Ohio Police & Fire’s risk/return tradeoff

The Ohio Police and Fire Pension Fund has overhauled its asset allocation, more than doubling fixed income and controversially introducing leverage at a policy level. As part of this new asset allocation, private market investments will double. Amanda White reports.

At its most recent meeting in February the board of the Ohio Police and Fire Pension Fund approved a private markets investment plan for the year, which includes committing up to $350 million to private markets between now and the end of the year.

The new target asset allocation for private markets will shift to 7 per cent, from its current position of about 3.3 per cent.

The new investments, each to be evaluated on merit with no obligation to invest if nothing suitable is discovered, will focus on fund-of-funds both domestic and international, secondary and individual partnerships.

The focus on private markets is only one of a number of plans the $10.5 billion fund has been contemplating, and with the recent announcement of a risk parity approach to asset allocation has put focus on lifting returns, while managing risk, in a bid to address its funded status.

Spokesperson for the fund, David Graham, said the primary reason for adopting this new approach was to reduce risk while maintaining its long-term expected return.

“The board believes that this should strategically provide a better risk-adjusted return over the long-term as compared to the current portfolio, however not every year,” he says. “The board selected a 1.2x levered policy, which, relative to our current policy, does not increase expected return, but does reduce expected risk by 91 basis points.”

The new approach, under the guidance of consultant Wilshire & Associates, dictates an allocation away from equities, in favour of fixed income, with leverage used to boost returns.

While not wanting to comment directly on Ohio’s decisions, managing director and head of investment research group at Wilshire, Steve Foresti, says he views the risk parity approach as the “removal of a constraint connected to building a portfolio”.

[See In Conversation for more consultant views]

The removal of this long-only constraint at the policy level does require a philosophical change of thinking by the board. For Ohio the new asset allocation will see the portfolio have a market exposure of 120 per cent.

This will be achieved by reducing equities from 58 to 43.4 per cent, and fixed income exposures increasing from 20 to 51.6 per cent.

This will be heavily weighted to long-duration fixed income at 23.7 per cent (up from 6 per cent), high yield bonds 15 per cent (up from 8 per cent) and global inflation-protected bonds will have an allocation of 12.9 per cent (from 6 per cent).

Alternatives, which previously had a 22 per cent weighting, will increase to 25 per cent with a new commodities allocation of 3 per cent, adding to the private markets (7 per cent), real estate (12 per cent) and timber (3 per cent).

While the new allocation will be leveraged by 20 per cent, it is expected to have the same overall return, as risk is reduced by 91 basis points.

The Ohio fund will manage leverage by using turnkey products in asset classes where leverage is necessary for implementation.

For many funds the use of leverage is a difficult concept to get approved at the total fund level, and instead invest in strategies, or a portion of the portfolio, that use leverage. Public pension funds in the US are looking at such approaches to improve their funding status.

And for Ohio that is an added benefit in the current environment.

“Additionally, the risk parity approach is expected to reduce the total cost of funding benefits should negative market environments continue to be experienced over the life of the plan,” says Graham.

The implementation of the new program will take some years and there will be no immediate effect on the manager line-up in the first instance.

“Given the absolute level of interest rates and their probable future direction, we plan to implement the additional allocation to fixed income carefully over time,” he says.

While the fund acknowledges risk management to be an important element of the overall management of the pension plan, it has not identified whether any new risk management tools will be used to monitor the new strategies.