Record valuations across all asset classes are among the most troubling threats lying ahead for veteran investor Chris Ailman, chief investment officer of the $221 billion California State Teachers’ Retirement System.
“We know that the reversion to the mean is a ruthless force of nature in the investment world and it will break,” Ailman warns. “We just don’t know if it will be two weeks or two years from now.”
As CalSTRS begins 2018, Ailman is preparing to navigate the widely anticipated correction in bonds, shares and towering real estate and private equity values. Higher interest rates and uncertainties such as North Korea and Brexit add to the risks.
It means charting a balance between staying in markets to benefit for as long as possible while the upside continues, and protecting the portfolio from the correction when it comes. Ailman must strive to hone portfolios for whatever value remains in individual countries and companies, while playing to CalSTRS’s strengths to ensure access to opportunities in a market so awash with long-term capital that even the US’s second-biggest pension fund feels the competition.
Protection against a correction is the idea behind CalSTRS’s new allocation to risk-mitigating strategies (RMS). The fund’s key holdings include a 55 per cent allocation to equity, 13 per cent to fixed income, 13 per cent to real estate and 8 per cent to private equity. Now a newly funded $18 billion RMS portfolio containing a mix of long bonds, equity risk premia and global macro strategies, all with a negative correlation to global sharemarkets, will account for 9 per cent of assets. The hope is RMS will offer the diversification the fund has been seeking since the financial crisis laid waste to traditional theories about non-correlating assets.
The RMS portfolio contains a “basket of strategies” rather than any specific security, Ailman explains. It “gets away from asset names” to look instead at the underlying characteristics of how allocations work in extreme market conditions. This is why the portfolio includes factor strategies that are defensive but also sit in the equity portfolio for their high beta.
“It’s about peeling away the cover and looking at the way these assets really move,” Ailman says.
The RMS allocation also reflects his belief that the characteristics of traditional fixed income have changed. CalSTRS’s assets are still split between equity and debt to the same degree they were five years ago, but with the introduction of the RMS portfolio, that debt portion is no longer just bonds.
“Some aspects of bonds are highly diversifying but others are kind of correlated,” he explains, listing large credit exposures, high yield and emerging-market debt as examples of the assets many fixed income investors have “drifted” into, thinking they bring diversification.
“These things aren’t fixed income like we used to know it, they are equity surrogates and have a much higher correlation to equity; that’s great in a bull market, but it won’t act as a brake or diversifier in extreme market conditions.”
He does say interest rates are set to slowly rise and that this will make traditional fixed income more attractive as a diversifying asset; however, he doesn’t think there will be much of a hike, given the fact the US Federal Reserve has significantly lowered its definition of “normal” levels to about 4 per cent.
“We have been vocal that we would like to see rates get higher,” Ailman says. “Rates near zero skew valuation metrics and cause higher-risk assets to trade at tighter spreads, which we don’t think is healthy.”
The theme of evolving along with asset classes continues in CalSTRS’s $18 billion private equity program, where CalSTRS has also recently expanded the sub-asset classes by adding a core allocation that holds assets longer.
“Rather than traditional ‘2 and 20’ highly leveraged buyouts, this new allocation is a recognition that we are starting to see value in buying and owning private companies for longer,” Ailman explains. “We are long, patient capital and I would argue that even a buyout fund with a 14-year life is too short-term for us.”
The allocation will probably have lower returns than traditional private equity because it is less leveraged, but that will also mean less volatility.
“Time will tell what the correlation is between this and traditional private equity but we expect to see more funds expand into this area in coming years,” Ailman says.
Related to this trend is another change in the investment landscape – the steady fall in the number of public companies in the US and around the world.
“We are going to see more companies seek capital by staying private than we will see going public,” Ailman predicts.
Even private equity exit strategies are increasingly eschewing initial public offerings.
“Barely a third of private equity exits are IPO anyway,” he says. “There are more private-to-private transactions because of the high cost of being a public company.”
Along with the costs, vocal shareholders are also cited as a catalyst for this trend. Ironically, Ailman says shareholders have stronger rights in private companies, and that private companies can make better investments for pension funds because they are more focused on the long term than public entities.
“The value of a private company is that it doesn’t worry about 90-day earnings; they think longer-term, making investment decisions knowing that the short term may cost money, but in the long term there is a pay-out – and we know in life that these are the better decisions,” he explains. “Public companies know the right thing to do but they don’t do it because they are too focused on short-term profits.”
Ailman should know. He spends much of his time persuading companies to think long-term. Over his 17 years at CalSTRS’s helm, he has built the pension fund’s reputation for low-cost, passive investment and led the crusade for lower management fees. Taking long-term sustainability mainstream or, as he says, “raising the bar for everyone”, will perhaps be the most enduring hallmark of his leadership.
He says, for example, that it’s time to change the language of ESG because one of the barriers to corporate take-up of ESG is, in fact, the term ESG.
“People get hung up on words,” he says. “If you say ESG, it doesn’t resonate with the board or management. But if you say long-term sustainable profits, managers all nod their head and say, yes, we are interested in that, too. Many see ESG as a specialised, unique area but if you walk people through it, they get it.”
Ensuring CalSTRS’s continuing ability to access the best investments when the fund has to compete with long-term capital from giant investors in Asia, the Middle East and Norway is another challenge.
“We have situations where we meet with prospective GPs [general partners] and talk about a $200 million investment,” he says. “But when you come out of that meeting, a member from a new sovereign fund – not an old one – will be sitting in the lobby to go in after you and they are going in to talk about making investments of several billions.”
It means crowding-out in venture funds and private equity, and in traditional active management in equity and fixed income.
“People hit capacity and if you are at capacity you want easy money, you don’t want hard-to-get, demanding money like us,” he says, in reference to the many rules and regulations that govern US public-sector investment compared with other funds. “We are still well known and still have a strong brand, but the old, stable kind of money is not as interesting.”
His response is to play on CalSTRS’s reputation as a good business partner with stable, experienced teams and a long-term focus.
“New, fresh money looks interesting and catches their eye but there is value in having a long-term partner that you know well and understand, and who understands you,” he says.
Partnerships in infrastructure
Another way to stay competitive is to team up with other pension funds and cut out investment managers. Infrastructure investment, requiring an enormous amount of capital, is an obvious place to start.
Ailman notes initiatives such as IFM, a global manager owned by Australian super funds, and the UK’s GLIL, which is backed by five local authority schemes to invest in infrastructure, as examples of co-operation in practice.
“We will see more funds syndicating and doing deals together,” he predicts. “It won’t replace the money-manager world, but if we can buy direct and break the distribution chain, we will.”
The strategy doesn’t come without challenges, none bigger than building the right structures to hold partnerships together for the long term.
“When you do business with peers, you may get along at first, but the board changes, the staff change and, lo and behold, it’s not the same relationship,” Ailman says. “I’ve seen partnerships start out great, but not go so well over time.”
Even so, he’s encouraged by the growing co-operation among pension funds around ESG.
“In the past, we were spoon-fed by Wall Street, but now we are all sharing information ourselves,” he says.