LACERA: It’s all in the process

Jonathan Grabel, CIO of the $87 billion Los Angeles County Employees Retirement Association, believes good processes form the bedrock of successful investment. Processes govern how investors identify the best opportunity and underwrite investments; they shape liquidity management, operational effectiveness, building the team and how staff provide information to the board, he tells Top1000Funds.com from the investor’s Pasadena offices.

“Investment involves an uncertain future state. Good processes don’t necessarily guarantee the best outcomes, but they are critical.  Strong processes, likely, increase positive outcomes by reducing impacts from uncompensated risks – mostly operational ones,” says Grabel, who has overseen America’s largest county pension fund since 2017.

Perhaps the most important element of the process is strategic asset allocation, where LACERA staff completed implementation of the latest asset allocation in January. The new allocation has built out investment grade fixed income and credit (both now 13 per cent) and reduced the allocation to global public equity to 28 per cent.

The adjusted portfolio allows LACERA to draw a greater contribution from higher interest rates both in terms of return and diversification and is the culmination of the triennial re-appraisal of multiple factors including changes in capital market assumptions, new philosophies to emerge in terms of asset allocation or best practice, and any movement in LACERA’s liabilities where the mature fund’s benefit payments exceed contributions.

“Our current asset allocation is set to perform in a period of heightened uncertainty. If you look at the environment over the last five months, you hear the word uncertain a lot and the best strategy during times of uncertainty is diversification. You never know what markets are going to do, but we take comfort in the excellent process behind our SAA that supports building and monitoring the portfolio,” says Grabel.

LACERA allocates to asset categories comprising a 48 per cent allocation to growth (global equity, private equity and noncore real estate) a 15 per cent allocation to to risk mitigation (core real estate, natural resources and infrastructure and TIPS) and a 24 per cent allocation to risk reduction (investment grade and government bonds, diversified hedge funds, and cash) as well as the 13 per allocation to credit.

The cash overlay (1 per cent) also showcases process in action.

LACERA created a cash overlay in 2019 to support liquidity needs and eradicate cash drag in a low-interest-rate environment. The overlay was also created to support rebalancing and help reduce over and underweights on a daily basis to better adhere to the strategic asset allocation. It was put in place as a risk mitigant rather than a source of alpha, but the overlay has generated over $500 million of gains.

“The cash overlay allows us to best manage liquidity by being able to hold more than our 1 per cent allocation yet no be penalised by a drag on performance. The cash we hold above 1 per cent is equitised based on our SAA so we can offset under and overweights at the functional asset category level.”

LACERA has also introduced a 90-day rolling cash forecast to ensure it has at least three months of cash equivalents on hand for benefit payments, operations and investment purposes. “It’s something we have maintained since 2020 and ensures we have sufficient liquidity at all times,” he says.

Staff must ensure their direct portfolio does its job and performs based on the mandate, without losing sight of the indirect asset classes that influence their portfolio and the wider contextual environment, he says. For example, a good private equity investor needs to understand the cost of capital and credit markets because it’s a key component of financing private equity.

Gabel says the biggest driver of the whole portfolio is beta, which sets the direction of the portfolio’s performance.

Sources of alpha

That said, the most important source of alpha has come from LACERA’s 13 per cent allocation to credit, the best-performing functional asset category for the last three years. The allocation doesn’t differentiate between private and public credit (analysis showed that the private allocation was actually more liquid) and focuses on moderate risk, eschewing distressed assets.

“A key return component is yield.”

The standalone allocation was set up in 2019 when Gabel brought all LACERA’s disparate credit exposure and benchmarks that spanned high yield to syndicated bank loans, hedge funds and real estate debt into one allocation with a single benchmark to mandates to 12 key relationships. The core element of the portfolio is allocated to separately managed accounts in evergreen structures rather than having to continuously invest in funds. Benefits include hard fee hurdles and more profit retention for LACERA than investing in funds, he says.

Elsewhere, numbers show alpha is much higher in private equity co-investment rather than fund investment, but in another example of process at work, the allocation to funds supports co-investment and is an example of LACERA using “all the tools” at its disposal. LACERA has a 17 per cent target allocation to private equity, divided between direct (co-investments and secondaries) and fund investments.

The benefits of investing with emerging managers

LACERA allocates to emerging managers in credit, public equity and hedge funds, and is about to roll out emerging manager mandates in real estate and real assets for the first time. Relationships are based around revenue sharing and securing capacity rates for subsequent investments.

“The goal of the emerging manager program is to enhance returns for the fund as a whole. By investing with emerging managers, we aim to find opportunities that might be capital constrained or more niche. We don’t want to just enhance returns, and we also seek investments that mitigate risk. Our goal is to have these programmes outperform underlying categories and hopefully secure future investment rights for LACERA,” he says.

Allocating to smaller firms that are earlier in their cycle is supported by policy statements and a belief that inclusive and equitably run firms that diminish groupthink will outperform because they tap into human capital alpha.

“LACERA’s investment policy statement says that effectively accessing and managing diverse talent leads to improved outcomes. We want to tap into human capital alpha. It is a dimension of our underwriting across the entire portfolio that reflects that we think that people matter. We believe that we have a fiduciary duty to have the best collection of people manage assets on behalf of our members.”