Cash rate scenario analysis drives asset allocation reset at Maryland

The asset allocation of the $63 billion Maryland State Retirement and Pension System “is working” according to its chief investment officer Andrew Palmer with the fund producing a relatively good year of returns despite the market conditions.

The fund’s asset allocation is “better than a 60:40” according to Palmer with the asset mix specifically protecting the fund on the downside.

The long-term strategic asset allocation is 34 per cent public equities, 21 per cent rate sensitive assets, 16 per cent private equity, 8 per cent credit/debt strategies, 15 per cent real assets, and 6 per cent absolute return, designed to produce greater protection during short-term market volatility.

In fiscal year 2022 the portfolio returned -2.97 per cent, net of fees, which was well below the 6.80 per cent assumed actuarial return rate but ahead of the plan’s policy benchmark of -3.48 per cent.

“Returns relative to risks are very good. That’s what we are aiming for. We can always get higher returns by taking more risk,” says Palmer in an interview with Top1000funds.com.

“The high allocation to private markets has worked well over the past year, although with recovering public markets it’s holding us back a bit this year.”

The fund continues to tweak its allocations and is making some changes around the edges, including winding back allocations to emerging markets and bond protection over the next year or so.

Emerging markets has made up about 7.5 per cent of the total public equities allocation, and an asset allocation discussion in February specifically focused on China.

“When we made our move into emerging markets, China was a small part of that allocation now China is 40 per cent of EM equities,” Palmer says, adding that after an evaluation of the return expectations the fund has decided to wind back emerging markets and a lot of that is due to the outlook for China.

“Among EM we think China will have a lower return expectation than the rest of emerging market and developed market stocks and we think we should have a premium for investing in China equities,” he says.

The adjustment over the next two years will rebalance towards US equities (6-10 per cent).

“We think returns are broadly higher respectively in public markets now, so we can move back to less risky stocks,” Palmer says.

Biggest risks in the portfolio

While Palmer is clear that any investment decisions are based on risk /return assessments and not politics, he is aware of the geopolitical risks to the portfolio.

“The biggest thing we should be advocating for is China and the US to figure out their differences,” he says. “Biden and McCarthy need to figure out the debt negotiations and then China and the US need to respect each others’ sovereignty and look at the bigger things they can work together on, such as climate change, and partner together to be more impactful. This will take a reset.”

As part of a recent risk assessment of the portfolio by a large investment bank, scenario analysis looked at the impact of an invasion of Taiwan by China and the possible US reaction to that.

“With a Ukraine-like reaction by the US we would see a fall in the portfolio of 8 per cent immediately,” Palmer says. “If we reduce our exposure to China from 10 to 5 per cent then we can reduce that to a 7.5 per cent loss. There is so much interconnectivity because of the impact on global growth and inflation, the interruption to global trade is orders of magnitude bigger than Russia.”

Scenario analysis of various risks is a contributor to asset allocation changes for the fund and Palmer also points to climate risk analysis as a driver of the decrease in the absolute returns portfolio and an increase in infrastructure and natural resources a few years ago.

In 2015 when Palmer joined the fund as CIO the absolute returns allocation was 16 per cent, now it’s down to 6 per cent.

“A couple of years ago we shifted the absolute returns portfolio from 8 to 6 per cent and moved it into natural resources and infrastructure. The return scheme is diversifying but not sensitive to inflation and we wanted to add inflation sensitivity,” he says, adding he is still worried about inflation.

“After the financial crisis the central banks were fighting against deflation and fiscal stimulus that ended up driving the inflationary impulse. We are going to have a similar problem on the other side, to get inflation back down. It will be hard for them to get it materially lower,” he says. “The Fed has done a fair amount and needs to let it work a little bit. They were late to this, they should have been tightening when the government was stimulating.”

Recognising that all asset class teams do things differently when it comes to climate risk, one of the key projects at the fund is to coordinate efforts across asset classes to drive more effective practice.

Using the Alladin risk system to evaluate risks and build functionality to identify, reduce, and hedge climate risks Maryland is also incorporating an engagement program by first identifying the most effective places to engage.

“The focus for the next year or so is to build that out,” Palmer says.

Looking forward from a top-down perspective, the team is assessing the performance of non-zero cash rates and what that means for the portfolio.

“We are trying to earn 6.8 per cent and if you can earn 4 per cent on cash what does it mean for other asset classes and what should our return hurdles be for those,” Palmer says. “If an infrastructure manager is earning 2 per cent over cash and the money is locked up why is that exciting for us?”

Palmer still sees a lot of value in the private world and a differentiation of investments that can’t be replicated in the public space. But he wants to make sure the tradeoff is clear.

“It really depends on how permanent this non zero cash rate of 3-4 per cent will be,” he says.