Back to basics as CalSTRS rethinks active/passive mix

The board of CalSTRS, the second biggest fund in the US, has
three broad research initiatives for the investment team this year: rethinking active versus passive and the mix of internal and external management; commodities; and liability – driven investments. Chief investment officer, Chris Ailman, spoke to Amanda White.

The California State Teachers’ Retirement System (CalSTRS) will publish its business plans in the next week or so, and with a back-to-basics theme, the investment team has been directed to review its mix of active versus passive.

Chief investment of CalSTRS, Chris Ailman, says the board typically asks the investment team to review three broad themes in addition to its normal portfolio level and work.

“The board wants us to look at the mix of active passive in both equities and fixed interest investments. We have traditionally been heavily passive and that has helped us. Active management has been very expensive, at times it has proved its worth, at other times it hasn’t,” he says. “This is going to be a very open and honest dialogue and an interesting debate.”

The debate will centre around whether to increase or decrease active management and to change the fund’s policies around that.

About one third of all CalSTRS investments are internally managed, with about 80 per cent of fixed income and 35 per cent of US equities managed inhouse.

With three retirements this year the fund is currently recruiting for a new director of private equity, and director of global equities, with announcements due in the next month or so.

Ailman believes the fund could run more assets inhouse, at a fraction of the cost, but is cognisant of the limits of being a large public pension plan.

“If you are going to be an investment management company we need to consider that we are inside the structure of a governmental identity, which is subject to Governor orders and three-day furloughs, and that’s probably not the way you would choose to run an investment management organisation if you could. So we have to recognise and
have an honest dialogue about our internal strengths and weaknesses.”

In addition to active versus passive, the board has also asked the investment team to research commodities – whether they are really a hedge against inflation, or more just daily volatility – and next financial year to look at liability driven investing.

In July the board set a new asset allocation to its target policy, which saw the investments shift slightly to 54 per cent in global equities, 20 per cent in fixed income, 12 per cent in real estate, 12 per cent in private equity and 1 per cent in cash. It is now neutral to the policy benchmarks but it has been underweight global equities for much of the past year.

“What we are actively trying to evaluate is whether we want to be underweight global equities or overweight. The economic signs around us aren’t very strong, they are less weak, but that’s a far cry from saying there is economic growth,” Ailman says. “It has been frustrating to see this rally it has really surprised us. We think there are still some structural flaws in US and UK banks yet those stocks have rebounded. People have seen what they described as green shoots, we are a little bit more worried they’re actually weeds.”

While the asset class ranges only changed slightly (up or down 1 per cent) the fund also created a new absolute return asset class.

“We’re concerned about wanting to get more inflation protection in the portfolio. This will be in the form of global TIPS and then later we will look at infrastructure and are building up our local infrastructure team.”

CalSTRS is working cooperatively with CalPERS and some of the large Canadian pension plans with
co-investment a possibility.

“We describe it as a kind of London Club which can work cooperatively on deals rather than compete against each other.”

The fund made two changes to its long-term outlook in February, creating a taskforce – the equity return
committee – from a combination of the real estate, fixed income and private equity groups, to look at distressed debt opportunities. The board has approved up to $6 billion in these opportunistic investments.

“We were starting to see opportunities in those asset classes, and wanted to create a rigid fixed income analysis of
all of them. With capital being so scarce we really wanted to harness the talents of all of our team,” he says.

“We are not interested so much in distressed debt, but distressed sellers. What is interesting is there was such a rush for government to sell toxic assets in the banks back in March, but we haven’t seen any activity until just recently. We just started meeting with the nine firms that have been approved by the US government in the PPIP program.

“It is still questionable whether the banks are going to be willing to sell all this debt that they hold. I have said I am not interested in buying toxic debt but I am interested in buying debt that can be worked out at the right place.”

CalSTRS will be publishing its annual returns in the next couple of days, and Ailman says they are very disappointing.

“This year is clearly disappointing, the most difficult of my career. I am personally very disappointed we weren’t able to protect more capital,” he says.

“I wouldn’t be human if I didn’t second guess myself constantly, but what I have said to the board and I constantly say to the members, this is a marathon not a sprint. We design the portfolio to do well in decent global growth. If you designed a portfolio to protect capital in this one year out of 70 you would underperform dramatically
the rest of the time.”

This decade may be the worst decade for investments and financial instruments in the US since the civil war, and CalSTRS continues to engage with its business partners to try and improve the situation.

Within private equity Ailman says there is a close watch on the funds that it allocated money to in 2007/08, partly because they were such large funds.

“The real challenge will be to see how those funds we allocated money to in 07/08 funds, which raised very large funds, perform. Part of the question is, is that the right structure, are those funds too big for this investment environment? And we are having that kind of long term dialogue with our business partners.”

While CalSTRS will reduce its private equity commitments, it will continue to invest in middle market buyouts, somewhat to venture capital and some of the opportunistic opportunities.

It is also in open dialogue with Barra to refine the inclusion of private investments in its risk management processes.

Last year an innovation and risk group was created and it has been implementing Barra 1 across the portfolios.

“The challenge in a global diversified portfolio is trying to model the private asset classes. You end up modelling them in a proxy which isn’t very efficient, and we are working with Barra closely to refine that and zero in,” Ailman says.

“Both private equity and real estate portfolios are over $10 billion and have long histories. Each are 12 per cent of the portfolio, I know how 76 per cent of the portfolio is going to react on a day to day basis, and can model that efficiently. But that 24 per cent is where my risk lies, so it is important to get it loaded into the system and
be able to have comprehensive analysis of your exposure in so many ways.”