Michael Trotsky, executive director and chief investment officer of the Massachusetts Pension Reserve Investment Management Board (PRIM), managers of Massachusetts $53.2-billion Pensions Reserves Investment Trust fund, PRIT, is planning a raft of cost-saving measures from co-investment to more passive strategies and much harder fee negotiation.
He’s mid-way through evaluating the fund’s many managers and strategies, determined to shave costs and improve returns.
The fund has just posted 12.7 per cent for the 12 months ending June 30, beating its 10.9-per-cent benchmark and adding $6.2 billion to its assets under management, but cutting costs is now a central theme.
“We spend of a lot of time evaluating performance and analysing our costs and fees. It’s prudent and it’s what Project SAVE is all about,” says Trotsky (pictured right), in reference to the cost saving initiative he launched earlier this year.
Costs were an issue on which Trotsky grasped the nettle soon after his appointment in 2010 when, drawing on his hedge fund background, he restructured PRIM’s unwieldy hedge fund portfolio.
At the time the fund had five fund-of-funds managers, with $4 billion in 237 underlying hedge funds.
“The portfolio was struggling to beat its benchmark,” he recalls.
The fund now invests directly in 21 hedge funds and one fund of funds, managed by PAAMCO, specialising in emerging market hedge fund managers and amounting to 15 per cent of the portfolio.
It’s a process which Trotsky says has saved PRIM around $29 million in fees this financial year, and should be on course to save approximately $40 million per year once fully in place.
“Our hedge fund allocation is designed to reduce portfolio volatility with returns between equity and bonds. We are two years into our direct program and testimony to us doing a good job is the 3 per cent volatility for the allocation, compared to 12 per cent for the entire portfolio,” he says. For the fiscal year 2013 hedge funds returned 12.2 per cent.
Discussing the latest batch of returns from PRIM’s headquarters in the old quarter of Boston’s financial district, it’s equities that have been the star performer. The equity allocation, overweight accounting for 45 per cent of assets under management, posted returns of 18.4 per cent, beating a benchmark of 17.1 per cent. Now the plan is to pare back to target, says Trotsky.
“At 45 per cent our equity allocation is big against a target allocation of 43 per cent. It’s been based on the strong performance of equities; the normal rebalancing process will correct that overweight position.”
Of the sub allocations, domestic equity did best, returning 22.1 per cent.
Here a quarter of the portfolio is invested in enhanced index strategies benchmarked against the S&P 500 Index, with most of the remainder passively invested in a Russell 3000 Index fund.
Around 4 per cent of the domestic allocation is in an active mandate to small and mid-cap US corporates, the only “pocket” where Trotsky believes active management still pays in the domestic equity market.
Elsewhere in the equity allocation a developed-markets portfolio is split between a passive MSCI World Ex-US IMI Index fund and three active Europe, Australia and Far East mandates. An emerging markets allocation is split 50/50 between active and passive management.
More strong suits
Private equity and real estate, each accounting for 10 per cent of assets under management, were other strong suits, returning 14.1 per cent and 13.5 per cent respectively.
The private equity allocation, built up since the late 1980s and where PRIM considers itself “a pioneer”, includes over 100 managers and 200 different funds. Hamilton Lane has consulted since 2007 and the allocation aims to generate returns 3 per cent higher than US equities. It’s an area where Trotsky “does worry about the fees” but counters: “We have been doing private equity for a long time. The result is that we are in some of the best partnerships around the globe and have some very mature investments.”
The real estate allocation comprises core and none-core real estate strategies.
Core strategies include equity investment in both directly owned properties and real estate investment trust securities.
“We’ve had good performance from our direct ownership,” says Trotsky, adding that here investments are characterised by well-leased operating properties in the US that provide regular cash flows.
Non-core real estate includes more opportunistic investments such as properties that are not fully leased or require modest capital improvements.
Recently, in a bid to take advantage of low interest rates, the fund placed a moratorium on property-level debt in favour of portfolio-level leverage, issuing a $1-billion debt program in March 2013 through a combination of bank loans and private debt, but still maintaining a “relatively low” loan-to-value ratio of about 35 per cent.
“We were able to achieve an average duration of seven and a half years at 2.9 per cent; leveraged enhanced returns are a big kicker,” says Trotsky in reference to the cheap cost of borrowing and the enhanced return from investing the debt proceeds.
Positively, PRIM maintained its 6-per-cent expected five-to-seven-year return for real estate when it refreshed its asset-class return expectations earlier this year. Most other asset-class return expectations were cut, said Trotsky.
Elsewhere value-added fixed income, comprising high yield bank loans, high yield bonds, emerging market debt and distressed debt, returned 7.6 per cent.
The worst performing asset class at PRIM was core fixed income, in which strategies include Barclays Capital Aggregate benchmarked active and passively managed portfolios, treasury inflation-protected securities and global active inflation-linked bonds.
The portfolio was down at minus 0.3 per cent although “still 88 basis points above benchmark”.
The fund is now mulling reform of its entire fixed income allocation ahead of an anticipated change in US interest rates.
“We saw the effects in May and June of interest rates going up,” says Trotsky. “The environment has changed with the economic recovery and interest rates will slowly begin to rise off of historical low levels. The consensus view is that the 30-year bull-run in fixed income will be reversed. We haven’t made any decisions yet but we are definitely thinking about it.”
The manager also has a 4-per-cent allocation to timberland in the US and Australia. It is the fund’s only natural resource play and Trotsky particularly likes the diversity it brings. “The thing about timberland is that if you don’t like the price today, you wait. It grows and you get more,” he enthuses. But PRIM’s robust results come against a backdrop of deficit and underfunding. As of January 2012 the fund was labouring under a $23.6-billion deficit, only 65 per cent funded. It is governed by a state legislature-set return of 8.25 per cent and, like other public schemes, has struggled to retain talent, fighting to fill its top posts because it can’t match salaries in the private sector. It limits Trotsky’s ability to develop an internal team, something he acknowledges “others are doing”. For now it’s business as usual. “Our performance over the benchmark is proof that our managers are earning their keep,” he says.