“Darren’s passion for pension investing is clear, and he has led in the growth and modernization of TMRS’s return-seeking fixed-income portfolios. From day one, Darren collaborated with colleagues at all levels to build consensus around the plan’s newly defined private debt mandate, including multiple benchmark changes, asset-class reassignments and allocation prioritization decisions. With nearly 20% of the trust allocated to a diverse array of return-seeking fixed-income strategies across both liquid and illiquid markets, Darren has leveraged his industry experience, multidisciplinary network and intellectual curiosity to drive progress on numerous public and private markets initiatives across a rapidly evolving fixed-income landscape. Darren is a rare talent in the allocator space—his experience spans across investment banks, private investment firms and running global investments as a treasury leader at publicly traded company. I have no doubt that Darren will become an incredible chief investment officer one day.”
—Yup S. Kim, CIO, Texas Municipal Retirement System
The CHIEF INVESTMENT OFFICER Editorial Team shared a dozen questions with all our NextGen nominees and asked them each to pick six to answer. Their answers informed our decision to include them as a NextGen. Below are the answers from Darren Schlissel.
CIO: How are you dealing with interest-rate risk and economic uncertainty?
Schlissel: Unprecedented post-COVID-19 interest rate volatility urges investors to apply radical scrutiny to interest rate duration risk. Furthermore, following 2022’s reversal of the negative correlations justifying a 60/40 portfolio, we must also question the diversifying value of fixed-income duration during this period of elevated economic uncertainty. Investors have not experienced periods of high inflation in recent decades, and we must remain mindful that statistical analyses grounded in periods of low and/or stable inflation may offer more regime-dependent commentary than investable predictive value in today’s economic circumstance.
After scrutinizing and enhancing duration risk reporting across our portfolio, we also analyzed our liability profile and the investment opportunity offered by today’s downward-sloping yield curve. We have prioritized floating-rate return-seeking fixed-income investment strategies in today’s elevated rate environment, due to our plan’s modest liquidity needs and the ability to generate attractive equity-like returns in certain fixed-income strategies. In addition to attractive current returns, we expect that the performance of risky nominal debt during this period of heightened inflation will remain strong. The diversity of products within fixed income, of varying repayment profiles and liquidity features, enables us to construct a wide range of investment profiles for the uncertain period ahead.
CIO: What is the best way to bring more diversity to the financial industry?
Schlissel: Among many potential approaches for enhancing diversity, my preferred approach is to focus on diversity’s value-generating potential in producing high-functioning investment teams and improving investment outcomes. Just as it wouldn’t make sense to hire three investment analysts with expertise in the same sector while leaving other sectors uncovered, it makes just as little sense to recruit and train investors with narrowly similar backgrounds to the exclusion of those whose diverse experiences might offer valuable alternative investment skills and experiential perspectives. Investing involves the interpretation of numerous quantitative and qualitative sources. By proactively building teams of those who have experienced the world differently from one another, we nurture the ability to analyze and interpret investment signals in differentiated ways. Building diverse teams increases the value added by each individual contributor due to the differing perspectives that each will bring and the ways in which they will challenge each other. Building a diverse team is crucial to generating successful investment outcomes, and by approaching human capital strategy in this way, one is also likely to improve various measures of diversity across the financial industry.
CIO: What asset classes offer the best options for avoiding or mitigating drawdown risk in an institutional portfolio?
Schlissel: In my role overseeing fixed income, I firmly believe that a diverse return-seeking fixed-income portfolio offers the greatest flexibility for mitigating drawdown risk in an institutional allocator’s portfolio. Regardless of an investor’s risk appetite, target return, liquidity requirements and investment horizon, the diversity of the world’s $140+ trillion fixed-income markets offers a wide variety of potential investment profiles to mitigate drawdown risk.
First, as an immediate source of liquidity during sudden drawdowns, the vast universe of government and agency debt provides a liquid asset cushion to manage cash needs and near-term liabilities in any drawdown scenario. Next, when considering medium-term needs and the liquidity required to effect portfolio re-allocation, return-seeking fixed income (i.e. below investment-grade credit) also represents one of the largest and most liquid syndicated markets globally, with more than $3 trillion outstanding, significant price discovery, a market beta significantly below listed equity and a comparable Sharpe ratio to boot.
Lastly, even private corporate and asset-backed credit incorporate features to return capital in a timely fashion in the event of prolonged downturns. Credit’s definitive maturity dates, pre-payments, amortizations and covenant protections ensure that periods of stress do not necessarily elongate the anticipated access to liquidity which fixed income offers.
CIO: How can allocators address the growing global headwinds of demographics, geopolitical tensions and changing supply chains?
Schlissel: Allocators must urgently internalize that strengthening global headwinds such as geopolitical tensions and supply chain alterations won’t simply impact growth but will also have profound consequences on the global inflation outlook and mark a wholesale regime shift from the prior more-than-25-year period of trade-fueled disinflation. Global trade and the resulting disinflationary impulse of the early 2000s served to keep interest rates and inflation low in absolute terms for decades, and now even modest rates of interest and inflation in a historical context have dramatically upended markets.
While initially, duration-fueled asset losses and bank failures will be the most apparent symptom of this new regime, over the long run, the investable sectors and value-creation strategies which emerge as winners and losers will also be driven by a higher-for-longer inflation and interest rate regime. As allocators, the already difficult prospect of balancing duration and reinvestment risk must now be analyzed through a lens of unpredictable geopolitical influences that have not been part of the discussion for decades. If 2022 wasn’t enough of a lesson already, allocators must maintain heightened scrutiny of the role and budget for duration risk in their portfolios, given the uncertainty of this emerging new regime.
CIO: What traditional and/or alternative asset classes do you think are most important for institutional portfolios, and why?
Schlissel: Alternative credit asset classes, particularly corporate and asset-backed direct lending, are by far the most important rapidly evolving asset class for institutional fixed-income investors to consider today.
While the financial sector’s 20th-century evolution showcased the power of bank financing innovation and robust capital markets activity orchestrated by the nation’s largest banks, the great financial crisis of the early 21st century is leading to the rapid unwind of the banking sector’s role in distributing credit. In regulatory efforts to prevent future government bailouts and insulate global economies from a highly leveraged banking sector, the last 15 years of change has dramatically reduced risk-taking by banks.
Corporate direct lending in the U.S. is the first case study of the rapid evolution from a bank-intermediated market to an independent marketplace of capital formation and non-bank lending. As bank intermediaries weaken in sectors beyond corporate direct lending, including markets such as consumer lending, home mortgage lending, and commercial real estate lending which had historically been dominated by the banking sector, we will continue to see rapid growth and the potential for more attractive risk-adjusted returns in these new areas of private capital formation and non-bank lending.
CIO: What asset class or investment troubles you most right now, and why?
Schlissel: Valuations across illiquid alternative assets such as private equity, private credit and real estate are the most challenging and potentially troubling element of alternatives investing today.
While valuation policies are scrutinized by investors and regulators alike, the procedures are far from standardized and vary widely in rigor. Those giving an ‘opinion’ or reviewing the ‘reasonableness’ of valuations are not held to account if these valuations are inflated. Moreover, the very nature of volatility-based risk management encourages private capital markets to avoid radical valuation adjustment whenever possible.
I suspect that the necessary valuation changes to illiquid assets are only just beginning. When the price gap between willing buyers and sellers of assets grows wider, valuation of these assets becomes somewhat of a directionally accurate guess. No amount of policy and procedure and analytical prowess can alter the fact that when very few illiquid assets transact, it’s extremely challenging to say what they are worth. As borrowers are forced to refinance debt in the years ahead and transaction volumes recover for illiquid assets, I expect we’ll achieve more clarity around alternative asset valuations. Until then, it’s a mistake to think that we know what the illiquid assets in our portfolio are worth.
CIO: What new skills do you think allocators need to be leaders in the field in the coming decade?
Schlissel: Data science, analytical and information management skills are likely to be the most important for allocators emerging as leaders in the field over the next decade.
While the full potential of artificial intelligence to develop tools for investment allocators remains to be seen, it is clear that the advances of modern technology will make isolated spreadsheets and pitch decks of the past seem paltry in terms of the analytical rigor which will inform future investment decisions. Virtual collaboration tools, technologies and services have expanded rapidly in the post-COVID period, and those capable of harnessing these new tools effectively will possess unique information and efficiency advantages in our increasingly digital world.
As technological sophistication increases, however, so too has the complexity and opacity of many of the markets into which we invest. Alternatives markets dominated by several successful managers are now mushrooming with dozens or hundreds of firms competing for allocator capital. Furthermore, as bank and rating agency prominence continue their post-GFC decline, the migration of capital to smaller and less regulated investment managers only serves to decrease transparency and heighten the need for analytical excellence for the success of allocators in the years ahead.
