This year the $12 billion Ohio School Employees Retirement System is prioritising projects that fulfil the board’s desire to find income from alternative sources and manage risk, including allocating more to real assets, and initiating an RFP on a risk management system. Farouki Majeed speaks to Amanda White about the fund’s investment program.

 

With a fund the size of Ohio School Employees Retirement System (SERS), director of investments Farouki Majeed is enjoying the ability to be more nimble and opportunistic in the investment approach.

Previous to this role he spent five years at CalPERS as senior investment officer of asset allocation and risk management. While clearly there are many benefits to working at a fund like CalPERS, at 20 times the portfolio size of Ohio SERS it also has limitations. A $12 billion portfolio, fully outsourced, is a different beast to tame.

Ohio SERS completed its asset liability study last year, and this year will implement the minor tweaks to the strategic asset allocation, which include reducing the hedge fund allocation from 15 to 10 per cent, and increasing real assets from 10 to 15 per cent.

“We have had a shift to tangible/income related returns because of low interest rates and our need to look for income from other sources,” Majeed says. “We are looking at not just total returns but from income and growth and other sources.”

The real assets bucket, which was previously only a real estate portfolio, also includes infrastructure and REITs, with the fund also considering timber investments.

While the hedge fund program has been reduced, the fund is still committed to using hedge funds, and sees the recent move as more of management of the program, which has grown quickly since its introduction in 2009.

Majeed says the hedge fund portfolio, which is all direct, is also morphing from a 50:50 equities and fixed income substitute, to a more diversified exposure.

“We are making it more diversified across hedge fund exposures and reducing our equity beta. This means we are looking at event driven, relative value, and global macro strategies.”

In addition to the strategic asset allocation review every three years, in the past year the fund introduced an annual review of investments and capital market expectations so it can make tweaks to exposures along the way.

“This is a new thing to be more dynamic, but it doesn’t mean it will always result in change,” Majeed says.

For example allocating to inflation-sensitive assets has been a consideration for the fund, and at the annual investment review last week, it was decided an allocation shoud remain on watch.

“We have been questionoing the role in our asset allocation of the exposure to inflation-sensitive assets. Last year we said it was not the time to allocate, because of outlook for inflation and disinflationary trends. Last week we reviewed that again and decided we would not allocation to inflation-sensitive assets,” he says. “These are the types of things we look at it in an annual review.”

The fund is also looking at the feasibility of allocating up to 5 per cent on opportunistic investments.

“We already have about a 1.5 per cent allocation to a variety of opportunistic investments, which are organised with a special purpose to take advantage of certain anomalies, such as the concept of bank deleveraging in Europe.”

Ohio SERS already has two different funds targeting European banking debt, and Majeed says the 700-odd US banks on the FIDC’s official list of problem banks are also a target.

“They are under capitalised and had to write off assets, this is an opportunity for us to act as a capital provider,” he says.

With a strategic allocation to fixed income of 19 per cent, and an actual allocation closer to 15 per cent, Ohio SERS has a lower than average allocation to the fixed income.

While opportunistic allocations and hedge funds are a fill in for fixed income, the allocation is still underweight, and overweight equities.

Within the equities allocation, US and European equities are overweight and there is a slight underweighting to emerging markets. The overall allocation to equities is 45 per cent, with a further 10 per cent in private equity, and is split roughly 50:50 US and non US.

While the overweight position in equities is quite deliberate, Majeed says it is only a single grade, and the fund is discussing with the strategy team the option of a tactical asset allocation overlay.

“Underweight fixed income and overweight equities is a single trade, when it goes wrong it can go badly, so we need more breadth with our tactical positioning. We are looking to possibly partner on an overlay, purely derivatives and based on valuation, we are interested in style premia as well.”

Ohio SERS is looking at more optimal ways to manage its allocations, and understanding its exposures in risk terms, and is in “RFP mode” for a risk platform.

“We want to more optimally manage allocations. An internal risk system gives you some additional insights and metrics into positions, understanding exposures in risk terms and allocating accordingly.”

The board, which had an offsite last week, is also finalising its investment beliefs. While the fund has not yet adopted those yet, Majeed says beliefs around active management, risk premia, long-term holdings, and sustainability are being considered.

 

 

 

The CFA Institute’s president John Rogers, believes there is evidence of innovation in investment products that meet the needs of asset owners in a more sustainable, longer-term way, and points to the work of professors and advisors to the CFA , Andrew Lo of MIT and Robert Shiller of Yale.

 

One of the main thrusts of the CFA Institute’s Future of Finance project is around retirement security – shining a light at the systemic level on what constitutes a sustainable retirement system. Connected, and separate to that, is a focus on innovation.

“We want to ensure that the global financial crisis doesn’t lead to reduced innovation, the industry still needs health innovation,” Rogers says. “This means investment products that meet the needs of asset owners in a more sustainable, longer-term way.”

Rogers points to the work of professor Andrew Lo, from MIT, who is an advisor to CFA Institute has applied the concepts of pooling risk in the insurance industry to a fund that would generate double-digit returns as well as invest in orphan drug development.

Lo’s fund idea is that it pools a large number of drug development efforts into a single financial entity or “mega-fund.” With the lower risk that comes from investing in multiple drug trials simultaneously, the fund yields a more attractive risk-adjusted return on the investment and a higher likelihood of success in finding cures for diseases. This, in turn, enables the fund to raise money by issuing “research-backed obligations” or RBOs, bonds guaranteed by the portfolio of possible drugs and their associated intellectual property. Because RBOs are structured as bonds, they appeal to fixed-income investors, who collectively represent a much larger pool of capital and who have traditionally not been able to participate in investments in early-stage drug development.

In his paper, Financing drug discovery for orphan diseases, numerical simulations suggest that an orphan disease mega-fund of only $575 million can yield double-digit expected rates of return with only 10–20 projects in the portfolio.

It’s an example that Rogers says uses innovation to generate returns for investors as well as align them with society and the economy at large, which is the missing link, and criticism of the finance industry – that it exists in a silo with little concern for, or even recognition of, the wider economy and society.

Similarly the work of Nobel Prize winner, Robert Shiller from Yale, produces “hard headed” solutions for social purpose, such as bonds, making them attractive to investors.

Rogers believes in an era of fiduciary capitalism, where asset owners and other institutional investors regain the power and direction of where, how and at what cost their assets are invested.

“It is hard work for institutional investors, much of their time is spent on investing and administering their portfolios in an efficient way. Asset owners should feel good, they’ve insourced and indexed to ground down costs. It is commendable but unfortunately not the whole job,” he says. “It is hard for large asset owners to move in and out of investments which leads to them owning all of the externalities, positive and negative, of the companies they own, because they are universal owners.”

He believes there is an opportunity, and challenge, for investors to engage more effectively with governance and individual issues, across industry sector and public policy debates.

“It is a really difficult task and it is too often left to simply hiring a high quality proxy firm, but that is not enough,” he says. “There are enormous business opportunities for fund managers willing to provide engagement with asset owners.”

 

2013 was a great year to add value by using risk to assign asset allocation, according to chief investment officer of Windham Capital, Lucas Turton, whose fund added 300 basis points above benchmark last year by dynamically allocating according to risk.

 

Windham Capital Management’s style is to focus on measuring and understanding risk to then make dynamic top down asset allocation decisions.

“We use risk in assigning asset allocation, 2013 was a good year to do that, it worked for us, we generated alpha,” says chief investment officer Lucas Turton.

Depending on risk, and the health of markets, rather than economic or bottom up analysis means the allocation of assets is often contrarian.

The fund began last year aggressively allocated despite the fiscal cliff and government shut down in the US.

“This is because markets weren’t responding to this situation, but the news had investors cautious. It was contrarian to be aggressive,” he says.

In March and April interest rates were beginning to behave and real estate was converging on bonds, which was identified as more of a regime shift, so a reduction in risk ensued.

“We are not basing our investment decisions on the Fed or geopolitical activity but when markets are susceptible,” Turton says.

About half the time last year, the Windham portfolio was contrarian, and the other half it was in line with markets.

“In the middle of year there was greater consensus markets were becoming more risky. And we reduced risk twice in the middle of the year.”

However what remained contrarian was the degree to which the portfolio reduced risk, with a 30 per cent decrease in growth assets.

“The magnitude was contrarian,” Turton says.

The fund has constraints of about 30 per cent either side of a benchmark allocation, allowing significant shifts and value to be added through better asset allocation.

The benchmark portfolio is a globally diversified passively managed mix of global equities, fixed income, commodities and real estate.

Windham, which was founded by MIT professor Mark Kritzman, uses proprietary measures to look at the global market risk environment, recognise when it changes and position portfolios to take advantage of the conditions.

“What we’ve been trying to determine is where any view matters too much to investors. We don’t think valuations such as P:E ratios impact returns, something that looks inexpensive can become cheaper. We want to look at risk.”

So far this year Turton believes there has been a modest uptick in measures of risk, but that generally markets are calm.

“It has risen this year and is approaching the level of April last year but it’s nowhere near 2011. We have seen a sell-off in an orderly fashion where correlations were low, it’s a traditional pull back after very strong market,” he says.

The outlook in the near term is that risk is low, so Windham is allocating to a diverse set of risky assets, with commodities and US REITs both big diversifiers in the portfolio, and allocations to foreign assets increasing.

“Clients are concerned with alpha and downside protection. We believe short term returns are difficult to predict but risk is somewhat predicable and can add value,” Turton says. “We are correctly anticipating the direction of risk.”

This paper by the French National Center for Scientific Research (CNRS) investigates the main determinants of pension funds investment in private equity funds, and particularly in venture capital and leverage buyouts in the US and Canada over the 1996-2011 period. The results show some important differences between pension funds allocating to private equity and more traditional assets.

The first ones are bigger, mainly diversified private funds. They do not consider the age of their members when deciding this type of allocation and they present a higher discount rate. Furthermore, they specially take into account their private equity returns in comparison to management costs. It also shows that pension funds investing in private equity do not distinguish between venture capital and leverage buyouts.

 

To access the paper, click here

The determinants of pension funds allocation to private equity

Investor allocations to alternatives will increase over the next three years as the focus on outcome-oriented investments heightens, according to respondents in the annual conexust1f.flywheelstaging.com /Casey Quirk Global Fiduciary CIO sentiment survey.

The second annual survey, which included respondents from 56 asset owners with combined assets of $3 trillion, showed an accelerating trend to moving to outcome-oriented approach, as funds focused on meeting objectives.

For different respondents these objectives were different – for corporate funds it was meeting liabilities, for charities it is beating inflation and cash needs, for sovereign wealth funds growth and capital preservation and for public funds it is funding gaps leading to increased risk tolerance for growth-oriented funds and alternatives allocations

But Jeff Levi, director at Casey, Quirk and Associates, says constructing portfolios around these outcomes are more complex with alternatives allowing better management of risk exposures and low correlation.

“They are a valuable tool in executing these objectives,” he says.

Overall the survey showed the projected asset allocation changes in the next three years will see an aggregate average increase of 3.2 per cent to real assets, real estate and infrastructure, 1.8 per cent increase in illiquid alternatives (non-real assets), and 1.6 per cent increase in hedge funds. The losers will be fixed income and domestic equity.

Levi says there is increased demand for an unconstrained approach to investments in the “traditional boxes” not just within alternatives allocations.

“What have been boxed as hedge funds in the past is less relevant, they are a structure not an allocation. In the past long only allocations were style box driven, for example large cap value, and hedge funds were outside that style box. Now there is increased demand for unconstrained in the traditional boxes,” he says.

“They are re-thinking the portfolio around the risk factors, opposed to building around broad categories of type. The old way of thinking about objectives proved to be ineffective.”

As an example of the change taking place, Levi says managing fixed income against Barclays Aggregate Index is inappropriate as it has “nothing to do with the return streams the investors are looking to achieve”. As a result investors are looking more absolute return and floating rate benchmarks. Unconstrained fixed income is a hot topic.

 

Another clear trend is that investors plan to continue to aggressively invest in their internal investment headcount.

Investors were asked to comment on their plans for the three-year period from 2013 to 2016, and 37 per cent of respondents said they will increase their head count in finance, accounting and reporting, followed by manager research (26 per cent said they would increase), in-house portfolio management team (34 per cent), asset and strategy allocation (34 per cent), risk management (28 per cent) and technology (28 per cent).

Within manager research emphasis was being put on increasing in house expertise on alternatives as funds forgo fund of funds and gain comfort in investing directly.

Cost remained the main reason for insourcing, 40 per cent of respondents said they had plans to insource more non-cash assets, with 53 per cent citing cost as the main reason.

The average cost of internal resources of the respondents was 7.1 basis points, compared with 46.3 basis points externally. This means it is about six and a half times more expensive to outsource.

All asset classes were being considered as potential in-source management, but domestic equities were the most likely, followed by illiquid alternatives and non-domestic equity.

 

P17_LAOS_Results_InvestmentConsultantUsage_Page_18

 

For investment managers, and consultants, the results show some clear changes that need to take place in servicing these institutions, in particular segmentation becomes critical as there is no one -size fits all for the investor community.

“Buyers with in-house teams want different skills and investments and engagement model,” says Levi. “This also has implications for staffing. Fund managers need people who are consultative and have know-how to have a conversation with the CIO. You need those who are investment savvy, those with the tools to conduct analysis and have a customised views. And you need to wrap all of it in a strong investment brand, have innovative insights and thought leadership with a marketing presence. It is about flexibility, a conversation with one buyer is very different from another.”

In addition funds managers will be competing with the buy-side, as institutional investors look to their peer group for ideas and information exchange, rather than traditionally looking to the funds management community.

Similarly the investment consulting fraternity is undergoing a change, as institutional investors bring more manager research capabilities inhouse.

For the period 2008-2012, 31 per cent of respondents increased headcount in manager research, for 2013-2016, 36 per cent are increasing headcount in due diligence and selecting managers.

“In the UK and in US public plans it is mandated to have a consultant, but there are questions about the role of consultants and how they are used if the internal team size is increasing,” Levi says.

This re-adjustment of the consultants role is amplified by the fact managers are playing a larger role in unconstrained mandates and giving advice.

Change is afoot for all participants in the institutional investment chain.

 

 

Investors were challenged to think differently about their portfolios by the latest academic thinking from Stanford University at a one-day investment roundtable in California last week.

Chief investment officers from US public and corporate pension funds, endowments and foundations convened at Menlo Park, the home of Stanford University, for a one-day investment think-tank.

Three finance professors from Stanford presented their latest papers on active management, private equity and financial regulation, which were debated and workshopped by the investors in order to enable their application to the investors’ portfolios.

The roundtable sought to fuse the latest academic thinking with investment best practice to give investors an edge in their decision making.

This highly interactive discussion was jointly facilitated by conexust1f.flywheelstaging.com and Professor Stephen Kotkin from Princeton University, and supported by BNY Mellon and Lexington Partners.

 Return to event coverage

Investment think-tank discussion points

1.  Active management: measuring manager skill

The Nobel Prize awards in economic science in 2013 underscored the continuing debate about efficient versus irrational markets, and active versus passive portfolio management.

Professor Jonathan Berk’s research offers a rigorous approach to these issues, including delegated money management, asset pricing, valuations of firms’ growth potential, firms’ capital structure decision, and the interactions between labor markets and financial markets. He also studies the question of individual rationality in experimental settings.

The paper for this conference, which presupposes knowledge of another paper to be read, uses the value that a mutual fund extracts from capital markets as the measure of skill.

The paper finds that the average mutual fund has used this skill to generate about $2 million a year. The paper documents large cross-sectional differences in skill that persist for as long as 10 years.

It further documents that investors recognize this skill and reward it by investing more capital with better funds. Better funds earn higher aggregate fees, and there is a strong positive correlation between current compensation and future performance.

Professor Jonathan Berk, the A.P. Giannini Professor of Finance at the Stanford Graduate School of Business, has coauthored two finance textbooks: Fundamentals in Finance; and Corporate Finance, which remains the most successful first edition textbook ever published in financial economics, and is a standard text in nearly all top MBA programs around the world.

His research has won numerous awards, including the TIAA-CREF Paul A. Samuelson Award, the Smith Breeden Prize, Best Paper of the Year in the Review of Financial Studies, and the FAME Research Prize.

His article, “A Critique of Size-Related Anomalies”, was selected as one of the two best papers ever published in the Review of Financial Studies, and was also honored as one of the 100 seminal papers published by Oxford University Press.

Berk has received the Graham and Dodd Award of Excellence, the Roger F. Murray Prize, and the Bernstein Fabozzi/Jacobs Levy Award, in recognition of his influence on the practice of finance.

Berk was born and grew up in Johannesburg, South Africa, and received his PhD in finance from Yale University.

 

2. Overweighting and underperformance: evidence from limited partner private equity investments

This paper, “Local Overweighting and Underperformance: Evidence from Limited Partner Private Equity Investments”, coauthored with Yael Hochberg, examines the home-state bias in institutional investors’ private equity allocations.

This effect is particularly pronounced for public pension funds, where limited partners allocate around 10 per cent more of their private equity portfolios to home-state investments than would be predicted by the investment behavior of out-of-state investors.

Public pension funds’ in-state investments achieve performance that is lower by 2 to 4 percentage points than both their own equivalent out-of-state investments and equivalent investments in their state managed by out-of-state investors.

Professor Joshua Rauh, Professor of Finance at Stanford Graduate School of Business and a Senior Fellow at the Hoover Institution, has attracted national media coverage for his studies of state and local pension systems in the United States. He has won numerous awards for his research papers.

“Investment and Financing Constraints: Evidence from the Funding of Corporate Pension Plans” was awarded the 2006 Brattle Prize for the outstanding research paper on corporate finance published in the Journal of Finance.

“Public Pension Promises: How Big Are They and What Are they Worth?” coauthored with Robert Novy-Marx, won the Smith Breeden Prize for the outstanding research paper on capital markets published in the Journal of Finance.

“Earnings Manipulation, Pension Assumptions and Managerial Investment Decisions”, coauthored with Daniel Bergstresser and Mihir Desai, won the Barclays Global Investor Best Symposium Paper from the European Finance Association and appeared in the Quarterly Journal of Economics.

Professor Rauh received his PhD from the Massachusetts Institute of Technology.

 

3. The banker’s new clothes: what’s wrong with banking and what to do about it

The past few years have shown that risks in banking can impose significant costs on the economy. Many claim, however, that a safer banking system would require sacrificing lending and economic growth. Professor Anat Admati’s work reveals that the narratives used by bankers, politicians, and regulators to rationalise the lack of reform are invalid.

Professor Admati argues it is possible to have a safer and healthier banking system without sacrificing any of the benefits of the system, and at essentially no cost to society. Banks are as fragile as they are not because they must be, but because they want to be – and they get away with it. Whereas this situation benefits bankers, it distorts the economy and exposes the public to unnecessary risks.

Weak regulation and ineffective enforcement allowed the buildup of risks that ushered in the financial crisis of 2007-2009. Much can be done to create a better system and prevent crises. Yet the lessons from the recent crisis have not been learned.

Professor Anat Admati is the George G.C. Parker Professor of Finance and Economics at the Graduate School of Business, Stanford University.

She has written extensively on information dissemination in financial markets, trading mechanisms, portfolio management, financial contracting and, most recently, on corporate governance and banking.

Since 2010, she has been active in the policy debate on financial regulation, particularly capital regulation, writing research and policy papers and commentary. She is a co-author of the book, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It.

Professor Admati received her BS from the Hebrew University in Jerusalem and her MA, MPhil and PhD from Yale University.

She is the recipient of a Sloan Research Fellowship, a Batterymarch Fellowship, and multiple research grants.

She is a fellow of the Econometric Society, and has served as a board member of the American Finance Association and on multiple editorial boards.

She also serves on the FDIC Systemic Resolution Advisory Committee.

 

 

Delegates

Anat Admati, professor of finance and Economics, Stanford University

Eric Baggesen, senior investment officer for asset allocation and risk management, California Public Employees’ Retirement System (CalPERS)

Jonathan Berk, professor of finance, Stanford University

Mary Cahill, chief investment officer, Emory University

David Cooper, chief investment officer, Indiana Public Retirement System (PERF)

John Donaghey, head of North American institutional distribution, BNY Mellon Investment Management

Hershel Harper, chief investment officer, South Carolina Retirement Systems

MaDoe Htun, chief investment officer, William Penn Foundation

Jennifer W. Kheng, principal, Lexington Partners

Stephen Kotkin, professor, Princeton University

William Lee, VP, pension & foundation investments, chief investment officer, Kaiser Permanente

Jamie Lewin, head of manager research and performance analytics; chief investment officer, BNY Mellon Investment Management; Lockwood Advisors, a BNY Mellon co.

David Long, senior vice president and chief investment officer, Healthcare of Ontario Pension Plan

Farouki Majeed, chief investment officer, Ohio School Employees Retirement Systems (OHSERS)

Tom Newby, partner, Lexington Partners

Joshua Rauh, professor, Stanford University

Stan Rupnik, chief investment officer & interim executive director, Illinois Teachers’ Retirement System

John Skjervem, chief investment officer, Oregon State Treasury

Colin Tate, chief executive, Conexus Financial

Amanda White, editor of conexust1f.flywheelstaging.com

&n

Return to event coverage