Jim Grossman on Saving His Fund $2 Billion.

Jim Grossman, a stalwart at the $57 billion Pennsylvania Public School Employees’ Retirement System for 22 years, has been heading the fund as chief investment officer for the past five. Recently, he put a fee reduction plan in place with a goal to save $2 billion over 30 years, and published it online.
To date, one of his largest challenges was adding leverage to the portfolio. Leverage is often considered a four-letter word when it comes to portfolios, but after doing his homework and continually educating his board, Grossman found a way to use it as an effective tool.

 

CIO: You have a fee reduction plan in place that is planned to save your fund $2 billion. Can you describe how you’re going about it?

Grossman: When we started, we established certain guiding principles. A few of the guiding principles included the following assumptions:

1. Focus on investment manager cost efficiency.
2. No future changes to the strategic asset allocation.
3. Review potential investment manager fee savings by asset class, essentially a bottom-up approach.
4. Ability to hire nine additional investment professionals to realize cost savings from internal management.
5. No specific investment management fee reduction goals or targets were set for the study and there were no limitations on the amount of fees savings that could be achieved. We wanted a realistic plan which didn’t alter the risk/return profile of the fund.

It would have been easy to create a plan to save significant management fees by simply altering the asset allocation, moving allocation from private equity to public equity, and claiming victory. However, that would have violated assumption 2 above and would have altered our expected risk and expected returns.

The fee reduction plan we put in place last year focused on two areas: 1) renegotiating management fee agreements to create a better alignment of interest between PSERS and each investment manager, and 2) expanding our internal management capabilities.

With regards to renegotiating management fee arrangements, we are focusing on achieving a better alignment of interest with the active managers we retain. Our goal is to reduce the base management fees, which are guaranteed whether or not performance is good, and incentivize managers for generating alpha. We have strong portfolio management capabilities internally, so we hire external investment managers for their ability to generate performance above and beyond what we can do internally. If the managers perform well, generating above-index returns, we believe they should be compensated a percentage of that outperformance.

As previously noted, we have strong portfolio management capabilities in-house, but not the capacity to expand them. We have received approval from the administration to expand our professional staff, which will allow us to manage a variety of portfolios internally in a cost-efficient manager. As we have been expanding professional staff, we have been endeavoring to bring additional assets in-house. Today, we manage around 20 different portfolios internally (about 40% of the gross exposure of the fund’s net asset value), saving over $50 million a year in management fees.

CIO: What is your investment philosophy regarding risk reduction and fees?  

Grossman: In regard to risk and fees, my philosophy is that managers should earn a base fee for providing the beta from the allocation to them and a performance fee for exceeding the benchmark. As noted earlier, the goal from the fee reduction plan was to decrease base management fees but not change the strategic asset allocation. So, the overall risk profile of the plan was to remain stable, but the guaranteed fees paid to managers is expected to fall. But to be clear, the managers would have the ability to earn those fee reductions back if they performed well.

CIO: You’ve increased your in-house management significantly. Was there a learning curve? What indicated it was time to “take the training wheels off” and what are the best practices in doing it effectively?

Grossman: We currently manage 22 different portfolios or accounts internally covering equities, fixed income, real estate, infrastructure, risk parity, and private market co-investments. Our internal equity portfolio management goes back over 30 years. All the internal portfolios are held to the same performance requirements of external managers. If we can’t do it as well as external managers or operationally support it, we’ll outsource it no matter the cost efficiency. Net performance is what matters.

We have a strong expertise in indexing, so any time we would like to implement through indexing, we will do it in-house. There really is very little learning curve there. With active management, we will seed portfolios with a more modest sum of capital to allow the portfolio manager to build a track record before increasing the size of the account. A good example of this is in risk parity. In 2012, the portfolio manager of our non-US equity index portfolio expressed an interest in managing a portion of our risk parity allocation. She had a passion and conviction in balanced portfolio construction and believed that this was the best way she could add value both at the portfolio level and at the total fund level in allocation strategies. We seeded her portfolio in early 2013 with $100 million and she built a very good track record. As the track record evolved, we moved money from the external risk parity managers to her portfolio. Today, she manages a $2.6 billon risk parity portfolio which represents about 50% of our allocation to risk parity.

The best practices to doing internal management effectively would be to make sure you can properly resource the effort. This means not only having a capable portfolio manager, but also strong and well-resourced operational support for them. A mistake we made earlier in the build out of the program was to hire strong portfolio managers but neglect the operational support for them. There is a lot that goes into managing an internal portfolio beyond buying and selling securities and you really need to account for that. For smaller funds, internal management makes less sense since scale is needed to support the costs of internal management.

CIO: Many funds won’t consider using leverage in their portfolios. What advice would you give them for weighing if it’s right for them, and implementation?

Grossman: I’d revise the statement to say that many funds won’t consider using “explicit” leverage. All funds use implicit leverage, which is why equities and private equities have higher expected returns (and risk) than bonds. They are at the bottom of the capital stack and, by definition, are leveraged to the operational success of the company. Public funds in the US generally roll out the efficient frontier to generate higher returns at the cost of increased risk.  This has led to a concentration of equity risk in many portfolios. We use explicit leverage to balance portfolio risk by increasing diversification. We are trying to achieve similar returns as an unleveraged portfolio but take less total risk, which leads to a higher expected Sharpe ratio over time. Our portfolio is constructed to reduce both left and right tail exposure. We believe this balanced portfolio, especially with a negative cash flow profile, will accumulate wealth more efficiently over time than a more concentrated portfolio.

The advice I’d provide to other funds that want to start using leverage is to do so in an evolutionary, not revolutionary, manner. There is a point of entry risk to any investment strategy. A balanced portfolio will at times underperform its concentrated counterpart. I believe that modestly adding leverage and additional balance to a portfolio is the best bet for longevity. Otherwise, there is a risk that your board throws in the towel if the strategy has poor relative performance over a three- to five-year period.

Regarding implementation, it is important that you have the capabilities to gain leverage through derivatives or other financing vehicles. We have strong internal derivative capabilities and the operational support for them. There are third parties that can provide those services to smaller organizations or those less able to staff up appropriately. Finally, you have to monitor the various risks that come with leverage, including counterparty risk and liquidity risk.

 

– interview by Christine Giordano