CalSTRS’ leap of faith brings assets in-house

In an act of faith for the investment staff at CalSTRS, the board has approved that a further $15 billion in assets be managed in- house, including some strategies outside those first recommended by the investment staff.

Chris Ailman

Chris Ailman

The approval follows a comprehensive board analysis of external and internal management over a period of three board meetings, and is expected to save the $154 billion fund millions of dollars in investment management fees.

Investment staff, led by chief investment officer Chris Ailman, and the fund’s consultant Pension Consulting Alliance, recommended a list of strategies that could be potentially managed in-house, that were grouped into three categories using the criteria matrix, prioritised according to the extra staff and resources that would be required.

“To our surprise the board approved all of category one and two and said ‘be quick’. It means an additional $10 billion to $15 billion will be brought in-house in the next four months,” Ailman said.

The board approved that staff move forward with the potential strategies from category one and two at their discretion, mindful of implementation and timing needs. There is also a potential to move even more assets in-house, with strategies from category three potentially managed in-house following more analysis.

In addition to the cost savings of internal management – bringing the category one portfolios in-house will save the fund between $1.5 million and $3 million alone – the board discussion also considered other advantages of managing internally including greater control over the assets, coordination among asset classes and the ability to customise mandates.

“In considering what we could manage internally, we created a decision matrix which included the complexity of the market, operational efficiency, and skill. Cost was a factor but not overriding,” Ailman said.

The category one strategies are:

  • Russell 3000 passive portfolio (internal staff already managed 59 per cent of this $40 billion portfolio)
  • US equity tactical passive portfolios
  • FTSE RAFI US 1000 portfolio (a fundamental index)
  • S&P 500 equal weight portfolio
  • High yield portfolio
  • Contributions and distributions (currency management)
  • US REIT passive portfolio

Category two:

  • MSCI EAFE and Canada IMI passive portfolio (market capitalisation weighted index that is designed to track the performance of the 23 largest non-US developed equity markets)
  • Global environmental passive portfolio
  • Non-US tactical passive portfolio
  • Securities lending cash collateral
  • Currency repatriation

CalSTRS’ internal staff has had a reasonably long track record, managing about one-third of the fund’s assets over a 12- to 15-year period, and has had a round of internal audits in the past year. (CalSTRS broke away from CalPERS in 1983, and at that time all the assets were managed externally.)

“We have demonstrated our capabilities in managing the entire fund and of discrete portfolios,” Ailman said. “We are pleased the board said yes to us managing those strategies, and pushed it beyond our recommendation. It is a nice vote of confidence for our staff. We have existing internal capability, and this is a positive move for us.”

Some of the category two strategies that will be managed in-house, may require some new internal systems, for example, the equal weighted S&P500, REIT portfolio, and foreign currency management, Ailman said.

A lot of the foreign currency exposure will be brought in-house (last year the Californian Attorney General filed a suit on behalf of CalSTRS and CalPERS against its currency manager, State Street, which is still outstanding); and CalSTRS will also start to look at whether it can manage international indexing in-house.

Ailman said bringing these additional assets in-house would bring it in line with its global peers which manage around 55 to 60 per cent of assets in-house, until this review CalSTRS had about one-third of its assets managed internally.

“This will take us to that level,” Ailman said.

Among those managers to lose mandates were State Street Global Advisors, and BlackRock.

The board asked the investment staff to consider the internal versus external decision making about a year ago. The criteria matrix was developed following the identification of a set of key decision factors that would help standardise the process of whether an investment strategy should be implemented internally or externally. Subsequently the three categories were identified.

Category three strategies, which staff said could be implemented internally with an increase in staff and other resources, but which the board said needed more analysis are:

  • Global equities:

Non-US fundamental index portfolio

Low volatility portfolio

High dividend yield portfolio

Enhanced index portfolio

Option collar portfolio

Covered call portfolio

Best of analysts portfolio

Market neutral portfolio

Fundamental active portfolio

  • Fixed income:

Emerging market debt

Internal securities lending

  • Private equity:

Purchase a general partner

Sponsorless deal/CalSTRS direct investment

  • Real estate:

Non-US REIT passive index

Core real estate portfolio

  • Infrastructure:

Master Limited Partnership passive index