Rhode Island goes back to basics

The $7.6 billion Employees Retirement System of Rhode Island, (ERSRI), is cutting its allocation to hedge funds. In a “back to basics” strategy, the fund will slash its hedge fund allocation by $500 million over the next two years, reducing the allocation to 6.5 per cent of assets under management, down from 15 per cent. It will reallocate funds to more “traditional” strategies for growth and stability, consisting mainly of low fee index funds. The fund’s hedge fund exposure is currently about $1.1 billion.

“Most hedge funds aim to produce positive returns that have low correlation to the movements of the global equity markets,” says general treasurer Seth Magaziner, a native Rhode Islander whose role heading up the state’s treasury department includes overseeing investment strategy at the pension fund.

“While some of our hedge funds have delivered on this mandate; too many have not. In recent years, too many hedge funds have shown low correlation to the market when the market has been strong, but high correlation in times of market decline. At the end of the day, absolute return strategies need to generate positive returns and provide legitimate protection from market risk in order to justify their fee structure.” With this in mind, the fund will only keep the hedge fund allocations which show adequate non-correlation to the market to protect the fund from volatility, and a strong enough performance to justify fees.

New strategy

Cutting management fees is a key motivation behind the latest strategy at the fund which serves 60,000 active and retired public sector workers in America’s smallest state, and where none of the active allocations are managed in-house. Rhode Island frequently monitors its returns net of fees and compares the figure to peers, as well as the fund’s index fund performance, the fund’s benchmark, and a hypothetical 60/40 stock to bond ratio fund, explains Evan England, a spokesman for treasurer Magaziner. The overall hedge-fund portfolio has posted a return of 4.85 per cent after fees since its launch in 2011, but many of the individual funds within the allocation haven’t met expectations. More than half the gains of the hedge fund allocation have been swallowed by the high fees.

Reducing the hedge fund allocation is part of wider changes to Rhode Island’s asset allocation following a comprehensive review of the fund’s target allocation. The process included modelling potential portfolios against potential market conditions. The new allocation portions 55 per cent of the fund’s assets to growth. Along with low-fee index funds, the growth bucket will include a 15 per cent allocation to private equity – more than double the previous allocation of 7 per cent.

About 39 per cent of the fund will be in stabilising assets divided between volatility, crisis and inflation protection strategies and include allocations to fixed income, real estate and momentum, among others. Six per cent of the fund will be in income strategies. The new strategy comes on the heels of lagging returns. As of June 2016 the fund posted a one-year loss of 0.3 per cent, a five-year return of 5.8 per cent, and a 10-year return of 4.8 per cent versus a 7.5 per cent assumed rate of return.

Magaziner was only sworn in as general treasurer in January 2015, joining from environmental, social and governance (ESG)-focused asset manager Trillium Asset Management. As well as being quick to push on manager fees, he is also championing greater transparency. His “transparent treasury” policy now asks the fund’s 100-odd managers to publish their fees, but also their performance and expenses on a regular basis.

“If you are managing public funds, the public has a right to know how you are performing and what you are charging for that performance. Not a single one of our managers left us when we initiated this policy, and we have seen no evidence that it has limited our options when we have been searching for new managers to invest with.

“Since we announced this policy, other public pension funds, including large public plans in New York and California, have followed suit. I believe that the type of transparency we have championed will soon be the norm,” Magaziner adds.

Say-on-pay

It’s the kind of collaboration he would like to see in other areas too.

“Rhode Island is a small state with a relatively small pension fund. While we work to be thought leaders on issues facing pension funds globally, it often makes sense for us to team up with our larger peers to attempt to drive change.” One area he believes collaboration will begin to bring real change is corporate governance in investee companies.

Rhode Island is already a vocal shareholder, most recently voting against management-backed pay proposals at US giants Facebook and eBay in “say-on-pay” proposals where companies ask shareholders what they think on executive pay packages.

“When the companies we invest in award excessive pay packages to executives, it comes at the expense of the pension fund and the public employees we serve,” he said.

“Our say-on-pay effort reflects our position that executive compensation should be transparent and based on performance.”

So far this year the fund has voted “no” on executive compensation plans at 75 companies. It sends a letter to all companies that received “no” votes to inform them of the fund’s opposition and offering to open dialogue on how best to progress on “the important issue.”