In the Classroom
 Pension Fund and Investment Management

Given the beating they've taken in the market over the past couple of years, many investors are naturally looking for alternatives. But this isn't necessarily the best tack, concludes Jeff Jaffe, academic director of Pension Fund and Investment Management, a program he has taught for the past 15 years.

"We always spend a session or two looking at alternative investments, and because of the market's dismal performance lately, more people are looking at these alternatives," Jaffe said. But he cautions that it can be deceiving to think that the market's performance will remain down.

Alternatives to "plain vanilla" investing — such as hedge funds or managed futures — take risky bets on interest rates, foreign currencies, or risk arbitrage and, as such, need alternative analytical tools. "We don't have as much data on these types of investments," Jaffe said.

Pensions Become Personal

Understanding the different investment options for retirement funds used to be something only investment managers worried about. But it is increasingly becoming something individuals need to think about as corporations shift from defined benefit retirement plans to defined contribution plans, Jaffe said.

"Most or all retirement plans used to be defined benefit; but over the years, that has become too expensive and risky for companies. Instead, they pushed the risk onto individuals," Jaffe said. Under today's more common defined contribution plans, employees make the decisions where to invest their retirement deductions. "Thus, all gains and losses go to the employees, not the firm," Jaffe said.

"Personally, I would say alternative investments and hedge funds are too risky and speculative for individuals," Jaffe said. "These types of vehicles demand too much knowledge."

Instead, Jaffe recommends indexing. "Buy into a mutual fund that tries to mirror a broad-based index like Standard & Poor's, one that does little trading," he said. "These funds are doing what the overall market is doing." This strategy allows investors to benefit from the market's overall positive historical results.

"Look at the results of the 20th century: returns on U.S. stocks have been very good — an average return of between 10 and 11 percent a year. This is much higher than in bonds and probably better than in international stocks," Jaffe said.

Investors who want to push for higher returns will have to take the time to educate themselves about these riskier alternatives. Such active management — such as careful timing of selling and buying individual stocks — can result in additional benefits, Jaffe said, but just how much of a benefit is hard to calculate. "When you do that, you will be paying higher commissions, and it's not clear you will be able to increase your gross returns to make up for those commissions," Jaffe said.

Choosing a Fund Manager

Just as institutional investors choose fund managers, personal investors who seek a financial advisor need to be aware of a money manager's performance and style, Jaffe said. "Performance is simply how well they've been doing relative to a benchmark. Are they beating the S&P 500? There are a whole set of techniques available to analyze and adjust for risk. It may look easy getting a 15% return while the S&P did 14%, but there are more things that have to be accounted for," Jaffe said.

Determining a manager's style is not as clear cut as it appears, Jaffe noted. Does the manager invest in large-cap stock or small cap? In growth or value? Domestic or international? In stocks or bonds? "A lot have style drift — their style changes," Jaffe cautioned. "You think they are a growth manager and then find they're really investing in value stocks. The problem occurs after you give a manager your money thinking, for instance, he's in old-line industry, and then you find he's more high tech than you bargained for," Jaffe said.

Determining a manager's style is complicated by the vague language used to determine different types of stocks. Jaffe cited the story of a reporter who asked various money managers to describe their style of investing and what stocks they actually bought. "While they were all over the map defining their style of investing, they all recommended Phillip Morris stock — whether they called themselves value, growth, small-, mid-, or large-cap managers."

    

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