How Dynamic Portfolio Strategies Can Help Corporate Pensions

(May 24, 2012) — Corporate pension funds should implement dynamic portfolio strategies in order to meet their challenges, according to research published by the EDHEC-Risk Institute.

Pension risk is not only driven by the funding ratio of the pension fund, but also by the financial strength or weakness of the sponsor company, the paper — produced alongside BNP Paribas Investment Partners — asserts.

One of the key findings of the paper shows that imposing a cap on funding ratios has a positive impact on both pensioners and bondholders, while only having a minor negative effect on equity value. Dynamic asset allocation strategies aim to control sponsor risk by avoiding states of the world where the pension fund is underfunded and the sponsor is unable to make up for the gap, the paper says.

The release by the EDHEC-Risk Institute follows research published by the CFA Institute, which championed dynamic portfolio construction to manage risk. “Portfolio management is moving toward a more flexible approach capable of capturing dynamics in risk and return expectations across an array of asset classes,” the paper written by Peng Wang and Yizhi Ge of Georgetown University and Rodney N. Sullivan of the CFA Institute earlier this year asserted. “The change is being driven, in part, by the observation that risk premiums vary as investors cycle between risk aversion and risk adoration and that the decision to invest—whether to take risk and how much—is the most important investment decision. Certainly, managers should take risks, but only if the returns appear to represent fair compensation.”

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The CFA Institute’s paper concluded that the traditional strategic approach of fixed-asset allocation is outmoded, and that therefore, there is much-needed dynamic flexibility to the asset allocation process. When asked how dynamic portfolio construction compares with a risk parity strategy, Sullivan told aiCIO: “While risk parity attempts to equalize risk across assets within a portfolio, a dynamic risk approach aims to adjust risk levels across the entire portfolio in accordance with a market risk forecast. While risk parity has generally the same asset weighting across all market environments in the short-term, our model dynamically adjusts portfolio asset allocations commensurate with the market risk environments.”

New Jersey pension Chief Investment Officer Timothy Walsh speaks about the implications of the system's December $1.8 billion allocation across Blackstone's investment businesses, and what this means for the relationship between state pension funds and private equity firms.

(May 24, 2012) — “We walk…we avoid taxis,” Timothy Walsh, the Chief Investment Officer of the $70 billion New Jersey Pension system, said slightly out of breath while walking into aiCIO‘s New York City Midtown East office for an interview.

He was alluding to the tight budgetary controls of the New Jersey public pension fund that is faced with mounting deficits and liabilities. “Most public fund CIOs would agree that they’re understaffed, and there is only so much we can do with limited travel resources and man-power,” Walsh asserted, describing a push that led the system to strike a deal with Blackstone in December 2011. At the time, they committed $1.8 billion to funds managed by the money-management giant. “We use the Blackstone relationship as an extension of our internal staff, and so far it’s going very well,” he said, knocking on the wooden table in front of him.

The deal between New Jersey’s pension fund and the Blackstone Group, the world’s largest private-equity company, is known more generally as a ‘strategic partnership,’ or, as the New Jersey fund likes to call it, a ‘strategic relationship’. Walsh prefers the word ‘relationship’ over ‘partnership’, explaining that the former perhaps implies a sort of marriage.

This aversion to an implication of infinite commitment explains the terms of Blackstone’s relationship with the New Jersey system, which committed a total of $2.5 billion to the money manager during the entirety of 2011. “Anytime you hear ‘strategic partnership’ there are fees involved. We are uncomfortable paying a 2% commitment fee while the clock is ticking — we’re uncomfortable with many typical private equity-type fees,” Walsh said.

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The ‘strategic relationship’ between the New Jersey pension and Blackstone is one of greater flexibility, with the system able to maintain its independence and ability to make changes to the relationship should it turn sour. “With Blackstone, we had to have some skin in the game but there was a 0% commitment fee with management and incentive fees based on return projections,” Walsh said, adding that the pension actually brought Blackstone a few investment opportunities as well — the relationship is beneficial on both sides, he explained.

The success of the New Jersey pension following its now roughly 6-month-old deal with Blackstone may spur other large pensions — the largest clients of private equity firms — to follow in its footsteps, Walsh noted. The popularity of the ‘strategic partnership’ arrangement attracted the spotlight a month prior the New Jersey deal, when the Teacher Retirement System of Texas gave KKR and Apollo $3 billion each to manage separate accounts devoted entirely to the scheme.

When asked about the reasons for the relationship with Blackstone, Walsh cited Blackstone’s status as a leader in alternative assets, such as hedge funds, private equity, real estate, and commodities. “Blackstone is a top-quartile manager in a wide range of alternative assets, while a lot of its competitors don’t do it all,” Walsh stated, noting the fund’s prior relationship with Blackstone for its alternative assets even before the December deal.

Unlike traditional strategic partnership arrangements, however, the pension approached Blackstone with the concept of the deal. “The important point is that they weren’t soliciting us. We were previously big investors with Blackstone, and we brought them the concept of the ‘strategic relationship’ and fine-tuned it over three to four months.”

Despite the smooth sailing so far for the New Jersey system, Walsh is still perhaps somewhat wary about the potential implications that strategic partnerships may impose. “One has to feel comfortable with a general partner for a 10-year-plus investment,” Walsh said. “With our arrangement, however, if the world changes, we can slow down. When big opportunities present themselves, we can speed up.”

Looking ahead, commodities may be one area where Blackstone may be able to add the most value to the system, the CIO said. “I’m not convinced that blindly investing in indexes is the best way to invest in commodities, and I’ve been particularly impressed with Blackstone’s oil and gas investments.”

The New Jersey pension CIO said he does not foresee another deal as broad as the Blackstone relationship anytime soon because the money manager lacks a top-quartile competitor with its similarly vast alternatives expertise in hedge funds, private equity, real estate, and commodities. “We may eventually do something more targeted, and on a much smaller scale,” he said.

So then, what does this mammoth deal between the New Jersey pension and Blackstone signify? In a nutshell, according to Walsh: Money managers need to listen to the needs of asset owners and take ideas seriously. Private equity firms must shed intransigence. Fees charged by private equity firms will continue to decline following the financial crisis, and should.

Furthermore, according to Walsh, the interests between pension funds, like New Jersey’s, and private equity funds, like Blackstone, must continue to align. “There’s no better alignment of interest than writing a check,” Walsh said, smiling. “The business is changing. The trend will continue of top-quartile money managers gathering assets, while non-top quartile, generally smaller firms suffer.”

In other words, when it comes to private equity firms, the rich will become richer and the poor may become poorer, according to Walsh. The future of private equity firms will be marked by consolidation. Strategic partnerships will gain steam as institutional investors continue to seek large private equity firms for their expertise in managing more complex investments, such as alternatives, thereby lowering costs in the long-run while reducing relationships with managers. The large private equity firms with a vast swath of expertise and a willingness to listen to asset owner demands will thrive, while the others may slowly fade away.