This paper by academics at Erasmus University and the University of Chicago shows that hedge funds exhibit persistent exposures to extreme downside risk, and that tail risk is an important determinant of the time-series and cross-section variation of hedge fund returns. Further it concludes that these results are consistent with the notion that a significant component of hedge fund returns can be viewed as compensation for providing insurance against tail risk.
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Tail risk and hedge fund returns
Reducing equities, expanding the resources and changing the RFP process are on the agenda of New York City Retirement System (NYCRS) chief investment officer, Larry Schloss, as he makes structural and investment changes to turn the $123-billion fund around.
Two and a half years in to what is most likely only a four-year tenure – the CIO is appointed by the New York City comptroller, currently John Liu, who is an elected official with a four-year term – Schloss is making impact despite the structural hurdles in the way decisions are made and assets are allocated.
Schloss began life as the deputy comptroller, asset management and chief investment officer of NYCRS in January 2010, after spending his entire career in the private sector, predominantly in private equity, which included co-founding and leading Diamond Castle Holdings and as global head of CSFB Private Equity.
At the time he came to be CIO, the fund had roughly a 70:30 growth bias split and hadn’t done an asset allocation review for five years.
Over the 10 years before 2010 the fund had a return of 2.7 per cent, against an actuarial rate of 8 per cent, and one of the first things Schloss discussed with the board was whether they “really wanted a wild ride of the public-equities markets all of the time”.
“Once it was decided to reduce volatility, it followed that equities would be reduced,” he says.
Under his watch there have been a number of asset allocation changes.
For a long time the fund just invested in public equities and core fixed income, with high yield bonds introduced in the late 2000s and private equity in the mid-2000s
“We looked at the asset allocation and said what do you change? We missed most of the emerging markets rise, because we were very US-centric, so we thought we should allocate more to emerging markets, and decided to allocate less to US equities and less to total public equities overall.”
So the fund took about 10 per cent off its public-equities allocation and introduced hedge funds for the first time, allocating between 4 and 5 per cent, as well as 5 per cent to opportunistic fixed income.
“With opportunistic fixed income we had partners and allowed the mandates to move around,” he says. “We now have 10 per cent in smart, nimble money.”
The investment team also got a bit more aggressive in managing the asset allocation tactically and now can move within a 5-per-cent-asset-allocation band.
At the Big Apple’s core
NYCRS is made up of five pension funds – one each for the teachers, employees, police, fire and board of education – and each of those funds has its own asset allocation and own consultant.
Across the five funds there are 58 trustees, which is strangely juxtaposed with the NY State Pension Fund’s one trustee, the state comptroller.
The representation is equally split between the government and unions, with both Mayor Bloomberg and Comptroller Liu appointing representatives.
| The asset allocation at the end of March this year was: | |
| 41.36% | US equities |
| 28.1% | fixed income |
| 18.6% | international equities |
| 6.8% | private equity |
| 5.14 % | private real estate, hedge funds and cash |
When Schloss came on board as CIO, he suggested he should be on the board as the comptroller’s representative.
“It’s second nature for me to be on the board, I’m a private equity guy,” he says. “CIOs should be on boards of public pension funds.”
If there is a time at the board meeting when there is a discussion around management, for example, then they can leave, he says.
Across all the funds NYCRS employs 360 managers, of which 110 are in private equity and 50 are in real estate.
Globally there is a trend for pension funds of NYCRS’ size to expand internal resources, and it would be a natural progression for the fund. Since Schloss took up the job the in-house team has gone from 22 to 35.
“There is a resourcing issue within the asset management department,” Schloss says. “The fund finds it hard to attract the right people, partly because of pay levels.”
The fund’s asset management office is only a few blocks from Wall Street and the irony is not lost on Schloss. The average salary of the investment team at NYCRS is $100,000, the CIO gets paid $224,000 and there are no bonuses paid. Furthermore, the fund can only hire people that live in the five boroughs of NYC.
“If you work at NYCRS you have to live in NYC, so on a cost-adjusted basis the pay levels are dire,” he says.
There is still a lot to be done in terms of governance reform at NYCRS.
“We have five funds, five general consultants and five specialist consultants. I like having consultants but I think it is overly cumbersome,” he says.
While the CIO can be appointed from within, that has not been the practice in the past. Instead the position has been appointed by the comptroller. Succession planning is a problem that has repercussions on decision-making and subsequently returns.
“I would like to see the city hire a successor with close-to-market compensation. It’s in the world’s financial capital, that’s what frustrates me the most.”
So with potentially only 18 months left on the job, Schloss is focusing on what he thinks he can achieve, which is to change the procurement rules, the way the fund issues RFPs to become more nimble and assure the selection of the highest quality managers.
“My aim when I got here was to leave the fund better than when I found it,” he says. “One of our key initiatives is trying to change the procurement rules. To do that we would have to change the law, if we could get that done it would be very impactful.”
Formerly, the process was an advertisement placed in various media and managers applied based on the ad. Managers could only be selected from those who applied.
Now the fund still advertises but consultants can also give their recommendations and managers can be selected from the consultants’ recommendations.
“Before we came it took 18 months to select a manager; we want to get that down to six months.”
Investors should reconsider their currency hedging strategies as an undervalued US dollar is predicted to strengthen according to Colin Crownover, State Street Global Advisors global head of currency management.
The US dollar is as much as 10 per cent undervalued relative to other major currencies, says Crownover, who also forecasts that the economic-growth gap between the US and emerging markets will narrow in the coming year.
“We are bullish about the US dollar and not because the US economy is without the problems it certainly has,” Crownover says. “But currencies as always are a relative endeavour and of the major economies, the US economy has lesser issues than the others.”
Crownover’s views on the US dollar are within a context of slowing global growth and the eurozone “slightly slipping into recession”.
“Regardless what people say about China, the United Kingdom or Japan, there are really only two games in town and, in terms of large liquid investments, there are US-dollar denominated assets and euro-denominated assets,” he says.
“So, whether you are central bank or an institutional investor, if you have concerns about the euro-project – which it is valid to have – then at the margin that causes an allocation away from eurozone assets into US assets.”
Crownover cautions that the attractive relative valuations of European equity markets compared to potentially expensive US equity prices may mitigate some of these allocations away from euro assets.
The US dollar has shown counter-cyclical characteristics in recent times, with the currency strengthening when investors look to shed risk at times of market uncertainty, according to Crownover.
He notes the US dollar is now “a good diversifier” in the basket of currencies an investor holds, balancing out other pro-cyclical currency exposures.
Crownover recommends US-based investors look to slightly increase their ratio of hedged assets, given the likely appreciation of the US dollar.
“Our analysis would tend to indicate that 50 per cent is not a bad hedge ratio for the US over the long term. But you probably want to do a little bit more today because the US dollar is undervalued.”
Slowing dragon, emerging markets
The softening in world growth is set to hit exporting countries in Asia, and Crownover predicts that China will slow more than many market pundits suggest, while Japan could be a potential bright spot in the region.
“Relative to what is happening in the global economy, you are seeing a bigger impact on emerging markets this time around than you did at the advent of the GFC.”
Crownover notes that the Organisation for Economic Co-operation and Development’s leading economic indicators for the US and Japan show that they are holding up in the face of slowing growth, with China showing signs of its deceleration picking up pace.
“The leading economic indicators look gruesome for China, dropping by about 3 per cent year on year. So, in our opinion China is slowing down by more than what the official statistics would have you believe,” he says.
State Street’s view is that the Chinese economy will grow by 7 per cent and could even slow further if the central government decides not to carry out fiscal stimulus.
The company is not alone in its pessimistic outlook for China, with fixed income giant Pimco also warning at the start of the year that China could slow by more than many were forecasting.
Like State Street, Pimco sees growth as closer to 7 per cent than the 8 to 9 per cent typically predicted.
Buy and hold doesn’t pay
While acknowledging the underlying fundamentals of emerging markets generally, Crownover is quick to dispel what he sees as a myth regarding currency exposure to emerging markets.
It is common to hold broadly unhedged positions in emerging markets, with the view that over time emerging market currencies will appreciate against the US dollar on the back of relatively strong economic growth and healthy sovereign balance sheets.
Crownover says there are times when this buy-and-hold strategy for emerging market currencies has played out, such as the period leading up to and during the financial crisis, but over the long-term this approach has not paid off.
“For a US-dollar investor a market capitalisation basket of emerging market currencies has lost almost 10 per cent over the last year. If an investor simply bought and held that same basket of currencies over 10 years, they made exactly zero,” he says. “So there are periods when it looks quite good, but over the long run this has not added much alpha to a portfolio.”
Crownover says the underlying fundamental strength of emerging markets is already built into the price of most of these countries’ currencies.
Despite the recent sell-off, most of these emerging market currencies are overvalued, according to Crownover.
“Our advice to investors right now is if you hadn’t done emerging-markets-currency hedging previously, this might not be a bad time to do so,” he says.
OMERS Strategic Investments (OSI) is more than the international co-investment arm of Ontario Municipal Employees Retirement System (OMERS), it is the vehicle which the system uses to shape and implement several key parts of its strategic plan.
OSI is one of five investment groups that fit under the OMERS Worldwide brand. The other four groups have specific capital allocation and investment management functions – capital markets, private equity, infrastructure and property – but OSI has multiple functions.
While it does invest, across various vehicles and strategies, the overriding purpose of OSI is to implement the strategy of the organisation as a whole.
Chief executive of OSI, Jacques Demers, says this can include bringing opportunities to the investment arms but also forging relationships, conducting research and exploring co-investment.
“The actual investments, the sourcing of deals and opportunities, are undertaken by those investment entities. What we do [is] to support and enhance what they’re doing,” he says.
“So what OSI is doing is intended to assist them with operating investment plans, so when they’re ready, OMERS is ready.
“We are kind of like the R&D, skunkworks, strategic-relationship unit. We could feed back to be thematics in investment entities.”
Global Strategic Investment Alliance (GSIA)
OSI in itself also deploys capital, and Demers says most of that is unrelated to the other four investment arms, but in some cases it reinforces the fund’s relationships in certain areas.
The best way to exactly describe the function of OSI is to look at the recently closed Global Strategic Investment Alliance (GSIA) alongside the initial alliance members, Pension Fund Association and a consortium led by Mitsubishi Corporation, both from Japan.
The GSIA closed with $7.5 billion, of which $5 billion was committed from OMERS, to invest in large infrastructure investments. The role of OSI, which builds investment platforms and develops direct relationships globally, was to source the co-investment partners, and all GSIA investments will be originated and managed by the infrastructure-investment arm of OMERS, Borealis Infrastructure
This investment satisfies the OSI objectives, which are to establish a global footprint, raise capital for OMERS investment entities and supplement the fund’s corporate strategy by creating global investment platforms that would not otherwise exist. The idea is the platforms could ultimately be transferred to the investment entities, established as a standalone platform, or sold to third party investors.
“The whole point of GSIA is to achieve our objectives securing preferred infrastructure while advancing our presence; developing relationships and creating platforms,” he says.
At the moment about two thirds of the capital in GSIA is from OMERS, and Demers would like to see that get to about 25 per cent.
“Our target would be to have about six to eight members, to manage it effectively,” he says.
The idea is that each institution invests about $1.25 billion, but the concept of a feeder fund has been suggested, where up to 10 investors all contribute $100 to $125 million to that $1.25 billion aggregate.
The fund will be kept open to 2014, with some institutions pre-approved, and the aim is to raise $20 billion.
“We have about 100 outreach relationships now worldwide and about 20 to 25 globally, where we could pick up the phone to co-invest very easily,” he says. “At the end of the day we’re a pension plan – this is not a fee-driven exercise.”
Energy, capital and airports
Demers says OMERS is looking at how to develop those relationships and is considering secondments, exchanging employees with its collaborative players.
The GSIA is one of four platforms, or major investments, that the strategic arm has been involved in. The others include OMERS Energy, OMERS Ventures, and ADC & HAS Airports.
Demers says OMERS Energy, based in Calgary, is a mid-sized oil and gas operator and has grown from $300 million to $1 billion in three years. OMERS is the main investor but there are two other Canadian investors, and Demers says there is growing interest from institutional investors around the globe.
OMERS Ventures, which was launched last year with John Ruffolo at the helm, is part of OSI, and is a venture-capital investor that started from scratch and will invest across the life cycle of venture capital opportunities.
The fourth platform is ADC & HAS Airports, the Houston-based airport operator that is focused on markets less familiar to OMERS’ native Canadian market.
“Airports are strategic investments. For example, through our investing in Costa Rica we have developed a relationship with the government there and that will have flow on to other potentially attractive private-market investments,” he says. “We can act as an early scouting unit for emerging markets. So when OMERS private-investment arms go in, we’ve done some work.”
Light team
Demers says OMERS is shaping and implementing a strategic plan which includes moving to 100 per cent in-house investment management, a split of 53:47 between public and private markets and a return target of 7 to 11 per cent.
Part of the interpretation of that agenda, Demers says, is to advance the presence globally, and the fund now has offices in New York, London, Calgary and Toronto.
“We have developed relationships in Canada with pension plans, governments and public policy makers, and industry organisations around investments like infrastructure. Now we have to develop those kinds of relationships in other markets,” he says.
“OMERS leverages our intellectual capital and the all-in cost is less than 1 per cent of invested capital. Our feedback from other funds is that is very attractive,” he says.
OSI has a notional 5 per cent allocation of the total fund and it is now sitting at 1.6 per cent.
The strategic team has about 14 people, with OMERS Ventures another 13.
“It’s a light team because they’re strategic initiatives, but we do have support from other teams across the enterprise and can resource as appropriate.”
A few weeks ago I had a meeting with Ranji Nagaswami, chief investment advisor to New York City mayor, Michael Bloomberg. She’s the first mayoral chief investment adviser in NYC to oversee pensions and investments, an area that is usually the domain of the comptroller. She is an experienced and dynamic enthusiast with ideas galore on how to improve the city’s pension system. Which is a good thing. There’s a lot to be done.
New York City Employee Retirement Scheme (NYCRS), which will be profiled with an interview with its chief investment officer Larry Schloss on conexust1f.flywheelstaging.com in the coming weeks, is a governance mess, and there’s no surprise this has been impacting returns.
The $120-billion fund is made up of five separate funds for city employees. It has 58 trustees and five consultants for an asset allocation across the five funds that has about 90 per cent overlap. The boards still do beauty parades.
Short-termism is rife at the fund, driven by a structural element that sees the chief investment officer elected by the comptroller, a publicly elected official with a four-year term.
Furthermore, if you work at the fund you are required to live in one of the five boroughs of New York City, but the average investment employee salary is only $100,000.
(Apparently, according to a Bloomberg report, Nagaswami lives in Greenwich, Connecticut, so the city administration secured a waiver enabling her to work for the city. Her salary is $175,000).
Getting to the core
Wall Street is literally a stone’s throw from the 1 Centre St office of the City Comptroller’s Bureau of Asset Management, which manages the NYCRS investments, but geography is all they have in common.
Nagaswami, who before joining NYCRS spent more than 20 years at UBS Asset Management and Alliance Bernstein, was reluctant to speak with me on the record. Fortunately, and perhaps not so coincidentally, she has written a piece on the battle facing US public pension schemes in the spring issue of Rotman International Journal of Pension Management.
In this she outlines her observations and concerns, and many of the governance challenges have been acknowledged by mayor Bloomberg and the comptroller, John Liu, as well as some union members.
But widespread reform across investment strategy, decision-making, trustee governance and actuarial-assumption rates is needed to turn the fund around in the direction of best practice.
In the article Nagaswami outlines three clear challenges for NYCRS.
First, the investment-planning process should start with an understanding of the risks in the current portfolio as well as the short and long-term market and return environment. A new and multi-step investment road map should be designed to construct a long-term balanced policy portfolio. And the governance of the plans must be overhauled.
She wants to create a new starting point, redraw the investment road map, including a new attitude to the role of fixed income, and broadening the approach to policy portfolio construction, as well as getting the governance right.
Secondly, she says what is most needed in NYC is further professionalisation of investment staff and the board trustees to attract and retain the best talent at competitive market compensation rates while improving the board’s oversight.
She argues for consolidation of the existing five separate investment committees to improve efficiency and reduce unnecessary duplication.
And finally, she says, the fund needs de-politicisation to ensure that the structure is not influenced by the election cycle or shifting political agendas.
In the past few weeks Nagaswami, and the pension beneficiaries in NYC, have had a win that could jet her plan into action.
The city’s independent actuary has recommended a reduction of the actuarial rate from 8 to 7 per cent.
Perhaps Nagaswami, who also sits on the Yale University investment committee, is big and bold enough to generate change at the city.