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A TALK WITH TIAA-CREF'S INVESTMENT HONCHO (with audio)
With over $200 billion in assets under management, Teachers Insurance & Annuity Association-College Retirement Equities Fund (TIAA-CREF) is perhaps the nation's No. 1 retirement investor -- and Martin L. Leibowitz is its vice-chairman and chief investment officer. Business Week Senior Writer Jeffrey Laderman recently visited Leibowitz at his Manhattan office to talk about the markets and how they affect people who are investing for retirement. Here's a nearly complete transcript of their wide-ranging conversation:
I mean, true, it's unusual, but the economy has never quite been the way it is either. Business has not quite ever been the way it is. Technology has never been the way it is. So, why should we expect the stock market to behave by some principle that returns 10% or 11% a year, and that's all you can expect? Things are never the same. It's like what we all do when try to make the very best projection of what the future is going to hold. We take a look at the long-term past, we take a look at the recent past. But we should think a lot about what's the nature of what's going into the future, and then combine all three of those to make our best possible guess. There's a fourth element. One should bake a huge amount of humility into that cake. That cake should be iced with humility.
Q: Well, the first one, the first two -- I mean -- it's fact. So the only one in the fudge factor here is your reasonable, thoughtful outlook for the near future.
Q: Oh, O.K.
Q: Right. Some people, I would guess, it would almost sound like some people are paying no attention. I mean, they're just sort of mechanistically talking about, "We're this far out, we have to snap back like a --"
Q: Rushing to the mean ... Is that is what some people might call the naive assumption or something that in the absence of being able to do any better, you just sort of go with what you know. I mean, after all, the long-term returns have exhibited a fair level of long-term stability. So I think you've got to give them some serious weight. Especially when you look at them in terms of risk premiums over fixed-income numbers. I think the historical -- depending on how you look at it, between 4% and 9% or between 3% and 9% numbers become -- it's hard to think of really being outside that range for a long time. Let's put it this way: The burden of proof would be strongly, in our view, strongly on the contender, that they would be less or greater than that kind of range, which is a lot different than what we've seen in the past three-and-a-half years.
Q: If we do end up earning more in our equity investments than we have earned the past, do we have to save as much as we were told we have to save, or can we spend more now?
Q: Sure.
Q: In a bad stock market, it's not going to do well. So much of the discussions you see focus on what is our economy going to look like, and what are corporate profits going to be, and so forth. That's not -- it's an important question, but it doesn't answer the questions.
Q: Let's say we're all underestimating what the market can do, we're underestimating what the economy can do, and we end up earning more than we thought -- can you save less? I think what happens is that people start to think of what are different cascades of needs as they solve one problem or another. Now, they're focusing on retirement and get that in reasonably good shape, at least on an ongoing basis. Then the next question comes in: Well, what about the kid's education, housing, what about career interruption reserve? I mean that's another ingredient which is an important component of these days, when lifetime employment or career employment is going to be -- one should reasonably assume -- choppy.
Q: And there's also, I suppose, if they get to that level and say, "I don't want to drive around in a Chevy Malibu in my retirement, I want to drive around BMW or I want not only a condo in Florida, I want a summer home in Maine and --"
Q: Yes...
(audio) I mean, we're talking about, for retirement, we're talking about people having equity investment, not just up to the point of retirement, but deep into retirement now, with the longevity that one has in retirement. And they should be prepared to accept -- they should always have a risk posture. That means an equity percentage, primarily -- that's something they can comfortably live with that says O.K., this is something which even in the face of serious rumblings in the marketplace and serious surrounding news, which is not happy news, I can live with the long-term.
Q: Well even, I guess, certainly in retrospect, it's easy to go back and say, those were worth riding out, because we haven't seen any real big -- any bear markets in a long time. But what if -- I mean should people -- at what point does that market have to -- does the environment have to change that, where you say, "Wait a minute, this goes beyond riding out," I mean, what do you have to see there? The first thing is, there is the mantra about buy on dips. O.K.? Well, if you knew it was a dip, you only know in retrospect that it's a dip. So it's -- I think in a genuinely good environment, people have no idea how -- and generally in a good environment, all the stories and all the news and all your friend's views and everything you read in the press, tends to reinforce that basically things are O.K. When things start taking a serious tumble, and 200 points is no serious tumble at this time on the market. These are movements to be expected. And just expect it. And get yourself prepared for movements of 200 points and beyond, well beyond. It's just part of the game going forward. It's like acts of nature. The key thing is to get your allocation in order, in advance. It's almost how they tell you about estate plans. You know, don't write them in the hospital. And I think the same thing is true of asset allocation. Get it done in advance, so that you can have comfort that you can live with it. And that takes a lot more realism than most people -- they tend to be inertial and they tend to get scared when the market's going sour. These days people are sufficiently high in an allocation that they don't get -- the market increases an allocation for them when it's going up. O.K.? But when it's going down they tend to wonder: Is it decreasing it enough? And that's not the right time. Not the time to make decisions, not the time to try to assess what is -- the best of times are very difficult thing to -- Can I just say -- I want to come back to something.
Q: O.K. And that's the real question to ask. And to ask it in the context of: Don't look at returns only, look at what's going to be a bumpy road ahead. The odds are that the road is going to be bumpy ahead because the market road is always bumpy, and we've been not only having a somewhat golden period in the past three-and-a-half years in terms of returns, we've had a golden period in terms of bumpiness. The bumps have been relatively contained and relatively quickly. The dips have pretty much been dips and short-lived. So that's not the usual nature of our markets. And while one can make some arguments, I guess one could make arguments that that's likely to continue, I think the burden of history and logic, in this case, is not to expect it. Expect it to be rough, and ask how you're going to be able to live with it. What allocation can you live with going forward so that you don't have to worry about changing your allocation?
Q: Well, let's say you've determined you need to be 75% equities. O.K.? And the market's good and you're at 85%. So by the time you realize something is wrong and you take a look, you're down to 75%. "O.K., I was supposed to be 75 anyway." But what happens if the market then ticks it down to 60%. Do you go out and fill the coffer again, and get yourself back to 75%, if you can? I mean most can't. Especially in a 401(k) or something. You just can't start dumping money in there...
Q: You can shift from one account to another.
Q: But if you've been taken down in the aggregate and have to get back up, you just can't necessarily dump money in there either. It's not so much what your actual allocation is. I mean, what you always want to look at is what should your allocation be, given what your current circumstances are, your personal circumstances are. And then, for example, if you think you should be 75% equity, that's your normal allocation, and the markets go down, and you find yourself at 60%, that's a down move. You find yourself at 60% and your continued assessment is that you should be at 75% -- get yourself back up to 75%. And the same thing applies if you find yourself at 85%. If your assessment of your proper allocation is 75, get yourself back down to 75. Don't let your allocation get out of whack by buying more than -- certainly not more than 10%. Certainly not more than 7%.
Q: Well, how often does that mean you should revisit this -- your statement and try and get a sense of those allocations?
Q: Yeah. Quarterly?
Q: Right. In terms of your normal allocations, you're basically looking for things to change in terms of fundamental assessment of your risk situation. Now what could that be? Changing your circumstances? Your health? Your responsibilities? It could be a change in your portfolio. Suppose you have enough, and you suddenly found yourself with what looks like a very comfortable approach into retirement, and you're the kind of person who doesn't like to take risks. Or the fact that you've reached that comfort level. Actually, it's an important change. You should rethink your allocations, perhaps. Now this is -- and I think it's fascinating -- some people might find that a basis for reducing risk. They might say, "Here I am, I've got 85%, but a lot more money and really, I'm very close to a very comfortable retirement. I'm basically into it. And I had been at 75, but now I really don't need to take risks. Why should I take risks? And it will make me nervous to do so. I've got sort of a level of lifestyle that I want to have an assurance of sustaining. I could take it down below 75. In the same situation, somebody else might say, "Look, I have house money here. If I lose 15%, 20%, it's not going to kill me. And I have other resources, and beside which, I'm not personally a risk-taker." Even roughly, the same life situation, the same age, you could say, "Hey, I'm going to roll the dice. I'm going to escalate and take it up to 100%. If I get a super win, that's great. I'll be happy to leave something to my favorite alumni association, my favorite school. The kids will be happy. My multiple wives will be happy." You know? "So I can afford to do it and I want to do it." So I think, the same market movements, same earlier allocation, you have people who would and should, reduce their risk, and people who might want to and should increase their risk.
Q: So the lesson is...it all gets down to your individual... If there is a basis for believing that there's been some fundamental changes in this posture of the market. If hostilities break out, and it's really viewed as a fundamentally more dangerous world -- is that worth taking a reassessment? I say, yeah, take a look.
Q: Right.
(audio)
Is this sort of more a concoction of Wall Street than a real investment -- a viable investment option for people to take? Or is just a very immature market, and perhaps it has to be taken a little differently than others? For those who can afford to take some risks in the third and fourth tier, and it's going to be relatively modest, I would think under most circumstances in terms of an allocation that these are very interesting markets. Now, "interesting," as you know, is a Chinese curse, which is particularly appropriate when we're talking about emerging markets. The problem is that their operating characteristics and their return characteristics are not just risky, but it's hard to know how risky they are. It's hard to know how they will behave. Hard to know -- I mean, I think we're clearly learning about some of the --
Q: Because there just isn't that much history there, so you can't make judgments about them.
Q: We all can agree that they're risky, but we -- So, yeah, I think they're something to play carefully about. There are issues ofjust the nature of those economies and the nature of interactions with markets there which is very different than what we have here, and not ones which we fully understand and fully have the same level of controls or disclosures of transparencies. So I mean, we are, to a greater extent than normal, shooting blind or, let's say, "vision-challenged." And all these things are further components and further factors of risk that are different than the ones we used to. Having said all that, this is an area where there are enormous potential factors, that when aided and abetted by reasonable capital investment, and targeted capital investment, can give explosive returns to that investment because they have tremendous resources in terms of labor market terms of hard-working people, people who are eager to join the developed countries in terms of their level of their quality of life. So you've got a lot going for you, which when added to capital, it can give a tremendous return to capital, and so, theoretically, you want to go where the return to capital is high.
Q: In view of the size of these markets and the size of the developed international markets, would you say that maybe 20% of your international holdings would be appropriate to put in emerging markets?
Q: Of your international allocation, not 20 % of your total...
(audio) It's like the fellow who works for IBM shouldn't necessarily have his full allocation in tech stocks. So I have a feeling it's not just diversification, it's almost a hedge. I mean, one should not assume that over the next 50 years that the U.S. economy is going to be the dominant or have the same level of dominance -- that's the gentle way of putting it -- that we've enjoyed in the past, certainly, five years and even longer. As you go to a global economy, things flow through the best producer, the lowest-cost producer and the best producer, and that is making some radical changes in the course of not a lot of years. Because one of things what a global economy -- and certainly a global capital market -- means is that capital is not going to stand in the way of development. If you have a legitimate structure which can produce higher returns, the capital will find you. It will charge you maybe an appropriate risk-adjusted return as best as it can, but the capital will become available, the capital will flow, you will get the best returns. So things can shift in terms of relative strength of a given industry, a given sector, very, very rapidly. So, I think that's one of the reasons to be international. The other reason, and I think the standard reason is to reduce the volatility of your portfolio. I think that argument has its flaws. It's been pointed out that when you have a real downer in the U.S. market these days, sometimes foreign markets get in the chin. There tends to be a kind of bringing home of money, which means since we are the major market, we'll tend to often sink them worse than we'll sink us. But that's a short-term event. Over the long-term in terms of the diversified development of the different economic dates, if you will, destinies -- I think that there will be a long-term diversification -- will still hold. And one should both for diversification purposes and hedging purposes... I say hedging as opposed to diversification and there's a difference. Diversification is just where you operate with some relative independence. Hedging is where your win is somebody else's loss, and somebody else's win is your loss. So to the extent that the U.S. market may find itself more challenged by foreign corporations in some areas, there's a certain type of a hedging process as well as just diversification. So, you've got the answer. I'm a big believer in international.
Q: O.K. Let's move on to managed money. One of the things that's been obvious for the last few years, I know it runs in cycles, is that most mutual fund managers don't beat the index. And if you're really, really long-term, are you best served by going for a very low cost, low management fee, low transaction fee, just using different index funds that fill in the niches or the asset areas you need and be done with it?
Q: Now, you're a manager of money, although I know you do it both ways. And they're going to be a drag on your performance. So I think fees are terribly important. We're also a big proponent of consistency of returns. By that, I mean to configure a portfolio whereby your return is controlled relative to a well-specified asset-class benchmark as much as possible so that you get the benefit of knowing what you're going after, and you get a consistency of returns that are close to that. Now, we do that by doing both enhanced indexing in virtually all of our portfolios, together with the active management. And it's a little bit like -- I mean, I think if you look at what has been the history of investment management, I think you'll find a couple of things which partially explain why index funds are doing so well. First of all, it's a market in the past three years where it's very, very hard for managers to keep up with the index. Managers tend to have cash, they tend to have a broader distribution of stocks rather than the basic heavyweight concentration that the index has. The second thing is that most managers have not had the kind of focus on aiming for consistency of return, aiming for reducing the percentage of cash. I think there's a certain modern view -- we certainly think of ourselves as long-term proponents of it, I think exemplars of it, frankly -- where you run with the low cash percentage. You try to sit on top of that index like you're riding a horse. O.K.? You try to sit in the saddle of the market. You try to be higher than it as well. So you're trying for extra return with your active management, but you're firmly entrenched in the saddle of the market. And frankly, for most managers, that has not been, necessarily, their style.
Q: Yeah.
Q: Right.
Q: You're trying -- instead of market timing, you're focusing on security selection -- And we don't walk on water. We really basically walk on stones. And we are now relative return-seekers as a class. O.K.? Which means that the asset allocation is not being done by us. Whether [investors] know it or not, they're doing the asset allocation. And they should realize that the source of most of the returns that they've gotten, has been the markets themselves. O.K.? So there is a very, very big burden, which I don't think people fully, fully appreciate, which is on their shoulders, as they have really got to -- that's why I think I want to come back to that issue of checking your asset allocation now. Because most people just haven't done it. And you know, things are going well, they're happy.
Q: They've got more than they started with.
Q: Another thing we haven't really talked about -- bonds and interest rates. What are the implications of a lower interest rates? Especially for retirees? I mean, they'll drive all over town moving their money to pick up 10 basis points when their CDs expired. Nobody talks about this anymore, but rates or low rates kind of force you into equity to achieve the sums you have to achieve. You said, low interest rates...O.K.? And certainly the process of getting to lower interest rates is good for equities, as a general rule. You don't want to get there through a depression.
Q: Right. But, and this is an important but, if the market is a competitive, efficient market and assuming that equity pricing has incorporated all of these economic effects, then assuming we're all rational, which I recognize is a big assumption -- then Mr. Market should look at Warren Buffett's turf, Mr. Market should look at the level of interest rates say, "Hey, I'm satisfied if I get 4% above, 5% above." O.K.? And while there's no billboard which tells you what that percent above is, it's going to be some number. It's not going to be -- under normal efficient market circumstances -- it's not going to be 20% above.
Q: All right. I see what you're saying.
(audio) A: Again, this can go two ways, but take the person who is very close to what he can barely make due with, and he finds that 6% or 7% interest rates, he's basically going to be barely able to make -- he's not going to be able to live like he wants, but he'll live. Versus, if he gets more than that, if he gets 10% from this point forward, he'll really be able to get what he wants. Should he take the risk that's associated with getting that extra 3%?
Q: That's probably the least able person to take that risk, and that person might be tempted to do it. Again, I told you about the people going in a different direction. Somebody else who's basically, it's a question of to get the third home, he needs 10%, but at 6%, he's got two homes for retirement. But I don't care what he does. He may want to throw the dice. I don't care.
Q: Well, what about real interest rates and nominal rates? Most people just tend to look at nominal rates. We have a low nominal rate, but quite high real rates. I think the question as you phrased it -- you have to save more in an environment like that. And the answer is yes. Since in that case you've got a world which is not benefitting investors as much as it's benefitting borrowers, debtors rather that creditors. So the market is not giving you, the investor, a good shake. So yeah, you have to save more. Now the other thing is, in a situation like we have now, we have high real rates. You still have a problem. Because while you have high -- and high real rates are generally good for investors -- you want to be sure that the nature of your investments give you protection against inflation. Because, to go out and buy, for example, a long bond now at 5.7% is going to give you a nice real rate, but that's actually just a deduction from current inflation levels. And to the extent that inflation were to escalate, or you can expect inflation to escalate, you'd find yourself with deteriorating assets, and you wouldn't realize that real rate. Because you've locked in the nominal rate, you haven't locked in the real rate.
Q: So you can lock in a nominal rate in the zero-coupon bond, you can lock in a real rate, I guess, in these inflation-indexed bonds.
Q: One more thing: Above and beyond your home, do you think that securitized real estate is a good idea to put in a portfolio? People's homes are typically, not only their largest investment -- I guess now it's their second-largest investment after equities -- but it also carries a lot of risk. First of all, it's highly leveraged. It's probably the highest leveraged asset they will ever, ever own. O.K.? You don't usually think of your home as being typically -- at least -- often 5 to 1 or a 10 to 1 leverage, but, you know, at the outset it can be. It also has a fair amount of risk concentration -- it's like owning a lot of your own company stock. O.K.? Because it's in an area where there are probably a lot of systematic risks related to the business that you're in. It may not be always obvious, but I would say that --
Q: A house in Silicon Valley... So it's certainly both a consumption and an investment, but it's a very special kind of investment, and I view it as being a real estate investment like securitized real estate is not. I think they're really separate asset classes. And I think real estate certainly has a cycle. It has returns which generally partake both of equity- and fixed-income-type relationships. The fixed income comes out of long-term leasing arrangements that many components of the real estate market have. And I think that it's a good diversifying asset class to have as one of the building blocks. Not the major building block, but, you know, a significant one. It follows a somewhat different life than the equity market. Obviously, though, New York apartments are highly correlated with the equity market these days.
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Updated July 9, 1998 by bwwebmaster
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