Arizona targets commodities, emerging markets in allocations overhaul

This month the $24 billion Arizona State Retirement System completed an asset allocation overhaul resulting in new dedicated allocations to commodities and emerging market equities. Amanda White spoke with director Paul Matson about the decision-making process and the exposure and implementation decisions, including manager selection, still to come.
An NEPC-advised asset allocation study in consultation with internal staff has resulted in the Arizona State Retirement System restructuring its equities exposure, including moving into a dedicated emerging markets allocation, expanding into opportunistic and inflation-linked assets and exploring risk parity strategies.

It has been quite an extensive re-allocation of assets for the fund, which still manages 38 per cent of assets in-house through six portfolios, with debates on implementation and manager selection still to come.

Paul Matson

Paul Matson

The fund’s director, Paul Matson, speaks passionately and concisely about the rationale for the move, particularly the new emerging market equities focus, leaving the feeling there is nothing ad hoc about the latest allocations.

According to Matson the two crucial decisions to arise from the asset allocation study were a standalone emerging markets equities allocation of 3 per cent, and a commitment to commodities also of 3 per cent.

“We carved out emerging market equities from global equities and are looking for dedicated managers in that. Most people use diversification and returns expectations as driving decisions for allocation changes, but as the background to that we saw seven reasons why emerging markets equities makes sense for us,” he says.

These stem from cultural, political and economic observations impacting the emerging market countries such as the increasing work force, leapfrogging of technology consumption, elasticity of discretionary income and capital flow.

“There is a big workforce expansion in emerging markets as cultural barriers, such as gender bias, change,”Matson says. “The factors of production are money, equipment, time and people and all of a sudden there is a huge increase in one of those factors of production. There is also a demographic change and those two things create a bias for certain emerging markets countries.”

He believes the lack of required consumer deleveraging, because there wasn’t any leverage to begin with, and the elasticity of discretionary income with countries going from subsistence to above subsistence levels, all work to create an attractive opportunity in emerging markets.

In emerging markets Matson says the fund will look for global managers, not regional specialists, allowing the managers to make more tactical moves.

That way if there is a regional crisis they can be opportunistic and migrate the money. We want our managers to have a long term and short term tactical asset allocation ability within emerging markets.”

“On the US equities side we always allocated according to large, mid and small cap mandates but on the developed international equities side it was bundled, but we didn’t get large enough exposure to emerging markets.”

Technically the target allocation to emerging markets will come from international equities, but the allocation will also come from rebalancing overweight allocations, which now includes domestic equities, and the fund will look for managers in the first quarter of next year.

The fund has also decided to allocate 3 per cent to commodities partly as an inflation hedge, but also as a defensive real asset hedge and as a return generator, with the perceived advantage coming from its scarcity.

While the decision to allocate to commodities has been made, that is only the first of many steps, and Matson says the first quarter of next year will see the investment team and advisers debating the structure and implementation of that exposure.

The internal team, under chief investment officer Gary Dokes, also works with the consultant on asset allocation and conducts research in private equity, real estate and opportunistic investments. Part of its new gamut in early next year will be to look closely at these commodity opportunities with the consultant.

Matson says the fund is likely to consider investments in energy, precious metals, industrial metals, agricultural products and livestock; and there are five typical implementation models to be debated.

One of those is whether to take a corporate position by buying shares in a company that has inventories – effectively buying a piece of the balance sheet. The fund could also buy stocks in a direct exposure, such as an oil company. Alternatively it could use derivatives to get beta exposure, or an alpha benefit. Or it could take a physical storage position by buying, for example, timberland.

“The first quarter will see us debate all of these exposure and implementation options. Once we decide our positions then we will decide on what our naive benchmark might be,” he says.

This will most likely be either the S&P commodities index or the Dow Jones commodities index. This decision is important because‚ the indices have different weights, with the S&P index having more exposure to energy.

“We will probably use a benchmark like that but may not. Then in the second quarter we will pursues managers with the [appropriate] skill set.”

Meanwhile, another three new allocations have been made, with a range of 0 to 5 per cent to both risk parity and absolute return strategies, and 0 to 10 per cent in opportunistic risk.

“The exploration of risk parity strategies is about reconstituting the asset to have more total fund volatility from less volatile assets like bonds, using derivatives. And in opportunistic investments we will look at distressed debt, mezzanine financing, and high yield bonds,” Matson says.

Arizona State Retirement System: asset allocation at September 30, 2009

US equities large cap


US equities mid cap


US equities small cap


International equities large cap developed


International equities small cap developed


Emerging market equities


Fixed income core


Fixed income high yield


Private equity


Real estate




Risk parity


Absolute return