After nearly a year at the helm, Edwin Denson, executive director and chief investment officer at the State of Wisconsin Investment Board talks to Top1000funds.com about changes in investment strategy, noting that active management and the need to take on more risk for the same return, are current guiding principles.
Top1000funds.com: Are you venturing into any new strategies and allocations and if so, what is the rationale?
Edwin Denson: We have made some changes to the sub-asset classes within fixed income. That includes increasing allocations to more credit-spread sensitive assets and less efficient segments of the market as well as adding capital where the strength of our internal team creates alpha opportunities. For example, in 2020, we launched two new internal fixed income strategies, our mortgage-backed securities and high yield bond portfolios. In 2022, we are continuing to add capital and build out those strategies.
Increases to those portfolios as well as a new allocation to leveraged loans are being implemented alongside reductions to US government and US investment grade credit. An increase to long-term Treasuries will offset the loss of duration from allocating to leveraged loans and mostly preserves the overall duration of the asset class.
Within public equities, the 2022 asset allocation is tilting towards sub asset classes that have more expected active return potential to increase the likelihood of meeting the 6.8 per cent target for the core trust fund over the long term, including increases to US small cap, emerging market small cap, and emerging market ex-China large cap.
Our asset allocation and overall investment strategy allows us to take full advantage of the skill and knowledge of our staff. The confidence we have in the allocation comes because of the highly qualified staff that we have managing risk and generating the necessary returns through active management.
Q: What strategies do you have most confidence in and what is your strategy for a lower return environment?
A: Ultimately, we are long-term investors. The next 10 years will be challenging from a total return perspective as returns on assets are generally expected to be low relative to longer-term expectations, in part because of higher than average realised returns from risk assets over the last few years. The challenges of setting policy are twofold. First, the fund needs to take sufficient levels of total risk over time.
Second, the fund needs to shy away, to the extent possible, from the type of risk that can lead to negative short-term returns that are large enough to exhaust the WRS’ surplus used to increase annuities (the dividend surplus) in a short period of time, which could also put upward pressure on employee/employer contribution rates. To meet those challenges, we have implemented an investment strategy designed to weather various market conditions by allocating our capital to areas we feel the most confident we can generate reasonable returns based on the risk we are taking.
Active management is important to our investment strategy. Over the next 10 years, the policy portfolio is forecasted to return just 5.4 per cent which is below the system’s assumed rate of 6.8 per cent. We are using active management to make up some of that difference. Since the end of 2018, we have moved from 56 per cent to 69 per cent of the fund being actively managed. In addition, we continue to believe in the value of internal management to drive returns at costs lower than the fees paid to external managers when we can support the strategy with both people and infrastructure.
Using our own staff to actively manage the funds is a key cost-saving measure that helps grow the fully funded WRS. We are currently managing approximately 50 per cent of fund internally. By using internal active management with our current asset allocation, which is tilting towards sub-asset classes that have more expected active return, we increase the likelihood of meeting the 6.8 per cent target for the core fund over the long-term.
In addition, the core fund uses a modest amount of leverage in its investment strategy. SWIB’s independent board of trustees has approved a leverage target of 15 per cent for the core fund. We are using leverage where it can improve portfolio efficiency in terms of return for risk versus alternative choices that do not use leverage. The leverage helps reduce risk by supporting a higher allocation to lower risk fixed income securities and a lower allocation to equities at the same overall target return. This strategy is one part of our overall long-term strategy of greater diversification and risk control.
Q: Could you detail the findings of your recent stress test and what it has told you about the portfolio, particularly around the need to take on more risk to get the same level of returns? How will you do this?
A: First, I should point out that more risk is required in 2022 for any particular core fund return aspiration. For example, in 2019, when we engaged in our stress testing exercise, in order to achieve a 6 per cent return, there was a 10.7 per cent risk associated with that return. And for a 7 per cent return, there was a risk of 14.7 per cent. Now for those same two returns, 6 per cent and 7 per cent, we have to take almost 50 per cent more risk. We need to have 15.5 per cent risk to get the 6 per cent return and a little bit over 20 per cent risk in order to achieve the 7 per cent return. This is because more exposure to risky assets like public equity is needed in the allocation mix to achieve any particular return.
The outsized returns we’ve seen over the last three years have detracted from the forward-looking expectations. However, the good news is that higher returns over the last three years have built up the dividend reserve for annuitants. These returns have yet to fully flow through the system, given the five-year smoothing mechanism that is in place. And they do provide us a cushion to utilise an asset allocation that is expected to run a little on the cool side in terms of return over the next few years and avoid taking undue risk.
Q: Has the market regime shifted? Also, could you talk a little about the dangers of de-risking too soon and its impact on long term returns?
A: It is very hard to know in real time whether there has been a shift in the existing economic or market environment that will be persistent as opposed to transitory. The result is that at SWIB we have implemented an asset allocation that can help weather changes in market conditions without having to predict precisely when they will occur or if they are occurring. The structure of the plan also makes a huge difference.
The fact that the WRS is fully funded and operates on a unique risk sharing model means that we don’t have to chase every dollar of return as the risk climbs higher and higher. Instead, maintaining a disciplined long-term asset allocation allows us to take generate reasonable returns that help keep contribution rates for employers and employees stable and avoid large swings in annuity adjustments for retirees.
Q: How does technology support your active, in-house strategies? What is the fund doing specifically, and how is it changing how you invest?
A: We continue building out the technology to support internal management and new strategies. For example, we selected the SimCorp Dimension platform to serve as an integrated portfolio management and accounting system for our public markets portfolios. Ultimately, SimCorp will house a full view of our assets and will allow us to move away from using a third-party service provider for the investment book of record and middle office services. In conjunction with this new platform, we are also onboarding our first prime broker relationships.
SWIB uses eFront as a its software platform for private markets. This creates efficiencies in reporting, data warehousing and maintenance of the systems used for private equity, venture capital, co-investment, real estate, and hedge funds. As a result, we have automated transmission of transactional data and wire instructions, created consistent processing of transactions and valuations, and implemented key metric reporting.
Making enhancements to our data management to support the increasingly complex internal strategies and tools we are using remains a focus given the anticipated low return environment.
Q: What is your leadership style and why is enabling and supporting colleagues so important?
A: I think in the investment industry, it is easy to have tunnel vision and become focused solely on the investment strategy. My entire career has been concentrated on the investment side, but now, in the combined role of executive director and CIO, I find myself spending a meaningful amount of time focused on the culture at SWIB and my overall approach to leadership. My leadership style is to be less directing, other than reinforcing our mission and values and our vision and articulating the agreed upon objectives that help us get there.
And I apply that style consistently across the agency. I see myself as more of an enabler and a supporter setting folks up for success. I think that if we all live up to our organizational values – Excellence, Innovation, Integrity, Collaboration and People — that dovetails nicely with an environment where leadership enables and supports our employees rather than micromanage them. We need everybody to contribute, to be set up to win, and to be able to work together for us to achieve those objectives.
Q: What is the most important thing you’ve learnt since taking the helm?
A: The clear lesson from the past year is that you can’t be a good executive director/CIO by focusing only on the investment strategy. There is an impulse that pushes you toward what you know best, and it makes sense that if you can get the investment strategy right, everything else will work out. But there is a whole other skillset, and an entire list of non-investment challenges, that are just as critical to our success. So I am focusing on recruiting and retaining top talent across the agency, developing a culture that motivates employees, ensuring that we have the technology, systems, data and infrastructure to support our long-term goals, and engaging with our stakeholders around the state.
And, I’m also working on the investment strategy. The core fund returned 16.9 per cent in 2021, bringing the five-year return to 12.5 per cent and the 10-year to 10.10 per cent. Those returns exceeded the return of the core fund benchmark by 0.64 per cent, 0.43 per cent and 0.36 per cent, respectively, and continue to exceed the long-term WRS investment target of 6.8 per cent. We have a really solid foundation to build on, but we can never be complacent.