The $315 billion CalSTRS is looking to build a top-down portfolio function to better incorporate liquidity management alongside portfolio construction and to consider how it can better deal with often lumpy cashflows to maximise returns, while continuing to keep a tight rein on risk.
CalSTRS is developing a new top-down total portfolio function to better incorporate liquidity management alongside portfolio construction.
Deputy chief investment officer Scott Chan says the fund is at the early stages of enhancing its liquidity oversight and is building the teams and tools to centralise that function.
“Portfolio construction is at the heart of how we look at liquidity oversight, as a tool to enhance how you construct the portfolio. They go hand in hand,” he told Top1000funds.com in an interview.
“But it is integrating these components into the portfolio construction that is the hard part. You need all of your private and public markets working together and that’s hard for organisations to get right.”
Chan says the fund already has significant experience and tools for liquidity management across the various divisions, but the maturation of the portfolio meant evolving and enhancing the liquidity function was important.
The fund has a mature member profile and it pays more in benefits than it receives in contributions. In addition, a two-decades old private markets allocation means cashflows need smoothing.
“We have been increasing our allocations to private markets over the past two decades which has worked out remarkably well,” Chan says.
“But if you start every year with a negative cashflow and layer on more volatile cashflow there is an ongoing need to manage liquidity. For example, in 2021 we had a ton of cashflows come back from private investments but today not so much.”
CalSTRS’ liquidity priorities are paying benefits, avoiding selling assets at a discount, taking advantage of dislocation opportunities, and building a resilient portfolio that can rebalance to asset-allocation targets and take advantage of opportunities in the event of a recession.
“Liquidity is a tool that enhances your portfolio construction and helps build a resilient portfolio,” Chan says.
“Liquidity is the lifeblood. In this environment it’s becoming more and more important.”
A core goal in the liquidity and leverage management is to smooth out cashflows over a business cycle.
“Some years you get a lot of cash back and others you don’t, it’s lumpy cashflow,” Chan says.
“Over a cycle you can smooth that out using leverage and liquidity tools.
“We are not intending to take on permanent amounts of leverage, thinking of it more as a way to enhance the portfolio construction over a business cycle.”
Chan says the intention is that balance sheet/liquidity management will add to the existing investment strategy and risk unit which already looks after asset allocation.
A team will be hired, from both internal and external resources, and sit under a head of total portfolio management.
“It will be really critical to get this right,” Chan says.
“It is important to integrate this tightly and weave it into portfolio construction. It will be a multi-year evolution and phasing. Our organisation needs to mature into the idea of how we enhance the liquidity management.”
Chan says it is not just the technology and resources that need to evolve, but the governance structure as well.
“As we evolve we will continue to build out those risk processes,” he says.
“And we will have to build out further governance too, related to how we make the decisions. It’s going to be a multi-staged evolution for us.”
ALM and asset allocation evolution
The $315 billion fund recently went through an asset/liability exercise and made three significant changes to its asset allocation.
The global equities allocation was reduced by 4 percentage points with 2 per cent of that going to a new private debt allocation. The fund had previously invested in private lending through its innovation bucket and this is the first time that it has had its own allocation.
“Private credit is an incredible opportunity today,” Chan says.
“When you think about the portfolio of the future, here you have something near mid-teens returns and you are high in the capital structure, which is better in a recession. It is a critical part of our asset allocation going forward.”
CalSTRS’ innovation portfolio has been an incubation bucket for many asset classes that now have their own, more permanent allocation like private credit, inflation-sensitive assets and the risk-mitigating strategies bucket, which is where global macro, CTAs and other risk-mitigation hedge funds sit.
That bucket is now going to be expanded to consider other opportunities to add to diversification.
“We’re looking at how we can design greater flexibility to the portfolio,” Chan says.
“For example if there is a recession can we take advantage of the opportunities.
“The innovation portfolio has done well historically. Bonds might have returned 1.7 per cent over the last 10 years and we got a lot more return out of the asset classes [in the innovation bucket] and got diversification. We will continue to expand that opportunities bucket to flow into different areas. It gives us that flexibility that’s important in portfolio construction and asset allocation because the market is a lot more uncertain.”
It also allocated a further 1 per cent to private equity, taking it to 14 per cent, and another 1 per cent to infrastructure.
CalSTRS had a one-year return to June 30 of 6.17 per cent and a three-year return of 10.1 per cent, well above the actuarial rate of return of 7 per cent.