'Over time, our approach should reduce the equity risks we face.'

To see this article in digital magazine format, click here.

“We have a lot of equity risk in our portfolio,” Mike Mueller, the interim CIO of Oregon’s pension system, said from his Tigard-based office in May. He’s not alone: as the Global Financial Crisis revealed, most institutional investors were exposed to equities to a degree that they were unhappy with in hindsight. “In bull markets we do very well—just like many of our peers. But in down equity environments, our performance struggles.” As a result, Oregon and other large investors are altering the way they construct—and think about—their portfolios.

Let’s start with the thinking part. As seen with, among others, the Alaska Permanent Fund under ex-CIO Jeff Scott, large funds are trending toward the idea of defining their asset allocation as exposures or factors—and not buckets. “Not content with just one major innovation, in his two years on the job, Scott also has pushed for a new way of valuing risk and thinking about the fund’s portfolio,” aiCIO wrote in June 2011. “The idea is to focus less on the rigid categories of asset allocation, and look more deeply at the kinds of risk factors—corporate exposure, counterparty risk, currency fluctuations, inflation, and deflation—that so often cut across asset classes indiscriminately. Like Jesus said about the poor, unstable oil prices and variable investment results will always be with us. Yet, Scott hopes this new way of looking at risk might moderate the ups, and particularly the downs that roil the oil and stock markets.”

This idea has been partially mirrored by other funds—including the California State Teachers’ Retirement System (CalSTRS) under CIO Chris Ailman—and is gaining general acceptance, if not complete adherence. Ailman himself commented as such when talking to aiCIO in September 2011—and, echoing Mueller, spoke about the reason behind this shift in thinking on asset allocation models. “I’ve been quoted as saying diversification failed in 2008. It didn’t fail, but it didn’t work perfectly well either,” he said at the time. “In 2001/2002, and in 2008, all correlations pushed toward one, and diversification did not work as a risk reduction tool. So, as opposed to the short-term gains and losses seen in years like these, long-term results come from how you structure your portfolio, and your fund in general. It comes down to asset allocation.”

For more stories like this, sign up for the CIO Alert newsletter. 

Perhaps the most significant—or at least noted—result of this ideological shift has been the increasing frequency with which the words “risk” and “parity” are mentioned in the same sentence within the confines of pension magazines and conferences. It’s logical: if asset allocation is no longer about investment instruments and all about investment exposures, diversifying those exposures and the risks each makes sense. And while the jury is still out on just how popular risk parity products—offered with increasing frequency by asset management firms clamoring to enter a market pioneered by some of the world’s most sophisticated hedge funds—there has been a clear trend toward thinking about portfolios within a risk-parity framework.

Of course, few will know of risk parity without also knowing of the controversy around it—namely that in its passive form, some investors have concerns that allocating to certain asset classes (commodities, perhaps) does not yield a risk premium. But this argument is a distraction, a forest-for-the-trees moment. What exposure-focused or risk-parity investing really entails is a search for a better diversification. What Mueller and Oregon are doing reflects this. “Last year, we formalized our ‘alternative portfolio,’” according to the longtime fund employee. “It’s a dedicated strategic allocation, a real return bucket for the fund—targeted for 5% of the overall portfolio—with the goal being reducing the reliance on equity risk.

With this new portfolio we are trying to diversify into opportunities such as infrastructure, natural resources, and hedge funds. We want to access royalty streams, agriculture, and timberland—things that are really uncorrelated. We are very selective—especially with the hedge fund component—as we are not trying to create a hedge fund portfolio for the sake of having one. Instead, he believes, the true goal of this whole conversation is to find “truly uncorrelated things. This is not as dramatic as risk parity. Risk parity entails the leveraging of lower-risk assets— something we aren’t comfortable doing at the asset class level right now. Over time, our approach should reduce the equity risks we face.”

Of course, even when thinking of risk exposures and factors—as opposed to traditional buckets—all is not perfect. As CalSTRS’ Ailman noted, “We thought [what Alaska and others were doing] was interesting and we headed down that path but, in the end, it surprised us: You can’t divide the portfolio up neatly into these little risk categories. It would be nice if life was that clean, but it spills over. So, we’re developing a risk overlay idea—that there are six key risk areas that affect the portfolio and what we’re going to do is find ways to measure that risk and develop strategies for when they get to extreme points. The idea is that we become a little more nimble in periods of market disruption. We think this can help us with our risk and returns in the future.”

To see this article in digital magazine format, click here.

Like fishermen the world over, every asset manager dreams (and brags) of bagging The Big One. For these firms, there are no bigger ones than the public pension plans that inhabit state capitals across America’s vast expanse—and the past year has seen them bag some big ones indeed. Both fisherman and fish are labeling their newfound unions “strategic partnerships” or “strategic relationships”—which is pension-code for “getting a good deal,” or, perhaps more crassly, “making ourselves feel better about paying millions in fees”—and they are coming in various forms.

At their most simple, these partnerships are a lopsided exchange of information: Pension fund X will give hedge fund Y a significant capital allocation, expecting to be let in on the firm’s internal research and for someone to promptly answer the phone when they call. This style of relationship, while not new, dovetails with the nomenclature of those seeking to gather institutional assets—it is not “product,” but “solutions,” that they wish to sell to pension funds. Asset managers such as Bridgewater Associates have been doing this for years, of course—which, considering Ray Dalio’s success at both return generation and asset gathering, explains why others are so keen to do it now.

What America’s largest public pension plans are doing now, however, goes beyond this arrangement in two distinct ways. The sexier of the two is epitomized by the aforementioned Bridgewater and its new partial owner, the $101 billion Teachers Retirement System of Texas. Borne of the past relationship between Teachers’ CIO Britt Harris—before he moved to Austin, he was briefly the CEO of Bridgewater—and Bridgewater founder Ray Dalio, this past February saw the pension invest $250 million in the firm. (According to the pension, Harris officially recused himself from the Bridgewater deliberations months before the purchase in order to have an “objective” due diligence process. Deputy CIO Jerry Albright led the deal through its final stages.) The $160 billion Florida State Board of Administration, led by Ash Williams (see page 22), has made a similar move with New York-based Lexington Partners, a firm with which it has a long-standing relationship. And why not? If a pension fund truly believes in the persistent ability of one its managers to capture alpha, it makes complete sense to buy a stake in the expected continued success of that firm.

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

But while these clubby deals may seem sexy (well, as sexy as asset management can be), they are not on the leading edge of strategic partnerships. That title goes to the recent arrangements made by the public employee pension funds of New Jersey, California, Texas (Harris has been quite active), and a handful of others with the likes of Henry Kravis’ KKR and Steven Schwartzman’s Blackstone. Where these pensions once gave hundreds of millions to an individual private-equity firm, they are now giving billions—and it’s not just for private-equity investments.

“Hedge funds, private equity, real estate, commodities—Blackstone is top-quartile in all four of these areas, not just one,” New Jersey CIO Tim Walsh told aiCIO in May, following the fund’s $2.5 billion commitment to the firm. It wasn’t New Jersey’s first allocation to Schwartzman’s behemoth, but it was arguably its most important. “We call it a strategic relationship, not a partnership,” he said. “We use the relationship as an extension of our staff. There is only so much we can do with limited resources and manpower.” They are, Walsh asserted, a “source of investment opportunities around the world” and across their different specialties, and the trust New Jersey has put in them to act quickly is a result of years of relationship building. “It’s important to note that they weren’t soliciting us—we were previously big investors with them and we fine-tuned this relationship over time.”

Walsh is by no means an unthinking cheerleader for these arrangements. While he likes the ability to access opportunities that may not naturally arise within the relatively slow-moving public pension board approval process, “the interests just have to be aligned. What doesn’t get a lot of press is ‘what’s the alignment?’ Do private equity firms have skin in the game? If they have their own capital invested, there is no better alignment of interest.”

What public plan officials won’t say—or at least say too loudly—is that these deals are structured partly to circumvent American public plan governance. It’s cliché, but clichés often carry kernels of truth: ex-American plan design allows more CIO freedom via expert boards that are removed from the political process than their American counterparts. By allocating—skeptics would call it outsourcing—significant amounts of capital to an asset manager who will in turn take some control over tactical decisions, these American plan investment boards are being removed from the process on some level. Democracy is good only to a degree, it seems.

This isn’t the first time pension plans have invested large sums of money with a single private equity manager. Oregon’s pension system “did it a decade ago with KKR, committing $1 billion,” according to interim CIO Mike Mueller. But the explicitness with which these firms have been told to take full advantage of current market inefficiencies such as distressed debt and mortgage-backed securities is new. Add in the critical mass of state funds from Alaska, California, Texas, New Jersey, and others, and you have a trend—one that, hopefully, will allow these funds to avoid the critics’ most dour forecasts.