liquidity. The Equity Trader emphasizes the importance of liquidity, allowing him to move quickly in and out of positions and to capitalize on opportunities.

• Liquid positions: Essential for flexibility
• Illiquidity: Limits ability to capitalize on opportunities

Valuation Matters. The Equity Trader believes that valuation matters, and that it is important to buy assets when they are cheap and sell them when they are expensive.

• Valuation: Key to identifying opportunities
• Long-term returns: Not guaranteed regardless of price

Risk Management. The Equity Trader focuses on risk management, using options and other strategies to limit downside risk and to protect his portfolio from large drawdowns.

• Risk collars: Limit downside risk
• Downside protection: Avoid large losses

12. The Pensioner's Prescription: Risk, Leverage, and a New Approach

The main question I am faced with is how to run a large pension fund in light of these issues.

Flawed Assumptions. The Pensioner argues that the standard methods of asset allocation used by pension funds are based on empirically false assumptions, such as normally distributed returns and stable correlations.

• Flawed assumptions: Normal distribution and stable correlations
• Need for new models: To address risk and funding issues

Risk-Adjusted Returns. Pension funds should focus on risk-adjusted returns rather than just return targets. Big drawdowns and volatility matter, and portfolios should be constructed to account for extreme worst-case scenarios.

• Risk-adjusted returns: Prioritize risk management
• Drawdown control: Avoid large losses

Leverage as a Tool. Leverage, when used properly, can be a tool for improving portfolio diversification and returns. Levering low-volatility assets, such as government bonds, can help to reduce overall portfolio risk.

• Leverage: Can improve diversification
• Low-volatility assets: Can be levered to reduce risk

Pensions are Different. Pensions are different from other real money accounts because they are ultimately backstopped by the taxpayer. This means that pension fund performance has important societal implications.

• Taxpayer backstop: Pensions are "too big to fail"
• Need for reform: To address underfunding issues

Last updated: January 28, 2025