CalSTRS overlays its fuzzy buckets

After deciding at the last investment committee meeting to employ a new way of evaluating portfolio risk which overlays risk across asset classes, rather than replacing asset classes with risk categories, CalSTRS now just has to work out how to do it. Amanda White spoke with chief investment officer Chris Ailman about the fund’s journey to conquer risk.

Unfortunately life doesn’t fit into neat buckets, and neither, the investment staff at CalSTRS have discovered, does risk.

According to chief investment officer, Chris Ailman, the fund had intended to conclude its evaluation of risk management by allocating according to risk budgets.

“We came up with the risk overlay approach after a meeting in early January with Martin Leibowitz from Morgan Stanley, our staff and Allan Emkin and his staff. We fully intended to come up with risk buckets, but found that the number of risk buckets depended on your time period, and over the really long-term they blend in to one or two,” Ailman says.

“Everyone wants to keep the world in a spreadsheet but the world is messy, you can’t put into neat buckets. It would be nice if risk was neat, if for example you could say a particular risk was exactly 83.6 per cent and we could hedge to that decimal, but life is complicated.”

From a graphical viewpoint, tather than allocating risk according to a neat colour wheel, CalSTRS decided it was more like the mess of an artist’s palette, which Ailman describes as a “clever nuance”.

“We decided that you can’t say for example 65 per cent of the portfolio is exposed to global GDP – because it effects real estate, fixed income, cash, as well as equities.”

The fund has come up with six core risk factors, but instead of using them to divide the portfolio by exposure, they will be overlaid across the entire $146 billion portfolio, as well as used to dissect each new investment to understand its risks.

The six core risk factors are:

• global economic growth – uniquely, CalSTRS is considering dividing the world by the average age of a country’s population rather than the traditional division of emerging and developed, to determine a measure of expected global economic activity and corporate profits

• interest rate risk

• inflation risk

• liquidity – fluid markets

• leverage/financing

• investment governance risk

But, to some extent, deciding on what the risk exposures are is the easy part. The next step, according to Ailman, is to spend four to five months bedding them down, working out how to measure them and determine what their cycles might be.

“We need to figure out how to measure these risks. And we need to determine, for example what is the strategy if we think interest rate is a high risk or global GDP is a risk. What do we do about it, and do we need more tools?”

What is clear, is that CalSTRS is prepared to think of risks differently.

Together with Allan Emkin from PCA, it has come up with the idea of measuring global economic growth risk, according to the age of the population of the country, rather than the traditional developed and emerging country classifications.

The idea is that countries with an older and ageing population typically have low immigration and slower economic output  so would include countries such as Japan or Italy); middle age would pick up more mature economies such as the US which allow more immigration; and younger countries often exhibit more growth potential.

The other more administrative decision is to decide whether to reorganise staff, which depends a bit on how the portfolio is managed.

“We looked at whether to separate two portfolios, and reorganise staff that way, but the jury is still out. We are heading down the structural path that the asset people continue to do what they do, then there is an overlay strategy with a team that includes me, the directors and some traders,” Ailman says.

“We can do the overlay in a couple of ways. We need to develop the signals (the risks) then the next step is to determine how to implement those tools.”

What is important, Ailman says, is to recognise that insuring risk comes at a premium. You have to pay for it.

“We all do it as human beings – buy insurance to reduce the level of risk, and pay for it. In an overlay idea it’s the same thing: we have to realise there is a premium.”

The fund will consider the various options of how to implement the overlay, including the cash market and derviatives, which it uses already, as well as global macro managers.

It will also make subtle changes to its asset allocation, which typically has had tighter ranges than its peers, with movements of between 3 and 6 per cent allowed.

But one of the more exciting aspects of the overlay from the internal investment management point of view is it will enable the fund to be more nimble.

“It will let us be a little bit more nimble. I know with our government structure we won’t be entirely nimble, but we will be more nimble.”

The portfolio risk review is one of two studies the investment committee is looking at as part of its annual study plan.

The other study will be looking at internal versus external investment management, which began with an investigation at the last board meeting, and is a full and exhaustive review, concluding in June.

Ultimately investment staff will recommend strategies and asset classes that can be brought in house.

“CEM Benchmarking has some good work on demonstrating that internal management can be one-tenth to one-twentieth of the cost of external. There are some things we still should have external managers for, but about one-third is in house now and we could run more,” Ailman says.