Washington takes risks within wider framework

The $71 billion Washington State Investment Board has made a renewed commitment to overweighting emerging markets and private equity, but a comprehensive enterprise-wide risk management framework will help ensure the inherent risks of that strategy remain in check.

The WSIB conducted a significant review of its asset allocation a year ago and decided to stick with its strategy of a high allocation to private equity. It has a target of 25 per cent in that asset class, which together with 13 per cent in real estate and an overweight position in emerging markets gives the fund overall a fairly aggressive allocation.

But its analytically-minded executive director, Theresa Whitmarsh, is not worried, and neither is her board.

The fund’s returns, together with the culmination of a six-year enterprise risk framework gives the entity a strong defence.

“That review included rigorous analysis, including liquidity analysis, and an examination of whether to allocate more to cash. It also looked at the capital market assumptions and a review of the fund’s investment beliefs, and out of that came a focus on total returns. The board continues to believe there is a reward for the illiquidity risk premium,” Whitmarsh says.

In the year to June 30, 2010 the private equity allocation returned 24 per cent, and over 10 years it has returned 6.58 per cent. The fund, which has about $13.6 billion in private equity, also recently completed a consultant search, hiring Hamilton Lane to replace Capital Dynamics from January next year.

The WSIB has been more open-minded compared with its US public sector peers, and is well-respected among investors.

For example as early as September 2007 it adopted the Dow Jones Total Stock Market Index, essentially eliminating the home country bias in the process.

Within that global equities was divided into US, international developed and emerging markets with dollar allocations at the end of March consisting of $8.7 billion, $9.6 billion and $1.9 billion respectively.

Part of the strategy to move global was recognition of the role of emerging markets, and that belief has been enhanced in recent years.

“We had four dedicated emerging markets managers, and expected our international equities managers to give us some exposure as well. This year we added three more emerging markets managers and now we are very close to the Dow Jones,” Whitmarsh says.

Aberdeen Asset Management, Arrowstreet Capital and Mondrian Investment Partners were added, following a search done with Mercer Investment Consulting that reviewed 253 separate products.

The public equity annual plan was amended in January to allow for a greater exposure to emerging markets. It changed so that the “program has a bias to be overweight in emerging markets longterm, but may move to neutral or modest underweight during periods when opportunities appear limited and or valuations appear rich”.

In the six-year strategic plan adopted by the board, emerging markets was also identified as a future focus, and the fund is debating internally whether or not to move to an overweight position in emerging markets.

“Fundamentally we like emerging market economies, but we are debating whether or not they will outperform,” she says, adding the emerging market exposure for WSIB is more than just a debate about public equities.

The WSIB fixed-income team, the only asset class to be managed in-house, has had a focus on emerging markets for some time.

“That team has had significant outperformance and a lot of that is due to the emerging markets overweight,” she says.

The fund has $25.3 billion in fixed income, with the team returning 12.5 per cent in the past year and 7.4 per cent over the past 10 years.

Interestingly, WSIB also has an ‘innovation’ bucket, where up to 5 per cent of the fund can be invested, with Whitmarsh describing the assets that fit into it as “anything that doesn’t fit in to anything else”.

The allocation to innovation also acts as a place to test and incubate ideas before they are rolled out into other categories.

For example, when the fund was moving to a global equities allocation it challenged the policy of allocating passively to domestic equities. Similarly an oil and gas investment has been sitting in the innovation category but will be rolled in to tangibles soon.

As with other funds, the WSIB constantly looks at its active/passive mix. Within equities the fund has traditionally allocated passively to domestic equities, adopted a mixture for international equities and invests actively for emerging markets.

“We have done our own research, and with consultants, and found the general notion that international markets are less efficient and so active is the way to go, doesn’t necessarily hold up,” Whitmarsh says.

“We will always pursue active when we have ‘pound the table’ conviction in a manager. But if we don’t then the default will be passive.”

With regard to manager selection, and quite a few manager changes have occurred in the past year, the fund has a combination of qualitative and quantitative measures, and each manager has to reach a certain hurdle.

All this is done in the context of an overarching risk framework, which Whitmarsh began when she was chief operating officer, under then executive director, Joe Dear, now chief investment officer of CalPERS.

“Operationally six years ago it began a project with regard to how to best build capacity in the organisation, and risk was one the biggest projects,” says Whitmarsh, whose background is in data and analytics.

WSIB brought a data warehouse online this year, which examines among other things concentration risk, and is now in the process of implementing the BARRA risk system on top of that.

“Because we have quite an illiquid portfolio, data is hard to collect so we have been working with our private equity and real estate partners and also building proxies around BARRA for those assets.”

Through her association with the International Centre for Pension Management (ICPM), Whitmarsh has established good relationships with the Canadian and Northern European funds, which she says have shown the way.

“Canadians are leaders in this area and we have learnt a lot by visiting them,” she says. “We have decided to take a more organic, bottom-up, broader view.”

As part of that the fund has explored other approaches to risk, and in particular how private sector managers such as Goldman Sachs and GMO approach risk. Both helped contribute to the entire risk management framework WSIB has adopted which broadly divides risk into three main categories: managing assets; managing the organisation; and managing reputation.

Within managing assets, risk is divided into fiduciary risk and investment risk; and within investment risk there are eight risks including market, liquidity, leverage and counterparty risk.

The fund has an enterprise risk management team, which is made up of representatives from all departments who meet monthly.

“It is more about the conversation than the data, the data provokes the conversation. But we are mindful that you need a starting point, and that intuition doesn’t necessarily work.”

WSIB will now also issue a risk report to the board.

Washington State Investment Board, long term strategic asset allocation