Trillions of dollars of expense

US institutions discussed the prospect of a new investment world at the Milken Global Conference in Los Angeles at the end of April. Liam Kennedy, who moderated the institutional investors' panel, here discusses what they had to say

Just like their European counterparts, US pension funds are suffering from reduced funding levels, illiquidity in investments like private equity and the problem of how to deploy cash or to rebalance. The financial crisis has thrown up the problem of mid-term asset allocation - or how an investor views strategic asset allocation periodically. It has also concentrated minds on investing - do you prepare for your portfolio for a secular downturn or can you assume that at least some market norms will return?

"I am constantly challenged, even with my own staff, by wanting to manage the portfolio for just such a downturn, because it does create so much stress," Christopher Ailman, CIO of the Californian State Teachers Retirement System (CalSTRS) told the Milken Global Conference at the end of April. "But do you design a portfolio that only does well in those periods or do you design one that does well in the intervening period? I agree that if you want to make money on the downside, we have seen historically that protecting assets is key. But you can't just design a portfolio, load up a portfolio with gold, float it away from credit, just to avoid these kinds of downturns."

Catherine Lynch, CEO and CIO of National Railroad Retirement Investment Trust, also wanted to strive for an avoidance of systemic bias in asset allocation. "We can't have a portfolio that wins on one number and loses on all the others," she told the conference. "But insurance isn't cheap. If you want to build some insurance into your portfolio you're going to have to give up some upside."

Some pension funds have been big in cash. The $175bn (€126bn) Californian Public Employees Retirement System (CalPERS) was sitting on a 5.3% allocation, amounting to $9.5bn as of the fund's 23 April investment committee meeting, although signs are that this is being deployed in the markets. "We are looking for opportunities," says Joseph Dear, CalPERS CIO who recently joined from Olympia, Washington, where he was CEO of the Washington State Investment Board. "We are exploring other opportunities in terms of rebalancing. We will be asking for an opportunistic allocation to take advantage of shorter-term and quicker opportunities as they arise." CalPERS has already made a transaction in the term asset-backed securities loan facility (TALF).

CalPERS's board extended the fund's asset allocation ranges at the end of last year, so the investment staff do not need to constantly alert the board that the boundaries are being breached.

Portfolio changes
Ailman of CalSTRS says his fund started the last part of this decade underweight US stocks, but overweight international equities and emerging markets. "We were worried about sub-prime, but obviously not as worried as we needed to be," as Ailman put it. He also describes the past year as the most challenging of his career. As of the end of April, CalSTRS was pretty tight to its asset allocation targets - slightly overweight in all of them apart from global stocks. The question, according to Ailman, is whether to rebalance into global equities, or whether this can be done better tactically.

In fact, CalSTRS recently opted to move to a global equity approach, appointing two co-directors for the asset class, although the decision remains to be implemented - Ailman thinks the country decision is even more difficult to get right than the industry and country decision. "But we've recognised that US and non-US stocks are really one asset class and the risk of them is one asset class."
Harold Bradley, CIO of the Kansas City, Missouri-based Ewing Marion Kauffman
foundation, has fewer resources than either of the Californian supertankers but is arguably nimbler when it comes to making allocations. His fund sold REITs and commodities in the summer of 2008, but this was a "heads you win, heads you lose" move going into the autumn, he said. But now, he thinks, small and mid-cap valuations look the best since the mid-1970s, and because his fund is small, an allocation can have a meaningful impact at portfolio level.

Bradley also says his fund is looking to assess asset allocation every year, although it will still only formally change the asset allocation structure every three years. His fund is in a luckier position than most pension funds: if there is a funding shortfall the Ewing Marion Kauffman Foundation, which promotes entrepreneurship, cuts or curtails grants. "Our goal is to grow the endowment as aggressively as we can," says Bradley. "If we are wrong it's because the cycle is out of favour for a couple of years. We will make it up."

Liabilities and risk on the radar
Both Dear and Ailman attest that their funds are liability aware, even if their regulatory framework has spared them from the need to adopt a liability-matching strategy like their European counterparts. As Ailman put it: "Our liabilities are 30 years out and buying a bunch of 50-year zeroes doesn't look that exciting. We have had lengthy discussions with our actuaries because both we and CaLPERS are on a long duration index for a number of years, thinking that that matched to our liabilities. But the reality is that because of longevity and liabilities extending, it doesn't - it just introduces another layer of risk. You think you have paid your bill but the reality is that your duration is longer than the maturity of your bonds. We are likely to stay with a traditional-type investment mix to gain growth opportunities to get to a fully funded status."

CalPERS is also embarking on a progamme to manage risk better in its portfolio. "It's not just where the money is in the portfolio, it's about where is the risk in the portfolio," Dear said at the Milken Global Conference. "When I'm asked, ‘what did you learn about the last year?', one of the obvious things is to say risk management needs to get better. Our board has taken that to heart and has created an ad-hoc committee to deal with risk management both in the investment office and other aspects of risk such as health insurance programmes CalPERS administers for the state of California as well."

So CalPERS is embarking on what Dear says will be a two to three-year project to examine all dimensions of risk at CalPERS as a retirement system, and to develop policies and appropriate governance responses. This is to start with a policy on leverage across the organisation. "I'm really looking forward to that dialogue with the board because I think it really gets to the heart of some of the issues that are essential to the long-term success of our programme," Dear said.

Alternative concerns
The endowment model has been admired by many, at least since the approach was popularised in 2000 with the publication of Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment by the Yale Endowment CIO, David Swensen. But how has Bradley's Ewing Marion Kauffman foundation fared?

Like other investors, Bradley is concerned about funds of hedge funds - for their ability to generate higher returns with less volatility, and for appropriate fee levels. He asks himself whether we might be entering a world of higher volatility, which might make it more difficult for hedge funds to deliver that formula. "Do we really know anything about the volatility and performance characteristics of the hedge fund asset class?" was a question he posed.

For her part, Lynch recommends the work of Clifford Asness, managing principal at AQR Capital Management. In other words, there is much beta in the ‘alpha' of hedge fund returns.

Dear believes it is time for hedge funds to "mature into a class that can serve institutional investors, becoming institutional themselves, and that means changes in their compensation, so their interests are better aligned in the longer term. It means greater transparency and it means control of assets and better fees. Better alignment of interests means; when we make money, they make money and not the reverse."

However, it is with private equity that Bradley's foundation has the most issues at the moment. Having what he describes as a "terrific" relationship with his general partners, he has nevertheless received a bid for 45 cents on the dollar for holdings he wishes to sell to get into credit.

Despite the so-called illiquidity premium, the theory whereby long-term institutional investors get paid higher risk premia for holding long-term, illiquid assets, Bradley actually believes illiquidity is the issue. "Illiquidity is the biggest problem facing asset allocators today, in my opinion," he told the conference. "A lot of people on the foundation and endowment side have large exposure to illiquid asset categories. A lot of big groups have told their private equity investors, I hear, ‘if you call my capital I'll kill you', or something similar. So there's this, hold on, I want to get liquid, so I really think that the hard part right now is - how are these really valued? And I want to put a cost on that."

Bradley said he had been trying to sell private equity assets since the end of 2008, but he doesn't necessarily want to take the hit. "Do I really want to sell something that's 45 cents on the dollar?" he asked. Bradley also criticised the venture industry, where deals were done in multiples "beyond the stratosphere", as he put it.

He concluded: "My view is, if I can buy credits now, and we get another dip at 40-50 cents on the dollar, I have a much higher probability of recouping that more quickly than I do of recouping the multiples on these venture portfolios.

Christopher Ailman said CalSTRS wrote its private equity portfolio down by 15%, but he questions whether this was enough. "And I wonder did we ask the wrong people to value it? We were asking our general partners, who are generally conservative and tend not to want to write things down. What are some of these mega deals worth in today's market?"

Dear questioned the illiquidity premium, although Ailman was more vocal in support for it. "We've certainly discovered that there can be a price for that illiquidity in terms of meeting capital calls and watching distributions dry up in an environment when it's very difficult to sell securities raise that capital," said Dear. "So maybe we took the illiquidity premium for granted in that we were getting the benefit of it but not experiencing the cost. Dear added that CalPERS was getting more disciplined and detailed in its cash forecasts, in determining what its requirements are likely to be.

Ailman did not agree that the illiquidity premium has been "arbitraged away", as Bradley put it. Given that the quarterly reporting cycle of corporations has reduced the classic business cycle of three to five years down to something like 90 days, in his opinion, it should be possible for a long-term investor to benefit from the short-term thinking of others. "Maybe it's not an illiquidity premium per se, but I going to call it the long-term investment premium," Ailman said. "If you can hold your capital in there for longer than a mutual fund or a bank, then you should be rewarded for that. The problem in the United States is that short-termism has gone rampant."

And countering the short-termism of others, it would seem, is the goal of institutional investors like CalPERS. It wants to play an active role in shaping the next generation of financial regulation that will protect its interests in terms of transparency, better disclosure and greater regulatory independence. This will also involve better corporate governance. As Dear said in concluding the discussion: "We have had a very expensive lesson when we relied on improper, incorrect and outmoded beliefs about how markets would take care of themselves - trillions of dollars of expense."

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