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Books – The Undoing Project

My beachside reading on the recent winter trip to Australia was the excellent “The Undoing Project” by Michael Lewis.
Obviously when it comes to Michael Lewis expectations are high, both for the quality of the writing and depth of the research behind it. This is no exception. Some of the specific elements are familiar but Lewis does  great job of weaving the intellectual content of the Kahneman/Tversky collaboration into a compelling story about their lives and the contemporary history of the time. Which are plenty interesting in their own right. I’d say the only negative points would be an oddly-placed chapter at the start which rehashes many of the ideas from MoneyBall (it was interesting, just seemed oddly placed relative to the rest of the book) and the slight lack of compete chronological sense of order that comes with the style of hopping around and pursuing digressions. It probably makes the book more readable, to be honest, but I found myself having to go back and review sections to get the full Kahneman/Tversky timeline over the years straight in my mind.
Some of the key behavioural science insights of Kahneman and Tversky that Lewis covers and articulates so well include the following.
Kahneman and Tversky understood that the errors the mind made offered you at least a partial insight into the mechanism behind decision making. A bit like optical illusions offering an insight into the workings of vision.
“Features of similarity” Comparing two objects: the mind tends to make a  list of features, count up and compare the features that two objects have in common, in particular one object with reference to the other. for example Tel Aviv is frequently thought to be like NYC but NYC is not thought to be like Tel Aviv. NYC has more noticeable features than Tel Aviv. An absence of a feature is also a feature. “Similarity increases with the addition of common features, or the absence of distinctive features.
Transitivity in decision making. transitivity violated if someone picks tea over coffee, coffee over hot chocolate and then turns around and picks hot chocolate over tea. The features of similarity model helps explain why people will violate transitivity in this way. The context in which a choice is presented affects the choice. When presented with a choice people aren’t assessing each object on a linear scale and evaluating relative to some representative model of ideality, they are essentially counting up features they notice. but the context in which a choice is presented can have a big effect on the features that are noticeable. for examples two Americans meeting in NY vs meeting in Togo. “The similarity of objects is modified by the way in which they are classified”.
First heuristic – representativeness. When people make judgements they compare whatever they are judging to some model in their minds. How closely do the approaching clouds represent my mental model of a storm? How closely does Jeremy Lin represent my model of an NBA basketball player? It’s why players with Man Boobs don’t get selected in the NBA. It’s not that the rule of thumb is always wrong – in many ways it can work quite well. But when it does go wrong it does so in systematic ways.
Second heuristuc – availability. the more easily you can recall a scenario to mind the more “available” it is, and the more probably we find it to be. For example words starting with K vs words with K as the third letter. Again can often work well. But not in situations where misleading examples come easily to mind.
People predict by making up stories
People predict very little and explain everything
People live under uncertainty whether they like it or not
People believe they can tell the future if they work hard enough
People accept any explanation as long as it fits the facts
The handwriting was on the wall, it was just the ink that was invisible.
Man is a deterministic device thrown into a probabilistic universe
Theory of regret – emotion linked to “coming close and failing”. it skewed decisions where people are faced between a sure thing and a gamble. regret is associated with acts that modify the status quo. The pain is greater when a bad decision led to a modification of the status quo vs one that led to a retention of the status quo. Regret is closely linked to responsibility – the more control you felt you had.
Anticipation of regret is actually as powerful as regret itself. We look at a decision and anticipate the regret we might feel. Often we do not experience actual regret as it is too difficult to be sure of the counterfactual.
This all contravened expected utility theory  (which was a central part of some economic models of how individuals made decisions). Expected utility theory wasn’t just wrong, it couldn’t defend against contradictions. The Allais paradox was a good example that violated utility theory. it basically had two examples framed at different probability levels but with the same utility tradeoff underlying both of them, people chose differently depending on the framing of medium odds vs long odds.
A greater sensitivity to negative outcomes – a heightened sensitivity to pain was helpful for survival. A happy species endowed with infinite appreciation of pleasures and low sensitivity to pain would probably not survive the evolutionary battle.
Prospect theory – people approach risk very differently when it comes to losses rather than gains. risk seeking in the domain of losses and risk averse in the domain of gains. people respond to changes rather than absolute levels. but changes vs some reference point, some representation of the status quo. In experiments this is usually clearly definable, in the real world, not so much.
People also do not respond to probability in a straightforward manner. people will pay dearly for certainty. But they will treat a 90% probability as less likely than that (they do not treat a 90 chance as nine times more likely than a 10 chance). When it comes to small probabilities they do not treat a 4% chance as twice as likely than a 2% chance. if you tell someone one in a billion they treat it more like one in ten thousand – and worry too much about it (and pay more than they ought to rid themselves of that worry).
One consequence of prospect theory is that you should be able to alter the way people approach risk (risk seeking vs risk averse) by presenting problems framed in terms of losses rather than framed in terms of gains.
The endowment effect (Thaler) – people attach a strange amount of extra value to what they own (compared to what they don’t). they fail to make logical trades and switches.
The Undoing Project. The title itself refers to a theory similar to regret: counterfactual emotions, the feelings that spurred peoples’ minds to spin alternative realities. The intensity of emotions of “unrealized reality” were proportional to two things: the desirability of the alternative, and the possibility of the alternative.
Experiences that led to regret and frustration were not always easy to undo. Frustrated people needed to undo some feature of their environment, whereas regretful people needed to undo their own actions. but the basic rules of undoing are the same, they require a more or less plausible path to an alternative state. Imgination wasn’t a flight with limitless possibilities, rather it’s a tool for making sense of a world of unlimited possibilities by limiting them. The imagination obeyed ruled: the rules of undoing. The more items that were required to undo the less likely the mind would undo them. “the more consequences an event has the larger the change that is involved in eliminating the event.” also, an event becomes gradually less changeable the more it recedes in time.

Five lessons from UK Pensions for SWFs and Others

UK pension funds have been through a hell of a ride over the last 10 years, and more. changes in regulation, longevity, interest rates, equity markets and the changing fortunes of sponsoring companies have all contributed to making the UK pension industry a tricky place. But are the lessons learnt relevant to other investors, particularly Sovereign Wealth Funds in the current climate?

  1. Why having an over-arching objective helps set investment strategy
  2. Incorporate future expected cashflows (in & out) into investment decision making
  3. Risk managing a portfolio which experiences large outfows has unique challenges
  4. Tracking liquidity of the portfolio is a key metric
  5. Recognising the cashflow properties of assets is important
  1. Why having an over-arching objective helps set investment strategy

This is the first of our recently-published investment principles, so needless to say we think its pretty fundamental. If anything, it might sound obvious but all too frequently we hear of funds looking at exotic or niche investments or managers that may be interesting (and may be perfectly good investments) but are inconsistent with the objectives (either on grounds of return, risk, or liquidity). Simply testing each new idea, asset or manager against the test “does it move us closer to our objective” makes life massively easier (and can simplify governance), If each incremental decision aligns itself with the objectives then it makes it a very transparent decision making process.

Going further, an overarching objective allows for the setting of an investment policy framework – which is very powerful for effective decision making. There is a reason why professional scrabble players always arrange their letters in alphabetical order: because patterns emerge more easily when you look at things in a consistent way. Having an investment framework is exactly the same, specifically it has the following benefits:

  • Avoids knee jerk decision making (which can be sub optimal) ;
  • Avoids “flavour-of-the-month” decision making;
  • Makes decisions more transparent and accountable.

2. Incorporating future expected cashflows in and out is essential to setting investment strategy

Pension funds are generally subject to significant inflows (sponsor contributions) and outflows (benefit payments) through their life cycle. A projection model that can succesfully take these into account, and allow for them to be varied or updated is essential to understand where the fund is “aiming” for. Without this, the fund may unnecessarily be taking too much investment risk, or conversely may be locking itself into failure to meet objectives. It also allows the ability to set more realistic goals, sometimes given cashflow constraints a certain funding goal may just not be really achievable given likely asset returns.

3. Risk managing a portfolio which experiences large outfows has unique challenges

At some point in their life cycle all defined-benefit pension funds will become net cashflow-negative. Many already have. This presents a challenging risk to deal with, that has become known in some quarters as “sequencing risk”. Put simply, the challenge here is that if the fund experiences a particularly negative investment return, followed by the need to make a large payment out, this can be very detrimental to ability to achieve its long-term return goals. The existence of this risk makes precise risk management all the more important. Risk measures like required-return-at-risk can really help.

4. Tracking liquidity of the portfolio is a key metric

Illiquid assets can be a fantastic investment, and it is often said that one advantage a pension fund has when investing is it’s long-term horizon which may enable it to commit capital over a long period of time, and earn a higher return. Some assets are very clearly illiquid (eg private equity), and some are very clearly liquid (government bonds or large-cap equity). However many assets and strategies now sit in a very wide spectrum of semi-liquidity. As a pension fund you want to know that when you need it the liquidity in your portfolio is there – and to ensure this it helps to dive a little deeper into the liquidity level of the components of the portfolio, categorizing a broad swathe of the portfolios as “alternatives” for example can be particularly unhelpful, as parts of this could be very liquid and parts illiquid. Much more helpful to categorize asset classes according to their liquidity, and track the overall liquidity layers in the portfolio as a key KPI.

5. Recognising the cashflow properties of assets is important

A second basis on which to categorize assets, that is more helpful than the standard equities/bonds/alternatives categorization is the extent to which the assets’ return is linked to a contractual payment stream or not. For example a bond provides contractual cashflows (absent default), whereas equities are principally dependent on changes in the market value for their return. Understanding the contractual cashflow properties also helps manage the liquidity of the portfolio correctly.

combining these last two points gives a 2×2 matrix, which we believe is a more helpful way of categorizing assets that conventional definitions. This was designed to reflect the characteristics (liquidity and cashflow) that matter most to pension funds, but this applies equally to many other investors who have requirements for liquidity and cashflow.

2x2

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A Decade of UK Pension Risk Management in 2 Charts

The two charts below (data sourced from the PPF website) really tell you everything you need to know about risk management of UK pension funds over the last 10 years.

Prof Pen (2)

Assets have grown steadily from c£700bn to c £1.3trn, although admittedly a very large part of this (possibly all of it) is due to contributions. On the risk side, there has been surprisingly little volatility, bar a significant bump in 2008 the line tracks steadily upward with a modest level of annualized volatility of 5%p.a.

On the basis of that, you might think that all was fine in the world of UK pensions.

Sadly, the picture changes when you overlay the liabilities.

As well as ballooning over the period in question, it’s the risk element that is most interesting. The annual volatility of the liability figure is around 14%p.a., contributing the lion’s share of the overall funding level volatility of c12%.

I don’t think I’m overstating things with the statement

“You can’t effectively risk manage a UK defined benefit pension fund without controlling the liabilities”

LDI Continues to Thrive – 5 Takeaways from the KPMG Survey

As the UK Liability Driven Investing (LDI) market has grown over the last decade the KPMG LDI Survey “Navigating the LDI Market” has become a really useful tool for understanding the growth of the market at a high level and who the major players are from an asset management perspective.

The latest version of the survey, covering data up to the end of 2014 was released in June 2015 here.

What are my main takeaways from the latest survey ?

1. Total liabilities hedged increased to £657bn (or £1,164m of Pv01 exposure) – vs £510bn the previous year. So where does this leave the industry in terms of overall hedge ratio?

It’s always tough to estimate the aggregate industry liabilities due to the different measures used, but the PPF 7800 index which tracks one measure gave a total liability figure at Dec 2014 of 1,502bn. Meaning that on this basis the aggregate hedge ratio of the industry was around 44%. not surprising then that the overall funding position continues to be dominated by interest-rate driven moves in the liabilities, a point that I made in a recent blog here.

2. We know that 2014 ended with a large fall in rates, and associated increase in value of bonds and related hedges, KPMG estimate that around 75% of the increase in liabilities hedged could be put down to rates moves, with £32bn the growth attributable to new mandates.

3. Pooled LDI accounts for only about 10% of liabilities hedged, but around half of the liabilities by number of mandates. With a very competitive market in products with good 3-year track records now, pooled LDI is seeing serious growth with the amount of liabilities hedged doubling in the last year.

4. Equity exposures reported by the LDI managers increased quite substantially with a rise in mandates from 140 to 200 (across options, TRS and futures), and a doubling of notional hedged using options from £20bn to £40bn. The instruments used range from TRS, futures and options.

5. Type of LDI mandate. The last 12 months have seen the development of a much broader range of “non-passive” approaches to LDI hedging than was previously available, most of the main providers now offer various flavors of semi-passive or active management, endeavoring to harness mispricings between gilts and swaps (for example) to try and outperform, rather than just hedge the liability benchmark. Our experience when talking to clients is that these approaches are very popular and increased breadth and competition in this area is a positive development.

The LDI market continues to grow in the UK as more and more pension schemes adopt a risk management mindset toward their interest rate exposure. So far the LDI products provided by the main asset managers have played a key part in helping schemes manage these risks and I expect them to continue to do so as the next few years unfold.

Which Investment Strategies Will Thrive in 2015 ?

We see literally hundreds of fund managers and investment strategies a year; which do we think are most likely to be successful in 2015? We really see three important things to focus on: risk, diversification, and freedom. Let’s take each of those in turn.

  1. Risk. This might sound obvious, but as we see it, the behaviour of market risks has been very different in the period since 2009 compared to what we would expect over longer time periods, and this needs to be factored in to risk processes. Managers and strategies with an advantage in this area really need to be able to step back from current conditions and see investment risk in a much wider context, answering questions such as: what is the absolute level of credit risk in a portfolio, and are investors being compensated at the current price?” or: “ what could a return to more dislocated levels of volatility – and/or correlation – do to the portfolio?”
  1. Diversification. Strategies based on getting one or two big calls right can do well if these calls come to fruition, but it is a big risk. History tells us that consensus views on, say, interest rates can seem really sensible at the time, but have a terrible track record of forming historically. Much better to recognise that any manager, no matter how good, will get some calls wrong. But if the portfolio is correctly diversified and positioned sized accordingly, then one bad call should not make or break the year’s performance. It is probably tougher – and let is face it, a lot less glamorous work – to deliver performance based on a gradual accumulation of correct calls as opposed to hitting the “ball out of the park” in any one theme, but it probably delivers a better investment strategy over the longer term.
  1. Freedom. One theme of the post-2009 investment landscape has been the fact that many simple, benchmark-focused strategies have actually performed as well as broader and less constrained approaches. Going forward, it is more difficult to see this continuing to be the case. Opportunities probably will exist, but they are likely to be in more select areas. An investment strategy that has the ability to uncover opportunities in a variety of areas, or rotate asset allocation in a meaningful way, is probably more likely to be successful than one that is always anchored to being invested in certain sectors of the market.

It is certainly going to be a fascinating year watching some of these themes play out, and I look forward to returning to this topic later in 2015.

UK Pension funding ratio falls 13% in a year as yield swings continue

Data from the Pension Protection Fund as of March 2015 shows that while the assets of UK pension funds have risen in value by 12% over the last year, falling yields have driven a fall in funding ratio of 13%. The aggregate deficit stands at £292bn (this is down slightly from a recent high of £367bn at the end of January, although continues to be volatile). PPF March 2015

INFOGRAPHIC: UK DB Pension Deficits Remain Elevated Amid Volatile Yields

PPF Feb Update

Last month I reported on the record deficit level of UK DB pension funds (as reported by the PPF 7800 index). In spite of reasonable asset returns in recent years, the recent large falls in long dated yields had driven liabilities higher (nearly doubling in 5 years).

In February the volatility in long dated yields continued, although the move in the month reversed a small part of the previous trend, with yields rising and liabilities falling (by about £130bn in aggregate or c8%) compared to the previous month. This meant the aggregate deficit fell from the record high of £370bn to £250bn (which is still a level that has been rarely seen historically as shown on the chart above). The aggregate level of solvency of UK schemes remains at a precariously low level.

I should note at this point that the data here, being taken from the PPF 7800 index measures liabilities on the section 179 basis used for PPF purposes. By the PPF’s own calculations this results in a liability number that is up to 30% lower than a full buyout basis (Source: PPF purple book March 2014 chapter 4).

To put these moves into context the deficit was £61bn just 12 months ago, and there was a surplus as recently as June 2011.

These moves show that the major driver of UK pension funding position continues to be moves in long term interest rates.

PPF Feb Update