Chicago Teachers: Where succession fears put managers on watch

Succession planning among its external managers was front of mind at the February investment committee meeting at the $13.8 billion Chicago Public School Teachers Pension & Retirement Fund (CTPF).

Trustees voted to put investment manager Phocas, which oversees a $109 million allocation to US small-cap value, on watch following concerns about new leadership at the California-based manager.

Although the Chicago pension fund has invested in the Phocas strategy since 2016 and pocketed returns of 9 per cent net of fees to outperform the benchmark since 2016, a change at the top has given cause for concern.

In another flag, the strategy has approximately $800 million in assets of which CTPF accounts for 13 per cent.

“If there is a significant drop in assets, we will need to evaluate the situation carefully and reassess our position,” state board documents presented by CTPF consultants’ Callan, led by senior vice president Tony Lissuzzo.

CTPF trustees voiced the importance they attach to an in-house mechanism at external managers whereby when someone “steps out,” another member of the existing investment team “steps up.”

Yet at Phocas, two new hires from outside will pick up the reins when the firm’s current CEO and a member of the portfolio management team for the small cap value product retire at the end of March. It’s left CTPF unsighted on how the incoming team will perform going forward. Particular unknowns include their ability to bring ideas into the investment process, as well as consistency around portfolio construction and implementation.

For example, the two new employees’ area of expertise is growth equity, not value. And CTPF doesn’t want to move away from value, or inhibit the role of value, in its own portfolio structure.

“We can’t tell you with confidence there will be no issues here,” said Lissuzzo, who added that putting the manager on watch would give trustees time to evaluate and get to know the new team.

CTPF trustees also voted to keep William Blair international small cap on watch. The firm oversees $176 million of the pension fund’s assets and has been on watch since March 2023.

The allocation continues to labour under challenges in quality and growth assets in contrast to value denominated performance which has done better in international markets.  Trustees agreed it was “premature to pull the trigger now” and also voiced concerns around whether another international small cap manager would perform any better and be able to add value in the current market.

But they acknowledged that “if quality comes back” and the manager continues to underperform there will be “a problem.”

“The institutional-quality managers represented in CTPF’s portfolio focus on high-quality characteristics, which will tend not to do well when high beta, lower quality names dominate market performance,” stated board documents.

How a watch list works

CTPF’s watch list takes into account both quantitative and qualitative issues that span performance as well as any change in processes. Being on watch involves a formal review and deeper probe by staff to explore the extent to which a manager adds value net of fees. Typically, a manger goes on watch for 12 months.

Chicago’s watch process measures rolling and intermediate manager performance and risk on a 0 to 10 scale – when that number hits seven, the manager goes on watch. The board has the ability to maintain managers on watch or terminate them. The discussion also espoused the benefits of managers on watch coming to present to the fund.

The pension fund’s consultants also argued the case for Chicago’s $1.1 billion private equity allocation built up since 1996. Trustee frustrations include the fact the private equity portfolio is currently 8.56 per cent of the CTPF total portfolio against a target asset allocation of 5 per cent.

The most similar asset class to private equity is global equity, so if the private equity program was eliminated the most similar investment option would be to allocate the 8 per cent across the global equity portfolio. Yet private equity outperforms global equity over the five, 10, 15 and 20-year periods by an average of 4.1 per cent annually.

“In all cases the CTPF private equity portfolio was the better choice over the past 20 years.  Moving the private equity allocation to the Russell 3000, the S&P 500 or the Bloomberg Aggregate would alter the risk profile of the portfolio as laid out in the IPS and is not a prudent investment decision.”

The program currently comprises 30 managers across 101 individual investment vehicles in fund-of-funds and direct partnership managers. The portfolio also consists of a developed manager program and an emerging manager program that targets minority and women-owned business enterprise managers and developing managers.

“For every dollar Chicago has put into private equity it has got about $1.60 cents back. That’s a good number for a mature program,” said Lissuzzo.