James Grossman, chief investment officer of the $50 billion Pennsylvania Public School Employees Retirement System, PSERS believes disintermediation offers the most important opportunity for investors in coming years.
This global trend towards the reduced role of banks as middlemen, is an opportunity for pension funds to move into high yield corporate debt, he says, insisting that institutional investors are perfectly capable of directly lending to businesses to fill the gap left by banks.
“Pension funds can work with partners who understand how to underwrite credit and who have close relationships with corporate treasurers and know the companies well. In addition there will be no bank infrastructure costs eating away at returns,” he says, in reference to the securitisation process whereby banks’ corporate loans are repacked for institutional investors into lower yielding investments, reducing returns.
It’s just the kind of alternative opportunity that Grossman favours.
PSERS’ 60.6 per cent total funded ratio, as of June 2015, heavily informs investment strategy and his pre-eminence at the fund where he says “he has been around for a while” since joining as a compliance and risk officer in 1997, and becoming chief investment officer in 2014, has engendered many of the changes.
Volatility and risk have been steadily phased out with the reduction of the equity allocation to today’s 37.5 per cent target. While diversification has come with a range of strategies including a 20 per cent target allocation to fixed income, a 21 per cent target for real assets and a 10 per cent target for absolute returns – one portfolio, along with real estate and non-US equities, that did well in 2015.
It prompts Grossman into a robust defence of PSERS’ hedge fund allocation, up 4 per cent for the year, “right on target net of fees,” at a time when hedge fund performance and fees are under increasing fire.
“There is a misunderstanding of what hedge funds should or shouldn’t be doing in a portfolio: they aren’t meant to beat the equity market. If you’d like equity returns, hire a low cost equity manager. For us, hedge funds are a diversifying asset class with low beta and low correlation to equity markets, so that if equity markets fall, hedge funds are expected to do better.”
Casting a look back over PSERS’ 20 worst ever months in the equity market since 2005, hedge funds outperformed every time, with positive returns in 12 of those 20 months.
A new approach
New strategies will include PSERS increasing its allocation to diversified infrastructure from today’s one per cent allocation.
This will entail a more active, view spotting strategy focused on infrastructure within the private debt and private equity markets, rather than simply indexing global public market infrastructure equities.
“We believe the asset class has attractive characteristics and that it is less sensitive to economic cycles. There is lots of competition in infrastructure today but then there is competition for all assets with yield at the moment.”
Of the total fund, 22 per cent is in passive mandates. The 9 per cent allocation to US public equity is entirely indexed and 50 per cent of the non-US equity allocation is also in passive strategies; 80 per cent of the commodity allocation is passive.
Grossman does believe that there are opportunities to add value in non US small cap and emerging market equities where there is “less information flow,” and that active management also pays in fixed income.
Approximately one third of the portfolio is managed in-house with the rest with external managers.
“We don’t have the core competency or staff for private equity or direct real estate,” he says. Allocations to private credit and high yield are also outsourced.
“I believe there would be a cost benefit for the fund in bringing in more staff, but this decision lies with the Commonwealth,” he says, in reference to the State of Pennsylvania.
The decisions Grossman can control are manager selection and here he has persistently trimmed away. PSERS has terminated 19 managers over the past two years (101 mandates have gone over the past 10 years).
Other recent changes include bringing US equities in-house, and investment expenses fell over 18 per cent between 2014 and 2015.
“We are very aggressive when it comes to negotiating our fees, although in certain markets, namely private real estate and private equity, negotiation can be more difficult because of the increased capital going into these spaces. We maintain close relationships with all our managers, all the time. We certainly don’t give them $100 million and say we’ll see you in five years’ time. We meet and get to know them, sit on all of their advisory boards, and we are quick to spot any strategy drift.”
Tougher times for hedge funds means that negotiating fees with hedge fund managers has become easier, he says.
PSERS is also cutting costs by pursuing a co-investment strategy, begun in 2011.
Challenges include successful co-investment being dependent on the deal flow from managers – and managers having an excess deal flow they are prepared to co-invest out. It also requires a strong internal team able to do the due diligence and at PSERS Grossman has to rely on his existing staff to manage co-investments although he says he says he is “working hard” to illustrate the benefits of more staff in this area.
Co-investment, without any management fee or carried interest attached, layered alongside a standardised two and 20 private equity investment can effectively slash costs, he says.
“It can drive the all-in private equity and private real estate management fee and carried interest down, which amounts to co-investment being a considerable fee-saving vehicle, while at the same time enhancing net of fee returns.”
In 2010 PSERS had to sell 8 per cent of its assets to meet its pension obligations. Since then the fund’s negative cash flow has improved and reforms under the so-called Act 120 are gradually increasing the employer contributions to actuarially required levels. It makes for a stressful job but Grossman still enjoys it.
“We have a great staff and a good board of trustees who are supportive and open to ideas. I like mixing with some of the smartest people in finance and I’m definitely not doing the same thing every day.”