In one of the "main stage" events at a recent national conference for nonprofit investors, Commonfund Chief Investment Officer Lyn Hutton was interviewed by Zanny Minton Beddoes, the Washington, D.C.-based U.S. economics correspondent for The Economist and, previously, an economist for the International Monetary Fund. The interview took place following a lively debate between Jeremy Siegel, Professor of Finance at the University of Pennsylvania and a well-known author who has appeared on CNN, CNBC and NPR, and Keith Ambachtsheer, President and founder of K.P.A. Advisory Services, Ltd., a Toronto-based consultancy providing advice on pension fund management, finance and investment matters. It should be noted — for clarity regarding the Beddoes-Hutton exchange that follows — that Siegel and Ambachtsheer took opposite positions concerning prospects for the stock market and whether investors could continue to expect to receive, at least for the foreseeable future, the traditional equity risk premium. Ambachtsheer argued that the equity market is a cyclical downturn, similar to others of the twentieth century, that could last a decade or longer. Siegel was more positive about prospects for equities returning to long-term historic norms.

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Zanny Minton Beddoes: Listening to the debate, I wasn't quite sure whether to be pessimistic or optimistic, but did think that in the end I was lucky because I get to go back and start writing again rather than having to make investment decisions every day. For you, this is the world you live in. The question of the equity risk premium and the outlook for stocks is the essential conundrum for you day in, day out. I wanted to start our discussion in that real world of investing. I am sure all of you have seen the Commonfund Benchmark Study® report that shows that this is the second year of declining endowment returns for the educational institutions surveyed. In fiscal '01 the total average return was minus 3 percent. In fiscal '02 it was minus 6 percent. This is not a world where equities have done well. It is a world where concern about equities has to be great. And, it is a world in which your decision about whether to be optimistic, like Jeremy, or pessimistic, like Keith, has enormous ramifications. So, I wondered if we could start with your own perspective. You oversee a plethora of funds in all areas of the capital markets, and you come from this audience — from the McArthur Foundation, the University of Southern California and Dartmouth College. You've been there and now you are here. How do you react? How do you see the equity risk premium and how should people in the real world, who have to make investment decisions, be thinking about this?

Lyn Hutton: I have a few thoughts on the subject. The first one is that it almost doesn't matter. Most of our institutions have to earn their rate of spending plus the rate of inflation (and whether the CPI is an appropriate proxy for that is a separate debate), and they have to earn their cost of investment management. So, they have to take investment risk. It was mentioned during the Ambachtsheer-Siegel debate that the annual real rate of return on 10-year Treasury Inflation Protected Securities (TIPS) is about 2 percent. Our institutions — our investors — will not survive for the long run earning a 2 percent real rate of return — not when spending alone is averaging 5 percent.

Second, on the subject of risk and the capital markets, stocks are inherently more risky than bonds. The common stock of a company is a more risky investment than the secured debt of that same company. And, both are more risky than a Treasury security of a comparable maturity. There must be some type of return premium that investors expect to earn for taking risk. Whether the return premium on U.S. equities can be realized and whether it is likely to be realized in the future was the subject of the debate. If you couple the first notion — that our investors have to earn a real rate of return greater than 2 percent and therefore have to take risks — with the second — that riskier investments should earn a higher rate of return — then investors ought to expect that they are going to earn a risk premium. If not, then we'll just stop and all go home.

The third thought I had while listening to Jeremy and Keith has to do with the issue of bonds, and especially Treasury securities at this point in time. It is likely that we are at the end of a 22-year bull market in Treasuries. Michael Strauss, Commonfund's Chief Economist, who is a great historian of the markets, can probably tell you the exact date in 1981 when interest rates peaked. But, roughly, the 10-year note has moved down from 14.5 percent interest to 4 percent today. Two weeks ago the rates on 10-year notes hit 40-year lows. So now, there is an opportunity cost of being in bonds and not in stocks. The real risk is, what if interest rates rise? What if we go up from here? What if there is some amount of re-inflation? What then for our investors?

Time to Rethink Investment Policy?
Beddoes: Let's push a little further. If the safe rate, the TIPS rate, of 2 percent real, is not enough for your institutions, then you have to look elsewhere. But we have gotten very used to a world in which you have this equity risk premium and you are going to get it. Looking back, that has been the lesson of history … that you basically put your money in equities, sit back and the equity premium will be there for you. Do we have to have a new philosophy? Do we have to go beyond that now? Can we no longer say, "Let's put our money in equities" and that's it? Do we have to rethink our whole investment philosophy in this environment?

Hutton: We don't have to rethink it. I believe there are investors who have always done better in equities or in fixed income or in any of the asset classes by pursuing active management. Commonfund has believed since its founding and continues to believe today that active management within asset classes can add substantial value over a passive index. One of the things that I was happy to hear during the debate was that the S&P 500 return is likely to be only average and the average isn't going to be that good. If so, then it might well be an easy benchmark to beat. If average earnings are only going to be 5 percent and dividends are only going to be 2 percent for a potential nominal return of 7 percent, then it is more likely that value added can come from really good stock pickers and from those who can be really opportunistic. There is, I think, talent in the asset management world. There are people who can, and have, consistently done better than a passive index.

Beddoes: It sounds like you agree with Keith's remark at the end of his discussion with Jeremy, "Get rid of broad stock portfolio fixation" and manage actively.

Hutton: Yes.

Active vs. Passive?
Beddoes: Let's discuss that. In Jeremy's book (Stocks for the Long Run) there was a statistic that beginning in 1982 the average mutual fund has beaten the market in only three of the last 20 years. Those years, I think, were 1990, 1993 and 2000. Basically, the record of stock picking is not great. Certainly, in the recent past it has not been great. So, why do you expect that to be different now, and what is it that makes you confident that a strategy based on active management can be successful in this environment?

Hutton: We are talking about averages. There are a number of times when returns on the S&P have ranked near or in the upper quartile, but a good deal of the time they have been only modestly above the median. And, if you look at the large dispersion of returns of money managers — broadly defined, not just mutual funds — you will find that there are firms that are consistently in the top of the second quartile or bottom of the first quartile — firms that have managed to beat a passive benchmark regularly. It is also true that there are firms in the fourth quartile, at the bottom. They usually don't stay in business long or aren't able to continue to manag money. So, I would say the dispersion and the track record of active management has an upward bias because of the survivor bias.

Beddoes: How in this environment do you measure the performance of an active manager? If you are less concerned with or you don't want to be constrained by benchmarks, how do you gauge your performance and how do you set realistic goals for yourself?

Having the Right Benchmark
Hutton: Benchmarks should measure whether a manager added value against what is expected. One of the trends is managers who argue, "You have picked me for my skill. I have demonstrated that I have some talent and that I am a pretty good investor. And, we have an alignment of interests and we have common goals. And, then you constrain me. You limit my universe. You tell me that I've got to fit into a little box defined by style and capitalization range no matter what. I can't have style drift and I can only work in a limited market cap range." Whenever investors limit the opportunity set, they increase risk and reduce their chances of getting exceptional performance. So, I would say that one of the trends that you want to avoid is too narrowly constraining your manager, essentially using benchmarking as a box.

The second thing — and I think most everyone knows this — is that having the right benchmark is crucial. There was a period of time in the not too recent past — let's just take 1999 as an example — when the cap-weighted S&P was up some 20-odd percent. The equal-weighted S&P was down and more than 50 percent of the stocks trading on the New York Stock Exchange were down. We had a very large cap, momentum-driven market … a market in which more than 50 percent of the return for the S&P 500 on a cap-weighted basis was accounted for by fewer than 15 stocks.

Beddoes: That didn't show up in the overall average?

Hutton: The fact that the average stock lost value was masked by the cap weightings. If you didn't scrutinize the returns and understand the nature of the benchmark, you could have either fired a very good manager or given money to an overweighted manager at just the wrong time.

Beddoes: So you need to get the right benchmark, which is not always the simplest one, and you then need to give your manager flexibility around that.

Hutton: Yes.

Beddoes: Some institutions seem to be putting their core domestic equity allocation in an index and then concentrating their remaining resources on alternative investments and non-domestic equity investing. Do you see that approach, which I think a lot of large institutions are following, fitting in with the view you have just outlined?

Hutton: I believe, and Commonfund has always believed, that non-dollar assets and exposure to other markets besides the U.S. are important parts of an investment program … and not only because they reduce overall portfolio risks. Strictly limiting one's investment set to stocks traded on the NYSE or NASDAQ doesn't offer the best opportunity to exploit inefficiencies or returns in the broader capital markets. Today's capital markets are, indeed, global. There are opportunities for active management outside the U.S., for example, in emerging markets and the international private capital markets, both of which represent opportunities to capture good returns commensurate with risk.

Beddoes: We'll turn to those markets in detail in a minute, but I just wanted to be clear that I understood that you believe there is a role for active management in the domestic markets, too.

Hutton: Yes, there is. The risk an investor chooses to take in the domestic markets needs to be understood in the broader context of that investor's total portfolio. So, for example, if the portfolio has a substantial amount invested in venture capital, then the domestic equity allocation might be targeted to less aggressive, more defensive, larger cap stocks.

Beddoes: So this shift towards indexing isn't necessarily the right way to go for every institution.

Hutton: No, I don't think it is. I think that our investors have a reasonable expectation of being compensated where they are taking risk. And, that comes down to being stock-specific, as well as strategy-specific in the context of the whole portfolio, regardless of the market. You can only do that through active management.

Active Management vs. "Picking"
Beddoes: So, we have an environment in which active management and stock-picking ability is more important and in which one has to find specific places where risk is rewarded. Where do we find them? Let's do a little tour of the areas that you are responsible for and learn which directions would you might send us in right now.

Hutton: I believe that it is very, very hard to earn exceptional returns, even on a risk-adjusted basis, in those sectors of the investment markets where capital is plentiful. Because where a lot of money rushes in, opportunities to exploit the mispricing of assets tends to be diminished. The inflow of capital tends to move prices closer to fair value. In a number of instances, assets can become overvalued. And it is hard to earn good returns if assets are richly priced — i.e., if you buy high.

One area where you have a capital supply/demand imbalance is in the distressed debt arena. Professor Altman's work (Editor's Note: The reference is to Dr. Edward Altman, Professor of Finance and Vice Director of the NYU Salomon Center at the Leonard N. Stern School of Business. He is a leading authority on distressed debt.) shows that there is somewhere between $800 and $900 billion, at par value, of distressed or defaulted securities with a current market value of about $500 billion. If you allow that some of those companies are never going to come back and that there are others that you don't ever want to own, then we estimate there is a $300 billion dollar investment opportunity there.

Now, a year ago someone went through and added up all the distressed debt funds that were out there and all the money committed to the sector that was being raised, but not yet invested. I think they came up with $65 billion. Let's just say that that figure has gone up and it is over a $100 billion today. That is still a huge demand/supply imbalance and a market inefficiency to be exploited.

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Re-Inflation — What If?
Hutton: …We are very concerned about the prospect for re-inflation going forward and how an institutional portfolio might hedge against that.

Beddoes: Don't you have TIPS to protect you against that?

Hutton: Yes, investors have TIPS. But I would argue that the natural resource and real estate markets — hard assets — are a more cost-effective source of inflation protection and offer a better return — both in yield and potential appreciation — than TIPS do right now.

Beddoes: The real estate market? Some people would have said that the real estate market is in its own bubble.

Hutton: The residential housing market may well be, but I don't believe that can be said about other sectors or about all regions of the country. Real estate is property-specific. I think it is very hard to make general comments about the real estate markets at large, especially coming from a perspective of residential housing.

Beddoes: So, you go to the real estate market, you go to other hard assets…

Hutton: Like natural resources, for instance.

Beddoes: So, they become your inflation hedge. Do you look at the distressed debt market as an area where you have a capital shortage because people have been shying away? What about the private equity area? That is an area where capital has been flooding in? Is the party over there? Is the opportunity still there?

Hutton: I think it remains an opportunity. I am not sure it is in IT (information technology) or telecommunications start-ups, but there are opportunities in the middle market buyout sector of the private equity market and I think life sciences is a sector that didn't participate in the bubble and where there are investment opportunities for venture capitalists. They might not be as plentiful as they were a decade ago, but I think that we will see that there are opportunities from this point going forward that could be quite attractive. Yesterday, one of our European private equity managers reported that they hadn't done a transaction for 18 months. Now they are seeing more attractive investment opportunities than they've seen in years.

Beddoes: So there is a market. But, private equity in Europe is nowhere near as big as it is in the U.S.

Hutton: And it is a different type of market and there is a talent issue.

Beddoes: Are you confident that you can find the kind of talent you need?

Hutton: I am confident that we have relationships with general partners who can find some very good investment opportunities.

Beddoes: So you are finding overlooked opportunities in private equity? Like the life sciences, areas ….

Hutton: There are opportunities in the life sciences because there are very few talented people in that sector. A lot of capital fled the life sciences and went into technology and telecom, forcing many people out of the business.

Piling in to Hedge Funds
Beddoes: What about hedge funds and alternative investments? I mean, that is an area where many of the institutions in this room have been piling in. Can you find returns there or have we pushed that as far as we can? And, is it actually a sufficiently aggressive strategy? We started this conversation by saying you had to look for reward appropriate to the risks you were taking. Can you find that in alternative investments?

Hutton: In the alternative marketable strategies, yes, I think you can. However, as capital continues to rush into these areas, many of the opportunities could be arbitraged away. There might not be as great a return opportunity as in the past, but that doesn't mean that there aren't investment opportunities to exploit. It is the case that some of these strategies can reduce the total volatility of a portfolio and, therefore, the risk. This is one sector in which investors need to carefully think through their return expectations, their risk/return tradeoff and the role of these strategies in their portfolios. Are they really going for an aggressive, leveraged return or for a low volatility, absolute return?

Beddoes: Do you worry, though? You mentioned several times that you need to go to places that are capital short. Do you worry about the amount of money that is going into this area?

Hutton: I worry not so much about the amount of money going to this area, but the great number of managers shifting into this area …managers who don't have experience or expertise. Most of the strategies are liquid; there is broad market capacity. But is there manager capacity? The money management business is changing. Managers who could charge 50 basis points for a long-only strategy can earn "one and twenty" (one percent base fee plus 20 percent performance or incentive fee) for a long-short strategy. And, what would you rather earn — 50 basis points or one and twenty? So, a manager hangs up a shingle, puts "hedge fund" somewhere over the door and attracts a lot of money. Because these "hedge fund" managers are unregulated, and offer little or no transparency, they are very hard to supervise, monitor or even do thorough "due diligence" on at the front end. There is innocent money coming in. The manager makes a mistake that is magnified by the amount of leverage in the fund and the fund blows up. The manager realizes that there will never be an opportunity to earn the 20 percent performance fee. So, they get whatever funds are available back to the investor and then they go and change the name on their shingle and hang up a new one. Of course, they can't do that indefinitely, but…

Beddoes: That's a pretty dangerous world.

Hutton: That's a very dangerous world.

Beddoes: Particularly if you are smaller.

Emerging Markets — a Returning Opportunity?
Beddoes: We could talk alternative investments all morning, but another area where I think there is a lot of concern among investors, and an area where there is not a lot of information is the whole international area, is emerging markets. I was struck in reading the Commonfund Benchmarks Study to see that exposure to emerging markets has fallen despite the bear markets we've seen here. Is that a sector that is too volatile? Is it too risky? Or is that an area where you see good prospects looking ahead?

Hutton: I think emerging markets are a very attractive investment opportunity. And, it's one where there is tremendous opportunity for skilled, talented managers to make a big difference. Their markets are inexpensive relative to most other public equity markets in the world. They are growing and there are world-class companies in some of these markets. Corporate governance in the emerging markets has improved dramatically and most have adopted international accounting standards. There are market inefficiencies to exploit and they don't have a lot of capital.

Beddoes: That's great to hear, but I look around the world and I see Brazil in a mess, Argentina in a terrible mess, East Asia not growing as fast as it once did. Where does one go?

Hutton: In my "prior life," we had a debate: One of my investment committee members used to throw up his hands and say, "You know, we just have no business being in these markets. They are inherently politically unstable. They have always been unstable. They are just never going to go anywhere. There are just too many problems." Yet, his company was investing in the developing economies and actively exploiting business opportunities there. So, there are different ways to look at these markets. One of the comments made yesterday had to do with China. Now, the markets in China might be, by some measures, very difficult in terms of liquidity, access and what non-Chinese investors can buy. Moreover, there is the threat of government intervention. But, you go to Shenzhen and you can see 12 technology parks. It could become the manufacturing capital of the world. You then go to Shanghai and see that it could become China's major financial center. And you visit the free trade zone there, with its new airport and seaport, and you have nearly every major pharmaceutical company there along with some very well known IT companies. That gets you thinking, "This is a growing market." It is already a huge market. Whether it is a Chinese company or another company that really knows how to capitalize on the growth — just as we have seen in some sectors of India and other places around the world — someone is going to make money there.

Beddoes: And it is a market that is capital constrained right now.

Hutton: As an investor, you have to look at the emerging markets. But you need to look at them intelligently. You can't index them. The emerging markets are not a passive play. There are some countries where you might want to buy the sovereign debt rather than take any company-specific risk. But, clearly, they are an attractive opportunity.

How Can Risks Be Rewarded?
Beddoes: We're beginning to run out of time, so we'll move on because I want to put all this into the framework of the tactical overview that you have given us. We have talked about distressed debt, private equity, hedge funds and emerging markets. Let's try to bring it back to the investment objectives that everyone has. We are looking for risks to be rewarded, but it is a volatile world and it is a world where it seems to be harder to find those rewards. How does that impact the overall investment objectives that institutions have? Do we need to rethink whether we are going to be defensive or aggressive, and what implication does that have for the way investment professionals at endowments and foundations think about their strategy and the financial consequences it has for them?

Hutton: I strongly believe that there is no "one size fits all" approach. Each institution, be it endowment, private foundation, community foundation, hospital or hospital system, must approach the management of its endowment or investment pool from the perspective of its specific requirements: return objectives, institutional risk tolerances and unique circumstances. An educational institution where endowment income is never going to be more than 4 or 5 percent of the operating budget has a very different risk profile compared to a private foundation that has no new sources of income and that must, by law, pay out 5 percent. In that case, investment income funds 100 percent of operations; to meet payroll something has to be sold, to pay grants something has to be sold. Those are very different risk tolerances and each institution has to think about its investment objectives.

Beddoes: Let's briefly take those two and see what kind of investment profile they should have. Let's take the one where the endowment is a small component of the overall budget. Presumably that institution could afford to be more aggressive.

Hutton: Yes, and it doesn't have nearly as many liquidity constraints. Because it is also an endowment, its investment horizon is truly long term.

Beddoes: So where should it be looking?

Hutton: I think it should be looking in the private capital markets because it doesn't need to be nearly as defensive and can be more opportunistic. If it isn't concerned with liquidity constraints, then it can invest a higher percentage of its assets in non-liquid opportunities. But, generally, it would have to be willing to accept more risk. It might want to take more non-dollar risk and have a greater currency exposure.

Beddoes: And the foundation?

Hutton: The independent foundation has to be more defensive and careful of its liquidity constraints. It needs to do a different type of "risk budgeting," if you will. Institutions need to ask themselves whether their return objectives are reasonable and achievable over the near term. It does no good to say, "My investment policy and my return objectives are targeted to earn 10 percent a year" when you don't believe there is any way you can earn that rate of return or, in order to get that return, you need to take more risk than you can tolerate. At that point, I think it is incumbent upon the governing board to step back and say, "Well, maybe we need to take a more defensive strategy, preserve capital and live to fight another day until we see the opportunities."

Beddoes: It sounds then, as if you are saying that the lesson, perhaps of what Jeremy and Keith were debating, is that the old days are over … those days when you didn't have to make those decisions because you could rely on healthy returns from equities. And now you have to say, "We need to reevaluate what our investment objectives are, what risks we can take and what returns we can expect." And you have to position yourself over the continuum from this more defensive strategy to a more aggressive one depending on your time horizon and your own institution's situation. Would that be a fair characterization of the way it should be?

Hutton: Fair. Very fair.

Beddoes: Well, that seems to me to be excellent advice to anyone wondering exactly how to go forward in these extremely uncertain times. Lyn, thank you very much for your insights.

Hutton: Thank you.