Connecticut fund manager seeks cash flow

United States equities and real estate were the strongest suits at the $26-billion Hartford-based State of Connecticut Retirement Plans and Trust Funds (CRPTF) out of an entire portfolio that posted 11.6 per cent in the fiscal year ending June 2013.

Now the manager of Connecticut’s six retirement plans and nine trust funds is developing opportunistic strategies across the portfolio, as well as its alternative asset allocation.

It’s an approach focused on seeking investments that generate cash flow and strategies to protect the fund from rising interest rates against a backdrop of underfunding, with the biggest plan in the CRPTF portfolio, the Teachers’ Retirement Fund, only 55 per cent funded.

“Given our funded ratio, we need to make up ground and keep pace with achieving our targeted returns,” says Lee Ann Palladino, chief investment officer at the CRPTF, who joined in February 2005.

Explaining the challenge ahead she says: “It is a question of looking in the rear view mirror in terms of the portfolio value lost as a result of the market declines associated with the recession, and looking ahead to muted returns in the short-to-medium term horizons.”

Reducing equities in favour of alternatives

Following a 2012 review of asset allocation, CRPTF now has a 48 per cent equity allocation, reduced from 52 per cent, and a 20 per cent allocation to fixed income, pared from 25 per cent and comprising core fixed income, inflation-linked bonds, high yield and emerging market debt.

Connecticut’s private equity allocation is unchanged at 11 per cent, but it has increased its real estate allocation to 7 per cent and has 8 per cent of the portfolio in alternatives, with the remainder in a liquidity fund.

“Over the course of the last fiscal year, we have been overweight equities and this has been positive,” says Palladino. “Our plan is to reduce equities in favour of our alternative investment portfolio, going forward.”

As well as reducing its fixed income allocation, Connecticut will reposition the allocation to better “protect the principle and earn cash flow”.

Palladino explains: “Cash flow generation is a key element of our strategy given our plan-participant demographics. We have reduced allocations from US fixed income and treasury bonds to high yield debt. We also seek strategies that have a high component of cash flow within private markets such as secondary private equity, mezzanine debt and credit opportunities.”

She says the fund will use less constrained bond funds and hedging strategies to help protect its US fixed income portfolio against rising rates.

Real and diverse

Real estate is a particular focus for the fund in its search for cash flows. The portfolio, which returned 10.2 per cent in the fiscal year 2012-2013, is benchmarked against the National Council of Real Estate Investment Fiduciaries Property Index (NCREIF Property Index) and is focused on every sector, from retail and industrial to hotels and real estate investment trusts, looking particularly at “beaten down and value add areas”.

Palladino says that although the portfolio only invests in the US, it is diversified with a split between a core portfolio, accounting for 40 to 60 per cent of the total allocation, a value-added portfolio, an opportunistic portfolio and a publicly traded portfolio. Investments encompass externally managed separate accounts to limited liability companies or limited partnerships with a focus on professionally managed commercial properties and land.

The fund’s boosted real asset allocation, sitting within its alternatives, global inflation-linked and real estate portfolios, will offer diversity away from equities and fixed income and hedge against inflation.

Here the emphasis is on energy, global inflation-linked bonds, commodities, agriculture, metals and timber, says Palladino. The alternatives portfolio also includes an allocation for opportunistic investments such as dislocated European credit.

“We are long-term investors and committed to our diversified asset allocation strategy,” says Palladino. “However, we strive to be more nimble in these ever-changing markets and have built in flexibility across all asset classes, and in public and private markets, to allow opportunistic mandates.”

These mandates will employ more flexible investment guidelines versus the benchmarks and allow for short and intermediate opportunistic positioning, she says.

Equities exposure

Connecticut’s domestic equity allocation, invested in its mutual equity fund and benchmarked against Russell 3000 Index, is primarily passive. Developed-market international stocks also hold “a meaningful passive allocation” as does the fund’s core US fixed income allocation.

All other public market allocations are active. “Our philosophy for active or passive management is based on efficiencies of the market, the ease of replicating the benchmark, cost and the ability of active managers to add value,” she says.

Developed-market equity exposure, via its $5.6-billion developed markets international stock fund, benchmarked against MSCI EAE IMI, is 65 per cent active and includes an overlay that hedges 50 per cent of the currency exposure.

“This is a sizeable portfolio and we were concerned about our exposure to short-term currency fluctuations,” says Palladino. “The strategy has added 240 basis points to overall returns given the rise in the US dollar.”

The overlay is currently managed by Insight Pareto Investment Management. In other portfolios, such as emerging markets, foreign securities remain unhedged because of the smaller allocations to these markets. The overlay can be managed passively or actively, depending on opportunities in the marketplace, she says.

Connecticut’s private equity portfolio returned 9.5 per cent between 2012 and 2013.

The largest allocation is to buyouts but investments include early, mid and late venture capital funds, acquisition and restructuring funds, mezzanine debt funds, turnaround and distressed funds. Target returns vary between a 400-to-800 basis-point premium net of fees above the 10-year average annualised return of the Standard & Poor 500.

Palladino says primary funds are the predominant investment vehicle, but Connecticut also invests via secondary funds, funds of funds and separate accounts. Investments are diversified according to their vintage, geography, industry and strategy, she says.

Palladino’s internal team is made up of seven investment professionals and all assets are externally managed. “We are not entertaining any move in house; we are happy with how it is working,” she says. For now the focus is on clawing back lost ground and meeting an 8 per cent state legislature-set rate of return. “It will keep us on our toes,” she says.