The $152.5-billion Californian State Teachers Retirement System (CalSTRS) is undertaking an asset-allocation review that will consider the underlying risk factors of assets for the first time.

Chris Ailman, chief investment officer of CalSTRS, says the fund is in the middle of an asset-allocation study, which would likely take six months, and would take a different tack.

In the past the fund has only considered capital-market mean optimisation in making asset-allocation decisions, but now it will look at allocations according to risk factors as well.

“We will look at the drivers of risk – including inflation, interest rates and GDP – and what the fund is willing to include and exclude. We will optimise our allocations from a capital and risk perspective,” he says.

“If it reaffirms that we’re taking the right level of risk and return, then that is enriching the decision-making,” he says.

 Watching its weight

Ailman says the fund is adding points of view to the asset-allocation study and, at a recent board meeting, had an “interesting debate” on whether the goal of the portfolio was to make money or not to lose money.

“Capital-market theory and mean optimisation calculates risk by only one-term standard deviation, but it is much more complex than that. We apply so much math to investments because we want it to be a science, but it’s an art, and requires judgement.”

CalSTRS also makes tactical asset-allocation decisions and this week was due to hold a TAA meeting with one decision on the table: whether to go overweight the US.

At the moment the fund is neutral US, underweight Europe and underweight fixed income.

It has an automatic rebalancing process when allocations exceed the ranges, and Ailman says the question becomes when to rebalance and by how much.

“We are trying to build out an overlay portfolio with focus on left-tail risk,” he says.

Acknowledging inflation as a risk

Ailman’s view is that the biggest bubble in investments is fixed income, and acknowledging inflation as a risk is missing in most portfolios.

CalSTRS will look to expand its inflation-hedging portfolio among a basket of investments, including treasury inflation-protected securities and infrastructure.

The fund currently has a lot of growth assets, with 50.7 per cent in global equities and 14.5 per cent in private equity.

It also allocates 18.4 per cent to fixed income, 14.2 per cent to real estate, 1.6 per cent to cash, 0.2 per cent to inflation and 0.4 per cent to an overlay.


In a bid to achieve long-term returns without incurring the risk of today’s choppy markets, Asia’s biggest institutional investors are increasingly opting for alternatives in their asset allocation. The majority of respondents in a survey of 120 Asian institutional investors no longer deem long-held industry norms – such as lengthy holding periods or conventional 60/40 splits – as the best way to manage their portfolios. Respondents, including sovereign wealth funds, pension funds and foundations, each with an average $15.4 billion of assets under management, said the financial crisis has forced a change in their approach to risk management and a reappraisal of portfolio construction.

“Asian institutional investors have been shaken by the failure of conventional investment theories to protect assets and produce returns,” said John Hailer, Asia and Americas chief executive officer of Natixis Global Asset Management, publishers of the report.
“We’ve found that they are applying the lessons they’ve learned to create more durable portfolios. Increasing the use of alternative investments and making smart use of traditional asset classes is more likely to help them reach their goals in the current volatile markets, which appear to be here to stay.”

 

Alternatives are here to stay

Terry Mellish, head of business development at Naxtixis in London adds:
“The traditional long-only way of constructing a portfolio is sometimes no longer relevant. Alternatives add alpha and they are here to stay.”

One of the reasons institutions are increasing their asset allocation to alternatives is because the financial crisis means that traditional assets now correlate. It means volatility and illiquidity bleed across bond and equity asset classes, leaving few traditional safe havens. “A significant majority (71 per cent) agree that the best way to temper market volatility is to increase allocations to non-correlated assets,” finds the report.

Alternative-asset allocation means investment in hedge funds, private equity and even venture capital are increasingly sought after. Risk budgeting is another key, with institutions increasing their allocation of liquid alternatives such as global macro or long-short equity strategies. The low-yield environment encompassing bond-like asset classes with regular income streams, such as infrastructure, and diversified fixed incomes spanning bank loans and emerging debt, are also popular. The report found “89 per cent of respondents cited increasing allocations to fixed incomes as an effective risk-management strategy”. Commodity and real-estate asset allocations were the least popular among investors looking at alternative allocations.

The shift towards alternatives is a direct attempt to try and manage risk, which is now viewed as the “new normal”, and the overwhelming worry for investors – or, as Mellish puts it, the “thing that keeps them awake at night.”

“In the past, most schemes looked at the risk once their portfolio was in place,” he adds. “Now they are putting that risk at the front of the process and factoring risk into all decisions.”

Mitigating volatility and so-called tail risk – those events that impact portfolios unexpectedly – is now at the forefront of managers’ minds.

 

Fewer shocks

Encouragingly, the shift towards alternatives among Asia’s biggest institutional investors is starting to pay off. The survey found that eight out of 10 respondents “were pleased” with the performance of their alternatives, with more than half expecting that their alternative strategies “will outperform last year’s returns.” The survey found “alternatives are important not only for diversification but also for performance. The majority of respondents believe it is essential to invest in alternatives in order to outperform the broader markets”. 

Going forward, all the signs suggest alternative asset allocation and “new approaches to achieve results” will remain on the radar. Almost all respondents said government-debt levels and contagion from Europe will influence their investment decisions in the coming year and that the “staggered pace” of financial reform increases systemic risk. The findings – drawn from institutions in China, Japan, Taiwan and Singapore, and which chime with Naxtixis research across other regions – show institutional investors implementing and being rewarded for pursuing new and innovative strategies in today’s unchartered waters.

“Alternatives give clients the chance of achieving their long-term objectives but with fewer shocks along the way,” concludes Mellish.

Institutional investors across the planet are squaring up to changed realities in the wake of the financial crisis. It is difficult though to think of any that has found its operating environment transformed as fundamentally as Ireland’s National Pensions Reserve Fund (NPRF).

“Being turned on its head is a fairly accurate way to describe the changing role of the fund,” concedes investment director Eugene O’Callaghan.

Having the vast majority of its portfolio – some €20.7 billion ($26.6 billion) – siphoned off by the minister of finance from 2009 to 2011 to recapitalise two devastated banks (Allied Irish Bank and Bank of Ireland) was just the beginning.

The NPRF is now on a mission to rebuild its struggling country. It wants to transform the $7.5-billion rump portfolio still under its control by investing the majority in domestic infrastructure.

“We want to reverse the capital outflow that Ireland has suffered,” says O’Callaghan. It’s a lofty ambition, made even more daring by the drastic reduction in the “discretionary portfolio” that is still under the NPRF’s control.

Overall returns of -36 per cent in 2011 are equally difficult to match with a goal of changing the face of a nation. This desperately poor result was due solely though to a markdown of the bank shares that make up the NPRF’s “directed portfolio” – controlled by Dublin’s finance ministry.

 

Transforming a portfolio

To complete the major shift to infrastructure that it hopes will put Ireland on the road to recovery, the NPRF has three broad immediate responsibilities, O’Callaghan explains.

Firstly, space needs to be freed up from the discretionary portfolio – which returned a decent 2.1 per cent in 2011, comfortably beating both its benchmark and the average Irish pension fund.

For this purpose the fund has begun a sale of its $973-million private-equity assets in secondary markets and hopes to offload many of its $637-million worth of property assets as they approach maturity.

The most pressing item on its agenda, however, is to gain a new mandate that permits the NPRF to concentrate its assets in the Irish infrastructure basket.

O’Callaghan hopes for agreement “fairly soon” on mandate-review discussions between the NPRF commission and the fund’s sponsor, the government. The NPRF naturally wants its concerns to be enshrined by a changed text, such as that all new investments are made on a fully commercial basis.

Finally, the NPRF needs to scout novel opportunities in Irish infrastructure. Instead of waiting for clarification on its mandate first, a pro-active NPRF has already begun this hunt.

In fact, given the limited market in Irish infrastructure investment, the NPRF is coming close to pioneering a new asset class.

 

Getting others on board

O’Callaghan exclaims that the NPRFs new work on developing infrastructure opportunities “is a new world entirely. We find ourselves hustling to bring partners together, with half our team discovering things as if they are running a start-up business.”

The search for partners is a result of the NPRF leading efforts to attract up to $1.29 billion in funding to an Irish Infrastructure Fund run by asset managers Irish Life and AMP Capital.

The NPRF pledged $322 million to this in 2011 under a new umbrella Strategic Investment Fund – a move that won’t be implemented until the mandate review is complete.

O’ Callaghan admits finding partners has proved to be hard work, not least because it goes well beyond the typical work of a fund and is “more akin to corporate financing at times”.

Some hoped-for Asian investors for the Irish Infrastructure Fund have also turned out to be coy about gaining any eurozone exposure. Others want to see more “visibility” in the Irish government’s privatisation agenda.

There is a “comfort factor” for potential partners though in the presence of the NPRF in the fund as a major international investor, O’Callaghan reckons. He is also confident that once the NPRF-mandate review is complete, the funds will start to flow in that venture.

In another move, the NPRF’s newfound role as a national champion led it to clinch a novel deal with the US-based Silicon Valley Bank. The NPRF switched its discretionary portfolio’s US venture-capital mandate to the bank in return for a commitment to loan $100 million to Irish mid-stage tech companies.

O’Callaghan is confident that there will be enough demand from the small Irish economy for new infrastructure spending. There is certainly no shortage of proposals for what NPRF financing can be spent on.

 

Political association

The Irish Infrastructure Fund made its first investment in June – purchasing a wind-farm portfolio.

Some $161 million of NPRF funding has also been offered to aid the Irish export industry through Enterprise Ireland, while plans to help grant domestic small-to-medium enterprises much-needed credit are also in the works.

Installing water meters at every Irish home with a loan of $579 million and supporting an extension of broadband networks in rural areas are additional projects likely to tap NPRF funding under its Strategic Investment Fund.

The government is also looking for $965 million from the NPRF to support a public-private-partnership initiative proposed this June.

The close political association of many of these proposals begs the question as to whether the finance ministry knows more about the NPRF’s future than the fund itself.

“We just have to go with the flow. The government has articulated its plans for the NPRF, but everything we do has to be on a commercial basis, without which our credibility as an investor would be lost, and we are 100-per-cent determined to ensure that,” O’Callaghan says.

 

Managing the future

A report sponsored by Irish trade unions that was published in March 2012 suggested that close to half of the NPRF’s $7.5 billion discretionary portfolio should be pledged to support domestic infrastructure.

O’Callaghan concedes that even the majority of the portfolio could end up being invested in the asset class. If realised, that would be quite a staggering approach for a pension fund to take.

Managing such an unconventional portfolio is likely to be every bit as challenging as establishing it, particularly in capping risk. Infrastructure, after all, has a reputation across the world as a high-risk asset class.

“Well, we have the capacity to dial up and down the risk spectrum,” says O’Callaghan. “It will be a good few years before all that infrastructure money is deployed in Ireland and we have a liquid portfolio of global investments that we can use to balance risk.”

Efforts to de-risk the liquid portfolio got underway in 2011 with what seems to have been a well-timed move to shed both listed-equity holdings (now just 40 per cent of the discretionary portfolio) and eurozone sovereign bonds (a mere 1.4 per cent).

At the same time, the fund has been delving further into alternatives with $341 million of equity-put options (4.9 per cent of the discretionary fund) purchased in the middle of 2011.

Substantial existing investments in infrastructure plus property yielded 18.4 per cent and 9.1 per cent, respectively, over 2011.

 

Magic formula?

Gaining admirable returns in the discretionary portfolio of more than five percentage points over the average Irish pension fund in 2011 suggests the NPRF might just have stumbled on a magic post-crisis investment formula in the dramatic efforts to reshape itself.

Whether the NPRF can continue that success with its bold new infrastructure focus remains to be seen.

How it finds its way in at a time when financially decrepit governments are urging so many institutional investors to back local infrastructure projects should yield valuable lessons at the very least.

A swathe of UK pension funds is poised to increase its exposure to infrastructure.

In a small start, which enthusiasts believe will quickly grow, the Pension Infrastructure Platform (PIP) will launch as a fund in January 2013, targeting £2 billion ($3.24 billion) worth of projects with the backing of around 10 UK pension funds. The drive is being led by a trio comprising the UK Treasury, the £11-billion Pension Protection Fund (PPF), protector of 12 million members paying out on schemes employers fail to meet, and the National Association of Pension Funds (NAPF), which counts 1200 pension funds as members, with a combined $1.295 trillion in assets.

The aim is for the PIP to encourage more pension-fund investment in infrastructure as the cash-strapped government looks to institutions to help bridge an infrastructure gap put at $405 billion over the next five years.

Despite the complimentary fit of pension funds’ long-term liabilities with long-dated infrastructure investment, UK funds eschew the asset class, only allocating around 2.5 per cent of their portfolios to infrastructure, favouring equities, property and government bonds instead. The new fund could change all that.

Low charges, risk and gearing

One of the reasons pension funds have been lukewarm on UK infrastructure is because most existing funds are modelled on private-equity structures. These funds charge costly fees such as 2–20, when the manager charges 2 per cent of the total value of assets invested and 20 per cent of returns. They also have short-term investment horizons and the high leverage of many existing deals usually involves 85 – 90 per cent debt and 10 – 15 per cent equity, reducing the inflation linkage that pension schemes favour.

It’s still not clear whether the new fund will hire its own experienced team or use specialist City managers, but any manager will have a different mandate. As well as low charges and a limited degree of risk, it will have low gearing, employing leverage up to a maximum of 50 per cent.

“The PIP will be run by pension funds, for pension funds, as a not-for-profit company focused on providing returns. The target return will be retail-price-index plus 2 – 5 per cent per annum over the projected 25-year life of the fund,” says Councillor Paul Rooney, Glasgow city treasurer and governor of the $15.5-billion Strathclyde Pension Fund, one of the first schemes to announce plans to invest in the PIP. The fund will announce details of its route to market at launch, but it is likely that it will be via a form of direct investment rather than listed bonds or equities.

Of risk and competition

It is also likely that the fund will invest in greenfield infrastructure schemes but without shouldering construction risk. The idea here is that the government provides guarantees for the riskier projects – given pension funds’ natural aversion to undeveloped infrastructure projects – that are prone to delays, unforeseen costs and accidents.

“The government has talked about creating construction guarantees for certain projects. We look forward to seeing the detail on that,” says Joanne Segars, chief executive of the National Association of Pension Funds.

Another option could be that the government may shoulder the risk of building the asset, which it then sells on to pension investors. This happened when it built High Speed 1, the 109-kilometre line that connects London with the Channel Tunnel, then sold the right to operate the line to two Canadian pension funds, Borealis Infrastructure and the Ontario Teachers’ Pension Plan in 2010. The challenge here is that competition to buy into these kinds of projects is fierce.

Good timing?

Within infrastructure, the fund will invest in the public sector as well as transport, energy and telecoms. One concern is the lack of homogeneity within the asset class ­– many high profile projects continue to struggle with nuclear power, the waste sector and some of the early offshore windfarms have also had problems.

Despite the risks, the PIP has come at a time when more UK funds have announced infrastructure allocations. These include local-authority schemes and some large private-pension funds such as the Universities Superannuation Scheme (USS), telecoms group BT’s pension fund and RailPen, which manages $27.5 billion worth of pension funds for the UK’s rail industry.

Not a solitary PIP

The policy to pool pension assets to invest in infrastructure is nothing new.

Canada, where pension funds are at the forefront of infrastructure investment, has a similar model to the PIP via specialist investment arm Borealis.

Australia’s Industry Funds Management (IFM), owned by 32 pension funds with infrastructure assets worth $11 billion of its $35.1 billion total assets under management, is another example.

Pension funds in other regions are also getting bolder when it comes to infrastructure. California Public Employees’ Retirement System adopted a new investment policy in 2008, with a target 3-per-cent infrastructure allocation. Dutch pension fund Stichting Pensioenfonds ABP, Europe’s second-biggest, has a target of 2 per cent, which it plans to double in coming years.

In another breakthrough development, the Dutch government is providing inflation-linked guarantees in the financing to expand and maintain the N33, a road in the north of the Netherlands. Managers APG Asset Management, whose largest client is pension fund ABP, has provided €80 million ($103 million), about 70 per cent of the debt, on the project. “We have been asking the Dutch government to guarantee inflation-linked debt for some years; this is a pilot project but it will open the door to more and larger projects to be funded by pension funds in this way,” said Ron Boots, head of infrastructure at APG Asset Managment. Dutch fiduciary manager PGGM, owned by pension fund Zorg en Welzijn, is an equity holder in the project. 

Elsewhere, in Japan pension funds are embracing infrastructure in their bid to boost returns to meet rising payout obligations. In a survey of 126 Japanese pension funds by JPMorgan Asset Management, 7.9 per cent of funds said they were already investing in infrastructure, while a quarter of them had increased alternatives allocations in the previous year. Japan’s Pension Fund Association, together with a consortium led by Mitsubishi Corp and Canada’s OMERS, have set up a Global Strategic Investment Alliance with plans to invest $32.35 billion in infrastructure worldwide.

PIP! PIP! Part of the solution

The PIP could give UK pension funds the chance to swoop on some of the country’s most prized infrastructure assets and offer a solution to financing infrastructure at a time banks and governments struggle to do so. “We certainly don’t believe it’s a case of too little too late; the UK is crying out for more investment in infrastructure,” says Segars, confident the January launch will begin to make infrastructure a more compelling asset class for the UK pension industry.

Complexity is, well complex. And as trite as that sounds, it’s something investors, even professional investors, don’t understand well enough, according to Tim Hodgson, head of the Thinking Ahead Group at Towers Watson.

The Thinking Ahead Group (TAG), as has been reported here before, gets paid to think – a gig conexust1f.flywheelstaging.com is envious of. In the past year or so, the focus of that thinking for the group, based in London but with representatives from Towers Watson around the world, has been on complexity, risk and sustainability, producing multiple papers that reflect those themes.

“We don’t understand complexity well enough,” Tim Hodgson. “The CFA is still teaching modern-portfolio theory but today that is not a good model to describe the world. I’ve drunk the complexity Kool-Aid.”

The group, which has now also been recognised internally by the Towers Watson insurance group and will be hiring two new members, doesn’t look at traditional risks and opportunities but recognises that the world is interconnected, and that politics, economics, society, the environment, technology and finance all interact in different ways.

 

Manage expectations

One of their recent papers, The Wrong Type of Snow, has this notion of complexity underpinning it and basically surmises that “risk could be more wild than you’re planning for”.

Similarly the paper, We Need a Bigger Boat, which describes the detailed Telos Project done in conjunction with Oxford University, is premised on the fact the world is on the cusp of significant economic, political and capital-market transformations.

This is seen through market deleveraging, increasing resource scarcity and degradation, and an ageing population, all creating an “extra dimension”.

The relevance for the industry is that the paper says the portfolios and strategies judged to be well suited for present-day conditions will prove unsuitable in the future.

It goes on to discuss an alternative way that includes four key implementation elements: organisational design; risk management and governance; factor-based thematic and asset-allocation approaches; and mandate design for asset owners.

“My working hypothesis is it’s hard to create returns given this environment, so it’s better to manage expectations,” Hodgson says. “I’m known for being a bit bearish.”

 

Average really is average

While Hodgson describes those two papers as “weighty documents”, TAG has also done some “lighter stuff” including a paper called The Impossibility of Pensions, which concludes that not only are past returns not a guide to the future, they are not even a reliable guide to the past.

If that’s not complex enough, then there’s the paper The Irreversibility of Time, which Hodgson describes as “potentially geeky” and has the sub-title Why you shouldn’t listen to financial economists.

This paper found the theoretical underpinning for 2009’s Extreme Risks paper, which identifies 15 extreme risks, and when it was updated last year, two new risks were added: resource scarcity and infrastructure failure.

“There is an assumption in finance that we have infinite lives and we live them in parallel. It’s a version of the St Petersburg paradox. But actually we should run these events in series not in parallel. Arithmetic average is used because it’s easier, but it’s only an average.”

“If there’s a finite supply of investment projects, then when you move money chasing them, it will increase the price, which equals less than return. We aim to challenge people’s mental models,” he says.

And that can only add to the tool kit for decision-making.

There is a positive correlation between the investment performance of REITs and the “greenness” of their portfolio holdings, according to a new paper by Maastricht University’s Piet Eichholtz, Nils Kok and Erkan Yonder.

The paper – Portfolio greenness and the financial performance of REITs – finds that investment performance of REITs is positively related to the adoption of Energy Star and LEED certification in REIT portfolios.

The paper investigates the effects of the energy efficiency and sustainability of commercial properties on the operating and stock performance of a sample of US REITs proving insight in the net benefits of green buildings. It calculates the proportion of green properties for each REIT over a period from 2000-2011. Via a regression model it documents that the greenness of REITs is positively related to three measure of operating performance- return on assets, return on equity and the ratio of funds from operations to total revenue.

Further, it concludes that REITs with a higher fraction of green properties display significantly lower market betas. The findings, that REITs with a greater percentage of efficient, sustainable properties display significantly lower market betas, is explained by the fact that “green” properties may be less exposed to business cycle volatility and may be less prone to occupancy risks.

Eichholtz, who is professor of real estate finance at Maastricht University and chairman of the Global Real Estate Sustainability benchmark, says the paper shows there is a relationship between greenness and performance.

“The greener the company/portfolios the better the performance, also free cashflow was higher and risk was lower, and beta was substantially lower,” he says. “This paper shows that the relationship between financial performance and sustainability is really there.”

Eichholtz says the philosophy of GRESB is that “you can make good money by improving the world”, he says.

“Members of GRESB, the pension funds, see that sustainability and investment performance go hand in hand and they talk to companies and say get your act together.”

Eichholtz says there are some companies in the real estate sector who have acknowledged this, and benefited from it. In the latest GRESB Report, he points to a company called Big Yellow in Europe, which is a self-storage company and a sustainability leader.

“The chief executive of Big Yellow, who is also the largest shareholder, is not interested in saving the planet but he’s very interested in making money. His company was the number one in sustainability – he’s totally pragmatic.”

“The leaders are not the full green niche, but it’s the mainstream property companies that are the green leaders. This is another sign that anyone can do this.”