New Mexico’s Sovereign Wealth Fund on Real Return, Benchmarks, Compliance, and Fees

CIO: Tell us about your investing strategy.

Smith: Our investment program is driven by macroeconomic analysis, investment market conditions, and broad investment strategy, and is implemented with a top-down focus and discipline. From abundant academic research to extensive empirical evidence and through our long market experience, it is clear to us that the changing condition of the global economy, valuation levels of markets, long-term fundamental investment trends—and exposure to these things through asset allocation—by far drive the level and variability of long-term investment returns.

So we focus our efforts on those things. The team does expend extensive effort in constructing asset class structures and filling those structures with high-quality managers and investments, but we do so within a macro and strategic framework designed to have us fishing in the most productive ponds at any given point in the economic and investment cycle.

CIO: Has this approach differentiated the New Mexico SIC from other global sovereign wealth funds?

Smith: Sovereign wealth funds globally are diverse in their funding sources, distribution policies and the end uses of their distributions. While a variety of investment strategies are found in sovereign wealth funds designed to meet these disparate structures, there is a common investment-related need to all sovereign wealth funds: maintaining the purchasing power of the distributions and generating cash to make them.

Real return investments or real assets investments, despite their attractiveness in providing purchasing power protection and cash generation, historically have played a minimal role in sovereign wealth fund asset allocations. There is a long list of reasons why this has been the case. But many of the problems of incorporating these assets into a portfolio can be solved by defining this broad area of investments as a distinct asset class, and then carving out space for it in the broad asset allocation.

So one way that our macro and asset-allocation approach has differentiated us is that it has led to the incorporation of significant exposure to real asset investments into our portfolio, including investments in infrastructure, agriculture, energy, and other, similar assets and strategies. From our research, we are fairly early adopters over the last decade of both these assets and this particular approach to gaining exposure to them. Today, we are seeing increasing adoption of approaches similar to ours among investment consultants and peer public funds.

Key to execution in incorporating real return strategies at the size of allocation that we’ve taken on is building an asset class framework that structurally captures purchasing power preservation and income generation characteristics of these assets, and to then fill the structure with high-quality managers and investments.

While at least two full economic cycles will be necessary to determine our level of success in using these assets and this approach, our early results have met expectations.

CIO: How do you benchmark the managers and investments that you make in this area?

Smith: Benchmarking is tough in any of the private asset investment markets. Generally, we stick to trying to benchmark multi-manager portfolios and full strategies against broad benchmarks, rather than try to get too refined with individual managers versus narrow or specific benchmarks in this area of the portfolio.

But take that advice in context—the context that what we’re mainly after is exposure to investment risks and return factors driven by our macroeconomic, strategic and markets views. It is incredibly easy for CIOs and fund executives to fall into the trap of over-spending resources and time on benchmarking, alpha generation, specific manager selection, Sharpe ratios, and other important—but lesser—drivers of fund performance. Inadvertently neglecting the big picture is a tough trap to avoid in the day-to-day of portfolio construction and fund management.

Emphasizing the raw power of macro and markets and asset allocation is our method of producing high-caliber investment returns. This is best documented in our Annual Investment Plan, a document that we think is rather unique in the sovereign wealth fund and broader public fund world.

CIO: It’s always helpful to compare notes with peers. But there aren’t a lot of sovereign wealth funds in the US, compared to the rest of the world. I understand you have formed a forum for these American-based funds.

Smith: Pension funds predominate public funds in the U.S. and globally, and key peer resources such as conferences, professional groups, and industry associations supporting pension CIOs and executives are widely available. In the US particularly, there is only a relative handful of sovereign wealth funds in existence.

Desiring to hear from and collaborate with our peer sovereigns, we studied publicly available information and tapped industry contacts and our consultants to identify sovereign wealth funds in the US. We made contact with as many as we could find. We organized agendas and have hosted on-going calls for the group. We have benefited greatly from these efforts, and the group has continued to grow, exchange best practices, commiserate at times, as well as problem-solve for a number of years now.

CIO: You have some good ideas about compliance. Tell us about them.

Smith: The area of fees particularly—and compliance more generally—has been a hot-button issue for our industry for a number of years now.

CIO: How do you handle fees?

Smith: Generally, fees have been going up in the public funds universe. Allocations by public funds to private market investments have been growing. With these increased allocations come higher active-management intensity and higher investment management fees.

Combined with recent relative success of indexed public market investments, this has caused CIOs and fund executives to need to more transparently and precisely explain active management fees paid and more broadly explain the reasons for higher-fee investment types in the asset allocation to overseers and the public. So the question is an important one to consider.

A cutting-edge practice in this area is the use of outsourced fee validation services. We’ve embraced this new resource and are under way in integrating it into our investment operations and compliance efforts.