The investment staff of the $170-billion Californian Teachers Fund, CalSTRS, will present new asset allocation recommendations to the board next week, with a reduction in fixed income and the adoption of a new “absolute return” category the likely outcome.

The fund is in the final stages of the long process of its 2012 asset liability study and staff will present an asset allocation recommendation to the board on September 9.

The asset allocation recommendation is global equities 51 per cent, fixed income 16 per cent, private equity 13 per cent, real estate 13 per cent, inflation sensitive assets 6 per cent, absolute return 0 per cent and cash 1 per cent.

Chris Ailman, chief investment officer of CalSTRS, says the most significant change is the reduction in fixed income allocation, which as of June 30, 2012, was 18.3 per cent.

Ailman says the board has been involved in the asset liability modeling, and the fund has adopted a visual modeling system to present the various investment mixes to give board members an easy access point for the implication of various asset mixes on the overall risk/return outcomes.

The latest study does not diverge too much from the fund’s current risk/return profile despite new board members.

“It is interesting to me that in the past three asset liability modeling exercises – in 2006, 2009 and 2012 – there have been completely different board members and different capital market assumptions, but they have all ended up close to the same place,” Ailman says. “There have been 35 different people involved on the board, but they came to similar conclusions about the risk/return. This validates the risk/return profile this fund should have. There is constant debate of the long-term returns versus the short-term volatility. But we are not too dissimilar to where we were before; we are roughly the same spot on the efficient frontier.”

Just like price discovery on Wall Street, Ailman says the process has led to “risk equilibrium” of the board, and the getting and respecting of each board member’s perspectives.

“This leads to a more robust discussion and a better fiduciary decision,” he says.

 

Between theory and practice

CalSTRS has started to add asset classes that aren’t an asset class but are descriptive of a characteristic, for example, inflation-sensitive assets, and one of the key discussions at the board meeting next week will be about the confidence around absolute return.

“Academically, it looks good,” Ailman says. “But with our size and governance, is it appropriate? Given what we want to do, is it practical? It’s like the Cookie Diet fad in California at the moment: there is quite a lot of difference between theory and practice.”

The investment staff has had a discussion internally, which has not been taken to the board, about the idea of giving managers more freedom around their mandates.

“If you give managers freedom to make more decisions, they frequently make more poor decisions,” he says. “Having said that, I think we have also gone too far in giving them boundaries.”

Ailman believes that an absolute return category can be seen as assets with particular characteristics, and it breaks down barriers between asset classes.

CalSTRS will have three categories under the absolute return umbrella: stable return; overlay; and an innovation bucket, where different ideas and theories can be tested.

“We are recommending that the board adopts the absolute return category, but we don’t have to allocate money to it straight away. We want to be savvy investors.”

 

Next please

The fund’s next asset allocation study, in 2015, will look at filling the absolute return bucket.

The completion of this study will allow the investment committee to carry out some other investigations.

The active-versus-passive debate is on the CalSTRS agenda, and will start with the US market before looking outside the country.

There is also a plan to look at in-state investments in California. This may be pushed back, Ailman says, depending on the depth of the absolute return study, there may be a deeper dive in to some unexplored absolute return strategies such as equipment leasing.

CalSTRS is 100 years old this year, although the investment office has only been in existence since 1983, when the fund split from CalPERS.

Talk of tapering sent markets into occasional spins this summer – with negative reactions even following positive economic signals at times. Should institutional investors be concerned though of a seemingly impending slowdown in quantitative easing? Opinions are split as to whether a potentially damaging crash is on the horizon or investors can largely dismiss the simmering market fears.

Fixed income markets have clearly enjoyed a sustained boost on the back of the US Federal Reserve’s cheap money, sparking talk of a possible bust. Chris Bowie, head of credit for Ignis Asset Management, confesses to be “generally sympathetic” to this view. “Yields went too low and bonds have been offering fairly little value with considerable downside risk,” he says, adding “There has been enough of a wobble in sovereign yields for people to consider whether the bull run for fixed income is ending.”

Reducing bond exposure seems a natural response for investors concerned about the fallout from the beginning of an end to quantitative easing, which many analysts expect the Fed to start in September. It is a move that Christian Bodmer, head of investing consulting for Mercer Switzerland, advises. He warns of a “direct impact” of an estimated 6-to-7-per-cent loss on overseas bond holdings as quantitative easing is slowed down – and before interests rates even begin to rise. That could have potentially serious funding consequences for investors in Switzerland and beyond.

 

Sell government paper before they taper?

”Bond allocations are definitely a hot topic on all investors’ agendas because of tapering,” Bodmer says. Some investors may feel they have seen this risk looming on the horizon for some time though. The giant $1.2-trillion Government Pension Investment Fund of Japan recently reduced its targeted exposure to domestic government debt from 67 per cent to 60 per cent. A number of European investors have taken similar moves, with the $2.6-billion German Federal Environment Foundation (DBU) telling top1000funds.com it has reduced its government debt exposure from 20 per cent to 6.5 per cent over the past five years.

Not all investors have been willing to make such significant moves though. “It’s disappointing to see that only a few investors are proactively reducing their bond allocations, with most still at the debating stage,” says Bodmer about events in Switzerland. The conservative and slow investment process of Swiss investors is to blame, he argues – a feature that is surely far from unique to funds in the alpine nation.

Uncertainty in the market is also breeding reluctance to act, Bodmer reckons. “The easy conclusion is to reduce bonds, but when do you do that? There is no place to hide, but it’s a decision that takes a lot of time,” he says. “Reducing risk also means reducing performance and a lot of pension funds can’t live without performance”.

 

What can investors who haven’t moved their bond exposure do?

Bodmer argues that diversification within fixed income can be an answer to tapering fears, with short-to-medium-term bonds looking more favorable due to their reduced interest rate risks. Insurance-linked securities and senior secured loans, with almost no duration and little interest-rate risk, are also an attractive bond substitute.

In the US, Steven Center, vice president of consultancy at Calllan Associates, warns investors, on the other hand, “not to overreact to the potential impact of quantitative easing”. He advises that “institutional investors should remain focused on the long-term and avoid tactical positions in fixed income, in particular”.

Center reasons that there is little need to experiment with fixed income as it is an asset class that acts “as an anchor to reduce overall volatility” of an investor’s portfolio. “As the market has already reacted to the idea of tapering before the end of the year,” he says, “overall pricing is pretty close to where it should be.”

Many raise the prospect of high-yield and emerging-market debt seeing higher yields along with government bonds as quantitative easing is wound down. Center argues though that high-yield and emerging-market bonds have already been impacted “more than they should have been”. Healthy corporate balance sheets remain a clear positive, he reasons. He does single out US treasuries and mortgage-backed securities as areas most likely to see falls during an unwinding of quantitative easing, which he concedes could still end up being disorderly. All this is becoming familiar advice for Center, who admits taking a call every week from investors concerned about the outlook for fixed income markets.

Others stress that action is not only needed on fixed income allocations, pointing to a likely knock-on impact in other asset classes entirely like emerging market equities. “I’m pretty sure we’ll enter into a risk-off environment when interest rates rise, with a sell-off of these asset classes probable,” says Bodmer. Barclays Capital, for instance, rates Turkish equities as the most vulnerable asset class to a slowdown in quantitative easing. Jaime Martinez Gomez, chief investment officer of $5.2-billion Spanish pension fund, Fonditel, meanwhile says it has cut two-thirds off its gold exposure in the past year to pre-empt an end to loose monetary policy.

 

Beyond tapering

Despite Center’s calm outlook, he reckons interest rates are likely to rise eventually – in “another three years at least”. Economist John Higgins of Capital Economics predicts a gradual long-term increase in interest rates and bond yields, citing parallels to a slow post-war unwinding of loose monetary policy in the 1950s.

Whenever it arrives, the good news for pension investors is that those operating on a purely defined-benefit basis may actually benefit in the long run from a rise in interest rates and bond yields. “As discount rates on liabilities will rise with yields, defined benefit investors feel hedged,” says Bowie.

That is of little comfort to the world’s defined contribution investors or others without discounted liabilities. “I can see why defined contribution investors would want to avoid the very low yields in bonds and credit as well as the risk of negative future returns,” Bowie concedes.

With “pretty tepid” expectations for fixed-income returns after a 10-year bull market, Center is more optimistic about equities. Plowing investment returns into equities to gently lower bond weightings is a strategy he broadly recommends. Bowie advises avoiding investments in government bonds “until real yields become positive again” – UK 10-year government yields still being below inflation indices.

Higgins also cautions bond-heavy funds by pointing out that equities have outperformed government bonds by 300 per cent on an historic basis. “Perhaps there will be funds asking whether they want to put all their eggs in one basket when equities have performed three times better than bonds over time,” he suggests.

 

Disorderly unwinding overdone

Should fears of a downturn in fixed income be realised, the strain might be felt most at the more cautious investors. Georg Schuh, chief investment officer of Deutsche Bank’s $9-billion contractural-trust-arrangement pension fund, recently told top1000funds.com that should there be a disorderly unwinding of quantitative easing, he could foresee asking the sponsor to increase the risk budget of the fund, which is 85-per-cent invested in fixed income.

However, Patrick Groenendijk, chief investment officer at the $18.5-billion Pensioenfonds Vervoer, which has 69 per cent of assets invested in fixed income, sees no great need to act now. “I think the market panic about tapering is overdone,” he says. “Bernanke is not the only one buying US treasuries after all – it’s a wide market. Outside the US, the story is still pretty bad in Europe, China and the emerging markets. It is not inconceivable that interest rates drop even further.”

In an unpredictable economic environment, there is therefore little certainty for investors, many of whom need to make judgment calls on the impact of tapering.

Italy boasts relatively few institutional investors, but the Milan-based Fondazione Cariplo shows that new investing standards can still be set in the home of the renaissance. The €7-billion ($9.3-billion) foundation’s most coveted investment work is its pioneering Italian funds in social housing – an asset area that has been touted in larger markets as an alternative for the future. Chief financial officer Francesco Lorenzetti reflects that “the Italian social housing market was non-existent” before Cariplo took its first steps into it via a subsidiary set up by its fund manager Polaris in 2007.

Pioneering enthusiasm can be detected in the foundation as it tries to fulfill a promise of reliable long-term yields and a match to Cariplo’s charitable aims. Lorenzetti nonetheless explains that the foundation’s effort has been a laborious task. “The impact investment field, including social housing, has been sexy in the last few years but the Italian real estate industry is very complicated for many reasons,” Lorenzetti says. “Huge inefficiencies” in local real estate would make it difficult for international investors to allocate to Italian social housing.

The foundation has aimed to provide housing below the market rate that can generate inflation plus 2 per cent, in line with the benchmark return for its entire mission-connected alternatives portfolio. “The tools and mechanisms that we have developed as part of the social housing industry could be exported, I think,” says Lorenzetti.

Should Cariplo’s style of social housing funds indeed be emulated in other lands, Lorenzetti will be pleased to have given something back to the international investing community. He confesses to be constantly looking to the United States and Northern Europe for inspiration in Cariplo’s asset management. “We would like to learn from more experienced international investors,” explains Lorenzetti. “Since 1998 we have been working on having and improving a long-term social investment approach, which is now common to the more established international investors.” He cites recently published OECD principals on long-term investing as a further influence. “A proper approach to long-term risk seems to be an environmental and socially sound one, and that is what we aim for,” he says.

Diversificazione

There has been one overriding ambition behind the foundation’s investment strategy as it works on a long-term approach in line with its major overseas peers – diversification. The 7 per cent of the portfolio ($660 million) in mission-connected alternatives is clear testament to that. Italian private equity, infrastructure and venture capital find a place there along with the social housing forays. Microfinance investments meanwhile provide an international dimension to this alternatives segment.

If everything goes according to plan, seed capital investments will follow soon too, with the worthy aim of better monetising Italy’s famous cultural riches. “We would like to see if it is possible to promote new companies in sectors like culture and agriculture, neglected until now in Italy, despite being important in the past,” Lorenzetti explains.

The mission-connected alternatives play an integral part in the Cariplo Foundation’s funding activities due to an administrative difference to many of its international peers. While many US foundations make impact investments with grants, for instance, Cariplo has mainly deployed its alternative assets for the purpose, as its grants are exclusively intended for non-profit groups.

Flexible platform

Lorenzetti explains that on top of the mission-connected alternatives, the foundation is currently 60 per cent invested in fixed income and has a 33 per cent equity holding (with a benchmark of 53 per cent global fixed income, 40 per cent global equity and 7 per cent mission-connected investments).

Close to half of the equity holdings consist of a single stake in the Intensa Sanpaolo bank. This arrived through the Fondazione Cariplo’s founding as a way to continue an Italian legacy of investing banking profits for the social good. The foundation was actually 100-per-cent invested in another bank until 1998, when a de-merger allowed it to swap this for its current stake, plus the grand sum of 9 trillion lira ($6 billion). The foundation intends to maintain its Intesa Sanpaolo share for the foreseeable future, says Lorenzetti.

Apart from the single bank stake and the mission-related alternative investments, the whole of the portfolio has been entrusted to asset manager platform Polaris. Lorenzetti recounts that the link-up came as “we were looking for a transparent and cost-effective multi-management platform as well as the social housing arm.” Creating a platform that has a lot of freedom for Polaris to invest within benchmark and risk-budget constraints was important, he stresses. “Our platform can, in fact, very rapidly create new pools used by multi-management funds to explore several different investment approaches and also invest in alternatives,” Lorenzetti explains.

Tax headache

Years of fine-tuning a balanced diversified portfolio could have been threatened with a dilemma recently thrust upon Fondazione Cariplo by a change in Italian tax law.

It had been aiming for annual returns of 7 per cent (with an 8.5 per cent volatility) to cover a 2.5 to 3 per cent grant target and 0.2 per cent running costs plus taxes and inflation. Returns have only averaged 3.5 per cent (versus a benchmark of 4 per cent) between 1998 and 2012 though, largely because of the financial crisis, with the Intesa Sanpaolo stake suffering greatly along with the Italian banking sector.

An increase in investment tax from 12.5 per cent to 20 per cent of returns at the start of 2013 suddenly disrupted its investment target. Increasing the equity holdings to around 55 per cent would have been needed to try to meet this new obligation, Lorenzetti argues. Ramping up the risk of the portfolio in a period of low interest rates was not a move the foundation was comfortable with, however, so grant payout targets are to be reduced over the next six years instead.

Lorenzetti bemoans having to do this. “If you look at foundations across Europe and the US, they do not pay tax, so this is a major negative element here in Italy,” he says.

Assets are to be further diversified too, as Cariplo maintains its current benchmark despite the enhanced tax bill. It is to swap an equity benchmark that was previously half based in the eurozone to instructing Polaris to invest in a FTSE All World Local Currency benchmark. That will bring added global and emerging market exposure, which the foundation is also bringing into its fixed income investments.

Lorenzetti is confident that Fondazione Cariplo will then look even more of a part of the elite club of sophisticated international investors. Only its tax bill will look different.

Sally Bridgeland, chief executive of BP Pension Trustees, the £18.5-billion ($28.7 billion) pension fund for employees of one the world’s biggest oil companies, only works part-time.

She made the decision after a near-fatal skiing accident when she says her life passed before her.

She is BP’s first group leader to do so and is evangelical about the benefits.

“Part-timers need to come out of the closet and know they can achieve at this level,” she says, speaking from the company’s headquarters off a quiet central London square.

“I’m setting up a charity to help support executive-level part-timers.”

They couldn’t have a better champion for the cause. As head of one of the largest growth-seeking UK schemes, Bridgeland is among the country’s most influential institutional investors. Her keenly observed strategy now includes diversifying growth to include emerging market equities and high yield, as well as building up an infrastructure portfolio from scratch as the fund begins to mature.

Until now the scheme has avoided infrastructure for easier returns in other areas where its expertise lies.

Bridgeland says the private equity-style of most infrastructure investment has also put her off.

“Other pension funds have been able to directly bid for projects, but we have lacked the inhouse skill to do the same.”

Now, with the fund maturing and gilts so unattractive there is a need for cash flow, the time has come, she says, to broaden horizons. She expects BP’s first infrastructure foray to be a UK-based debt investment, but says the portfolio will develop in other ways going forward.

“As an oil company, BP does a lot of infrastructure, so there are related skills and my dream is to deploy some of those,” she says, adding that unlike in growth assets with infrastructure, it is more important for the portfolio to be diversified itself, rather than against the sponsor. She also thinks BP will look abroad for opportunities, most probably in Europe.

“Are you paying a ridiculous price to somehow get that RPI linking when in fact you could do something with the currency?” she asks.

She also notes how Canada’s big pension funds began to invest outside Canada at the same time cash flow grew in importance for them. Now it is just a question of patience, a virtue she says she doesn’t particularly have, until the right opportunity arises.

BP is one of many UK funds on the infrastructure hunt and others, not cash-flow positive and prepared to pay more, will be at the front of the queue. “It is about knowing what you really want and at what price. I don’t think the pensions industry is good at that yet. It is good at looking at the value and total returns, but not really good at looking at the cash flows.”

Equities: a work in progress

Emerging market equities are also on her list. Of BP’s 80-per-cent allocation to growth-seeking investments, which comprise public and private equity and property, 36 per cent is invested in UK equities.

It’s an anomaly that is surprising given BP’s own prospering in emerging BRIC markets particularly. The fund is seeking opportunities in these markets’ fast-growing companies, especially those poised to benefit from consumers buying more local brands.

“We don’t want to miss out on this. We have some exposure to emerging markets through our Far East portfolio, but we are light on Russia and South America,” she says. “This is a work in progress.”

However, Bridgeland balances her enthusiasm with the reasons for BP’s historical caution in emerging markets, regarding governance in particular. She questions whether growth in emerging market economies is passed on to listed state-owned companies on local stock exchanges: “How much of these shareholdings are actually being controlled by somebody else? As a shareholder, do you have the ability to engage and influence strategy?” she asks.

Direct lending and private equities

Bridgeland is also scouting for opportunities in high yield and credit. Here, investment will focus on direct lending to companies, an asset class in which she would like to call on sponsor expertise again.

“This is an area where we could develop strength because BP is used to dealing with lending markets,” she says. It’s an allocation that has nagged for development since the financial crisis when, she says, the fund could have “done more” to seize opportunities in distressed debt. Yet she is also sure it has been right to be thoughtful and cautious.

“Would it have made that much of a difference? Probably not. We needed the world to recover to take us back.” She is also inherently cautious when a particular asset class becomes highly sought-after. “It’s when you see dedicated conferences. That’s when you know there is marketing money being put into this,” she laughs.

BP is now adding Asia to its European and US private equity portfolio, begun in 2000.

Initial funds-of-funds allocations have now matured and the focus is on direct-fund investments. Although the scheme “will carry on committing in a steady way”, she says the portfolio got up very quickly and that this constrains the amount they have been able to invest.

“The fact that we had money when people were taking it out did us well. The most important thing about private equity is the relationships with good names. It’s the relationships that lead to the returns.”

Living with market risk

BP Pension Trustees doesn’t pursue derivative strategies or hedge currency exposure, and has no allocation to hedge funds.

“Our philosophy has always been that we can live with market risk because of our sponsor,” she says.

She is bemused by the choice of hedge funds – “How do you choose the right one?” – and believes that many UK funds developed hedge fund strategies because they couldn’t stomach risk during the financial crisis, only to now regret it. Nor do hedge funds fit with BP’s inhouse bias, however she does believe the tendency to manage assets in house will change over time as the return-seeking portfolio begins to dwindle. She says an equity house pursuing bond-like strategies will either have to build up expertise in these new areas or outsource, and she questions whether it would be worth nurturing strong new internal teams.

“Within 10 years the organisation will look different and we will be doing different things,” she predicts. Liability matching assets currently account for 20 per cent of the total portfolio and comprise UK corporate bonds, gilts and cash.

The scheme’s ability to portion so much to growth assets is attributable to its steely sponsor with an eagle eye on funding levels, currently at 100 per cent.

“Every year we review what our funding level is and what the contribution should be,” she explains. “If something happens that has a big impact on the funding level, it really does protect the downside if you do something about it quickly, rather than if you leave it for three years.”

But in spite of the scheme’s unusual and continued sponsor support, Bridgeland is also able to see that times are changing. She is mindful that BP closed its defined benefit fund to new members in 2010 and that tax changes in the UK have reduced pensioners’ benefits. “We are looking forward as the fund matures and its importance to BP changes,” she says, a statement typical of her balanced approach to investing and life in general.

Institutional investors need to be conscious of cyber threats, especially from the Chinese, who are interested in macroeconomic changes that may result in large amounts of money moving around, according to James Mulvenon, vice president of the defense group at the Center for Intelligence Research Analysis.

Mulvenon says the risks to companies of their intellectual capital being stolen is a real threat, and that the disappearance of companies such as Nortel and the recent Cisco Systems court battle were examples of the Chinese stealing data.

“We don’t know the scale of the problem, but we know it is getting worse because of us moving to the cloud and the general use of technology.”

According to Mulvenon the risk mitigation techniques should not be about keeping Chinese hackers out, but about managing them when they are in.

“I no longer spend money on defense networks to keep them out, but on monitoring networks on what is going on within the network.”

Mulvenon, a Mandarin speaker, says the Chinese are motivated to steal data in a bid to deepen their economy.

“For 25 years their economy has been shallow. We send them our components, they assemble them and then send them back. There are few global Chinese brands.”

In 2006 the Chinese government set out a plan to 2020 that had indigenous innovation at its core, and this included getting technology out of Western companies.

The good news is that most sophisticated companies in the US are running their own counter-intelligence operations with fake servers and information.

In addition, Mulvenon says he is not convinced that the Chinese would get “full utility from the information they are stealing in this cyber espionage”.

He advises institutional investors to look at their own organisations and those they invest in, and ask what is being done to protect data.

Mulvenon was a keynote speaker at the Risk Summit, convened by World Pension Forum and Conexus Financial, publisher of conexust1f.flywheelstaging.com.

Agency risk in public pension funds is a big problem waiting to surface, according to Britt Harris, chief investment officer of the Teachers Retirement System of Texas.

“In terms of beliefs, you have to decide whether the pension system is a profit centre for beneficiaries or a political system to influence outcomes,” he says.

“Also who’s money is it? The state contributes, but essentially it is a deferred tax, so in my case it is the teachers’ money and not the government’s.”

Harris says most of the world operates under professional management, but in the public sector, the board itself runs the system. “It is a formula for disaster.”

Before Harris started as chief investment officer, the fund had had seven people in the position in 10 years.

“You can’t expect to be great if you can’t attract and retain good people.”

Since he has been at the Teachers Retirement System, the board has been transformed.

“As an older CIO, I was able to say I wouldn’t work in that system or that most professional investors wouldn’t.”

Now the board sets the return expectations, the parameters and uses outside consultants to provide analysis of the team. The fund has been audited 30 times in the past three years, and Harris believes both the board and the chief investment officer are fiduciaries.

“It comes down to where the best decisions will be made and for investments, we believe that is with the staff.”

Harris was speaking in a session at the Risk Summit, convened by World Pension Forum and Conexus Financial, publisher of conexust1f.flywheelstaging.com, in which Hershel Harper, chief investment officer of the South Carolina Retirement System Investment Commission, says his fund still has a significant amount of start-up risk.

“In 2005 the investment commission started, but we have never been fully funded or fully staffed. This introduces operational risk and compliance risk.”

The panel, which also included managing director of Wilshire Associates Patrick Lighaam, vice president of strategy and asset allocation at CenturyLink Investment Management Mary Beth Gorrell and senior relationship manager at Bridgewater Associates Joel Whidden, was discussing portfolio risks.

According to Harris, Teachers Retirement System portfolio-risk management was more focused on bubbles than tail risk.

“We looked at tail risk but never did anything. We decided the amount of tail-risk hedging we could do relative to the whole portfolio wouldn’t make much of a difference,” he says. “Our ability to avoid a problem is low; what we do after the problem is our advantage. Before a bubble you need IQ and after the bubble you need courage.”

Harris says the fund tries to focus on where the fund’s competitive advantages are, and one of those is its long term nature.

The Teachers Retirement System has a duration of 24 years and pays out 3 per cent of the fund per year.