A decision by two of Missouri’s public pension plans to adopt a straightforward risk-based approach to asset allocation garnered their best result in two decades last year, while also providing investment staff with the autonomy to react quickly to changing market conditions.
The board overseeing the Public School Retirement System of Missouri (PSRS) and the Public Education Employee Retirement System of Missouri (PEERS) adopted an asset-allocation approach in 2009 that divides the portfolio into three simple buckets: safe assets, public risk and private risk. Both funds are managed by one investment team and overseen by a single board.
Chief investment officer of PSRS and PEERS, Craig Husting, explains that the approach gives clarity to the board by providing a clear, easily understood focus on a set of risks that are to be managed across the portfolio.
“We divided the portfolio into three buckets to try to identify how much money we could lock up in long-term illiquid investments where we could expect a higher rate of return,” Husting says.
The system is one of the best funded public-pension funds in the United States, with PSRS and PEERS enjoying more than 85-per-cent actuarial rates of funding.
This is on the back of a bumper year in 2011, where the combined assets of the two funds topped $31 billion. PSRS and PEERS earned returns of 21.8 per cent and 21.4 per cent respectively.
Husting explains that PSRS and PEERS use what he describes as an “intuitive risk-based approach” that focuses on liquidity, volatility, tail risk and the ability to meet the system’s assumed rate of return of 8 per cent per annum and a real-return target of at least 5.5 per cent per year.
“Sometimes people in our industry get caught up in terms of the value-at-risk in the portfolio or the standard deviation or the tracking error and other quantitative measures,” Husting says.
“What we mean when we take an intuitive approach to risk is that it’s a fairly simple concept to understand because our primary risk is liquidity or illiquidity, the ability to get 8 per cent, which we need to get, and tail risk, which is are we going to get killed by a left-tail event?”
The focus on risk is bearing fruit not only in terms of building a more robust portfolio but also in providing for more efficient returns relative to risk.
The system used Trust Universe Comparison Services (TUCS) analysis to show that the while the PSRS/PEERS total returns over three and five year time periods were marginally below the public-fund median return, they had taken less risk than 70 per cent of other comparable funds in the TUCS universe. Safe assets consist of mainly US treasuries and Treasury Inflation Protected Securities (TIPS). Private-risk assets are essentially illiquid and include private real estate, private equity and private credit assets.
Husting says the public-risk asset is broadly defined as any asset that is primarily liquid and has a risk component to it with this portfolio consisting of both US and non-US stocks, most types of credit, hedged assets and currency plays.
The 8-per-cent-return target, in the upper range for a US public-pension fund, means the investment staff cannot simply take risk off the table if they still want to meet the return objectives.
The public-risk portfolio, with its broad focus on liquidity, gives the investment staff flexibility, Husting explains.
“That [public risk] is a relatively broad bucket, with the intention of giving staff more flexibility to move assets around,” he says.
“For example, if equities seem expensive, instead of taking all the risk off the table by going from equities to bonds, we can lower the beta of that portfolio or bucket by going from full equities to credit or something like that,” he says.
Hedging your risk/return
Hedge funds play a vital role for the system, both from a returns perspective and as part of their strategy to manage volatility across the portfolio.
Hedge funds now make up 15 per cent of the total portfolio, with managers focused on providing lower volatility returns compared to the system’s broader equity portfolio, Husting explains.
This aspect of the hedge-fund program was funded out of allocations from equities and typically aims to have a beta much lower than the broader equity market of around 0.4.
“It is really there to lower the overall beta and volatility of the total fund, but still have some ability to capture upside,” he says.
Complimenting this hedge fund strategy are several low-volatility mandates the fund has adopted in its broader equity portfolio. Its private-equity investments also provide a lower volatility source of returns compared to public markets, Husting says.
The focus on low volatility means the investment team can also look to take on more risk in the remainder of the equity portfolio, he notes.
In addition, the system also uses hedge funds to provide an alpha overlay.
“The alpha overlay is essentially buying S&P swaps. We get exposure to the equity market through swaps and then we take the money and buy market-neutral-style hedge funds and overlay those hedge-fund returns over those S&P 500 swaps,” he explains.
Husting says the objective of the 10-manager program is to get alpha over and above the index, which in this case is the S&P 500.
“This program has been very successful providing alpha in excess of 400 basis points a year for the past several years,” he says.
When it came to managing tail risk, Husting notes the fund did consider tail-risk insurance but eventually decided to look to the safe-asset bucket to take on this role within the portfolio.
The fund has about 15 per cent in US treasuries and TIPS, which Husting notes acts as a buffer to potential risk events.
However, the fund is underweight safe assets compared to a policy target of 20 per cent.
“We are underweight because it is such a low-yield environment and we are searching for yield in other places so we have been moving some money out of safe assets into a little more risk-seeking assets,” he says.
The system is also underweight private equity as it gradually builds out its program. Private equity currently makes up 7 per cent of the portfolio with the board setting a long-range target of 10 per cent.
Autonomy with accountability
The autonomy enjoyed by the investment team also comes with accountability: the board established a process of benchmarks to hone in on the attribution of performance.
The board has set a long-term asset-allocation target for public-risk assets of 60 per cent, safe assets of 20 per cent and private assets of 20 per cent.
The investment team is given broad policy ranges for each of the underlying asset classes in these buckets.
Actual allocation vs target allocation
|Public risk assets
|Private risk assets
SOURCE: PSRS/PEERS Asset Allocation
The board then annually reviews the internal team’s performance by referencing a policy benchmark consisting of a broad set of market indexes, essentially a passive benchmark against a strategic one.
This benchmark is set monthly and aims to reveal whether the investment team’s decision to overweight or underweight certain asset classes added value to the fund.
In an additional step, the fund compares this strategic benchmark to actual performance of the fund to evaluate whether manager selection has made a positive contribution to performance.
Along with strategic asset-allocation decisions, the 11-person internal investment team has the responsibility, with advice from consultancy Towers Watson, to select managers.
PSRS and PEERS use external managers for all its asset classes.
As a final check and balance, any major moves in asset allocation must be signed off by Husting, the executive director and the consultant.
Getting what you pay for
When it comes to selecting managers, Husting says the investment team is focused on only paying for active management in asset classes in which it believes alpha can be consistently achieved over the long-term.
“We are moving more to the view that there are fewer asset classes where you can add alpha in,” he says.
“Definitely [in] private markets and hedge funds, we are fully active and think we can add alpha in those areas. But in large caps and straight bonds, we think it is very difficult to add alpha, so we have gone more passive in those areas. Emerging markets and small caps we are also more active in.”
Fund performance to March 31, 2012
|Fiscal year to date*
* The Retirement Systems’ 2012 Fiscal Year began on July 1, 2011.
**The Policy benchmark is comprised of 40.5% Russell 3000 Index, 16% Barclays Capital Treasury Blend, 15% MSCI All Country World ex-US Free Index, 15% Barclays Capital Intermediate Credit Index, 7.5% NCREIF Property Index, 4% Barclays Capital US TIPS 1-10 Year Index and 2% Merrill Lynch High Yield Master II Index.
SOURCE: PSRS, Total Fund Investment Returns