Ventures on the risk spectrum

Hershel Harper received an early education in finance when he used to read Business Week in High School. The 43-year old now at the helm of the $27-billion South Carolina Retirement Systems, investing on behalf of South Carolina’s 350,000 public sector workers, says he knew back then he wanted to manage money: “I really am one of the most blessed people; I am doing what I always wanted to do.”

As the new fiscal year begins Harper, promoted internally to chief investment officer of the South Carolina Retirement System Investment Commission (RSIC) a year ago, is overseeing two shifts in strategy at the fund, both designed to simplify investment and pare down the number of managers it uses. South Carolina’s equity allocation, comprising 31 per cent to public equity and a 9 per cent to private equity, hasn’t really changed over the past year. However the US and non-US equity assets are being combined to track a single global equity benchmark, the MSCI ACWI, instead of separate active allocations to US small and large-cap stocks, non-US developed and emerging markets equity. “We are moving to a global benchmark for a straightforward approach to manage and track our largest factor exposure. I expect our global equity allocation to become increasingly more benchmark-centric, with large portions of the allocation to modest tracking error strategies, or to be passive,” says Harper.

Trimming the hedge funds

In another effort to simplify its domestic equity portfolio, South Carolina is in the process of dropping a $3.9-billion portable alpha hedge-fund allocation.

Enthusiasm for portable alpha, a strategy that allows exposure to an index providing beta returns, as well as investments in uncorrelated sources of alpha, has chilled at the fund. “Portable alpha has been successful overall, however the volatility in the short term is no longer a risk we wish to maintain.We are simplifying our implementation for alpha and beta,” says Harper. Dropping the program is also part of a broader strategy to shave South Carolina’s $5.5-billion hedge fund allocation from 20 per cent to an 8-per-cent policy target of assets under management. (There is a 15-per-cent maximum allocation to hedge funds across the plan.) Part of the reorganisation of its hedge funds includes creating a smaller, dedicated hedge fund portfolio investing only in funds that have a low correlation to other asset classes including global macro, market-neutral or managed-futures strategies. Harper is also looking to better integrate hedge fund investments across the entire portfolio. “Hedge funds aren’t so much an asset class as they are an implementation strategy,” he explains.

The potential in house

Despite the potential to manage a simplified equity allocation in house, any move to boost South Carolina’s internal team of three has stalled for now. RSIC is still weighing up the cost of technology and recruiting its own expertise rather than continuing to pay outside managers, says Harper. “Managing more of the portfolio internally will save millions of dollars, which could remain in the Trust rather than paying manager fees to firms in New York or London, but we must weigh those benefits against the potential of increasing operational risk,” he says. Any move to manage funds inhouse would start with US equities, he adds. The only internal asset management is for short duration securities (3 per cent) and the cash allocation (2 per cent).

Inhouse management would provide a saving that could help plug the fund’s $15-billion deficit, another factor increasingly weighing on investment strategy. “We are only responsible for managing the asset component but we are aware of, and understand, our liabilities,” says Harper. The deficit makes holding liquid assets now more of a priority and was one of the reasons behind reducing the hedge fund allocation. Each month South Carolina pays out more in retirement benefits than it receives in contributions, amounting to about a $1-billion shortfall every year. “This gap has to be filled by the Trust and it is our job to make sure there is enough liquidity on hand to meet the benefit payments,” says Harper. It means South Carolina holds more cash than other public funds; a “cash drag” he says he is “prepared to live with in order to mitigate the risk of not meeting a benefit payment.”

Taking on risk, mitigating volatility

Neither does Harper believe a liability-driven investment strategy is necessarily the answer. South Carolina still looks at strategy from a performance perspective, locked into a legislature-set 7.5-per-cent assumed rate of return. Nor could the fund – only 60 per cent funded – perfectly use the strategy that matches assets to liabilities anyway. “We have fewer assets than liabilities, so a pure asset-liability matching strategy doesn’t make sense for us,” he says. “In a zero-rate environment, we must take on a reasonable level of risk in order to meet or exceed that mandate. We try to do that with a strategy that simultaneously includes elements of mitigation against volatility. Our primary goal is the soundness of the plan to ensure the payment of earned benefits. All of our decisions revolve around that fact.”

South Carolina’s 8-per-cent real-asset allocation is divided between real estate (5 per cent) and commodities (3 per cent). Harper sees opportunity in real estate on the debt side, lending on underperforming “good assets in good markets”. Target markets include the UK, Germany and Ireland but also peripheral Europe. “We have $1 billion in the ground, but we are underweight; our target is 5 per cent of assets,” he says. The fund’s private equity strategy, begun in 2007, has borne fruit with an estimated 14-per-cent return in the fiscal year that includes lag, although he believes the greatest bounty is still to come. “We have capital in the ground but we’re still feeling the J-curve affect,” he says. South Carolina also co-invests in private equity, portioning some funds to its private equity managers but also investing directly in the same projects. “We have several co-investments right now,” he says. “Some haven’t worked out but others have been very successful.” Harper would like to push co-investment to account for a third of South Carolina’s private equity portfolio, although he will need a budget and additional staff to do so.

Elsewhere, the fund has a 19-per-cent allocation to diversified credit comprising a mix of high-yield bank loans, structured products, emerging market debt and private debt, and a 15-per-cent allocation to fixed income. Here the allocation is divided between core fixed income, managed by Blackrock and Pimco and recently scaled down to 7 per cent from 10 per cent, and global fixed income. An allocation to opportunistic investments includes low-beta hedge funds and risk-parity strategies.

Harper believes one of the biggest dilemmas for US public pension funds in today’s low-rate environment is balancing venturing out onto the risk spectrum with staying comfortable, in turn risking increased contributions or cut benefits. South Carolina “pushed double-digit returns” last fiscal year, coming in 150 basis points ahead of the benchmark. It’s not surprising he is confident he’s got the strategy right. “We can achieve 7.5 per cent with high confidence and without taking undue risk.”