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In May of 2009, Cliff Asness, the former Goldman Sachs quant-guru and Founder of AQR Capital Management, flew to Juneau, Alaska. The following May, it was Bridgewater Associates Chief Investment Officer Robert Prince who made the trip, along with PIMCO’s Mohamed El-Erian. A few months after that, it was Asness again, back in Juneau with his AQR team.
So, what brought some of the biggest names in investing this far north? A fashionable hunting reserve for the rich and famous? Salmon fishing under the Midnight Sun? A fundraiser for one of the state’s prominent politicians? Actually, it was a much more important feature of state politics than Sarah Palin or Lisa Murkowski: the annual dividend checks given to every Alaska resident and, more specifically, board meetings of the Alaska Permanent Fund (APF), charged with investing a portion of the state’s oil and gas proceeds and distributing the profits every year via those checks.
Hedge fund honchos and asset management mavens flying around the world to meet investors isn’t unheard of but, in the case of the APF, these high financiers are doing more than recruiting investment dollars or paying a friendly visit to a big client. Along with GMO and Goldman Sachs Asset Management, PIMCO, AQR, and Bridgewater all serve as “external CIOs” to the fund, a new program started by Chief Investment Officer Jeff Scott over the last two years. Of course, the external CIOs manage assets, but their role also includes educating the APF and its board of trustees about why they’re investing that way. This includes giving lengthy presentations on everything from big-picture economics to the esoterica of risk management; lending their impressive research departments to the APF when they’ve got a theory to test; or just serving as an external sounding board and informal think tank. It’s the price these funds pay for accessing the cash of America’s largest state.
“The key thing when it came to picking external CIOs wasn’t just their past returns,” says Scott. “We wanted people who really were committed to working with us: who would fly up to Alaska for board meetings, really answer our questions, get into conversations about what they see happening in the market.”
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. 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 new way of looking at risk may seem isolated and distinct from the external CIO program, but Scott says that overhauling the fund’s approach to risk—or any major project like it—wouldn’t work nearly as well without the input and education the external CIOs offer. A new idea is only as good as its implementation and, to put his plans into place, Scott needs to educate not only his board of trustees, but also the state legislature and public.
“Usually, change is seen as risky,” says Prince. “The irony is that [Jeff’s] going to a less risky, more diversified portfolio, but we have to get across the message that the portfolio we have now is risky, the change isn’t risky. That’s the challenge in communication.” The ability to communicate with the board of trustees, says Scott, has been the key to getting everyone at the Permanent Fund thinking more deeply about risk. “It’s amazing the communication we’re getting now because of the education [from the external CIOs],” Scott says. “The board members are able to look at things and ask good questions and really understand.”
From attacks on the orthodoxies of portfolio theory and asset-allocation strategies, to tail-risk hedges, to the scrapping of old risk metrics and the development of new ones, risk management has been the topic in post-crisis institutional investment. However, Jeff Scott and the APF are changing more than just their tactics for dealing with risk. They are fundamentally changing the way they think about it and, perhaps more importantly, the external CIO program has helped create a space for the fund’s board to study, understand, and help implement these changes, instead of just entrusting their new CIO to create some risk-management black box that’s beyond their comprehension. It’s a dual-reform well worth studying for anyone looking to change their approach to risk, or get more from their money managers in return for those hefty fees. It’s also an idea whose seeds were planted well before Jeff Scott ever got to Juneau.
When Scott and Joel Wittenberg were hired by the Dow Chemical treasury department on the same day in 1992, they didn’t have an office or even desks. It was the best thing that could have happened to them.
“We would just go from office to office when people went on vacation, and camp out for a week or two,” says Wittenberg, who is now the CIO of the W.K. Kellogg Foundation. “It was quite uncomfortable but, at the same time, we got to know each other and became good friends, and we just worked incredibly hard, holed away in these offices.”
Born in Buffalo, New York, Scott lived in Florida and Idaho as a kid before he drifted through studies at Northern Idaho College and the University of Idaho until he stumbled into finance. “I took an investment class and started watching Lou Dobbs on Moneyline and thinking ‘Holy cow! This is fascinating.’ I fell in love with it,” says Scott.
The University of Idaho may not have been world-renowned for its business department, but it had something much more useful for a budding financier than Nobel-winning faculty or an investment banking pipeline for economics majors: money. Specifically, a $200,000 student-run fund set up by a grant from the founders of the Winn-Dixie supermarket chain. Scott became the portfolio manager during his senior year but, despite the real-world investing experience, he went to the University of Central Michigan to get his MBA after college, “because no one was hiring finance students from the University of Idaho.” From there, he finagled the job at Dow Chemical by promising that “I could do exactly the same things that Wharton and Harvard and Stanford students could do, I just didn’t go there.”
“Dow had some pretty high-caliber resumés,” at the time, says Scott’s fellow office-squatter Wittenberg, “and Jeff got his MBA from Central Michigan. He really pushed his way into that place, and they really liked his tenacity. He came in really wanting to prove himself and wanting to be at that caliber of a Stanford MBA, or whoever else.”
At the time, Dow was running a short-duration portfolio of about $4 billion and, because of the company’s broad international reach, Wittenberg and Scott had the chance to trade everything from currencies and swaps to derivatives and commodities in order to hedge the company’s far-flung sources of risk. “This was a highly capitalized business with lots of leverage,” says Scott, “and you had to be very cognizant of different risks, because they can blow up your business and margins. So, we were paying attention to the nitty-gritty of hydrocarbon risk, commodities risk, currency risk. It was that intense focus on risk that really drove our experience there.” Scott brought this same focus on risk when he moved to Microsoft’s treasury department in 1995, running a $5 billion portfolio. Thanks to savvy investing and Microsoft’s astronomical mid-’90s profits, that portfolio quickly grew to $80 billion invested in nearly every asset class, once again expanding Scott’s investing repertoire.
The kind of sophisticated risk management and hedging that you often find in the treasury department of a large corporation like Microsoft is decidedly less common in the realm of big public funds. For most large institutional investors, diversification and risk are viewed along traditional asset-allocation lines: Put a small majority of your money in stocks to up your returns; put a large minority in bonds to balance out the riskier stocks; spread around 10% to 20% in alternatives like hedge funds, private equity, or emerging markets in the hopes of upping returns and decreasing the correlation between your investments; maybe throw in an inflation hedge like gold for good measure. It’s a useful framework for viewing markets and your portfolio, with investments broken down into convenient categories and certain kinds of risks isolated. The problem is that these categories are sometimes simply superficial indicators of the symptoms of risk, not the real causes of it. Sure, bonds are generally more reliable than stocks, and often do well when stocks do poorly, but what if your bond portfolio is mostly in high-yield corporates, mortgages, and distressed debt, without much in government debt? Do typical correlation assumptions turn into naïve ones?
“Bonds are there to serve as a balance to stocks,” says Scott, “but all these hybrid [bond structures] ultimately are exposed to companies and the broader economy—if equities go to zero, bondholders becomes equity holders, and that drop in value is the same. This kind of portfolio only offers diversification if markets are going well—which isn’t the point at all.”
The idea, then, is to worry less about an investment’s rate of return or the superficial categories it falls into, and instead look more at what Prince calls “the underlying drivers of the return.” With this new approach, the Permanent Fund can gauge how a portfolio is affected by inflation, deflation, a strong economy, or tight credit market. (It doesn’t hurt that the external CIO program gives the APF access to Bridgewater’s high-powered computers, which can reportedly test how the portfolio will perform under countless market scenarios.)
When Scott arrived at the Permanent Fund, he broke the portfolio down into different risk factors, and what he found was a bit alarming. Despite a seemingly balanced and diversified portfolio, a single factor—corporate exposure—made up 85% of the fund’s overall risk. It would have been a good excuse for an immediate restructuring of the portfolio but, with a fund as large and publicly scrutinized as the APF, management and communication skills were needed as much as a savvy take on risk management. The hedge funds, asset managers, and corporate treasury departments that take a similar view of risk to Scott’s don’t just share an opinion with him, they share a process—a way of looking broadly at the forest instead of just the trees. They solicit new ideas, and experiment with different ways of predicting and managing what happens to that forest. Instead of just aping the risk management techniques of other funds, Scott needed to create this kind of environment, one where his traders and board of trustees (and state legislators, if they got curious) could better understand and appreciate the risks already in the APF’s portfolio, and think more broadly about how to manage and minimize those risks. That’s where the external CIO program comes into play.
In 2009, Scott met with a team from Asness’ AQR Capital, which at the time was running a moderate-size equity portfolio for the Permanent Fund. “We met with Jeff for the first time as he went around to meet existing managers, and we started discussing some of the broader capabilities of our firm,” says Gregor Andrade, a former Harvard Business School professor and Principal at AQR. “We’re more of a multi-asset class and alternative manager, and one of the things Jeff was interested in was some notion of a strategic relationship with managers with broad capabilities.”
In the back of Scott’s mind was a plan to simplify APF’s portfolio by dissolving its small-cap equities pool, which invested with 15 different money managers—including AQR—and put larger sums with fewer funds. A request for proposal got a reported 40 responses, of which a dozen or so were ultimately interviewed. One was AQR.
As Andrade and Scott had discussed from the outset, the APF was interested in more than simply farming out a large chunk of cash to a few independent managers. They wanted a collaborative process that pushed the boundaries of the traditional client-money manager relationship. Scott calls it an external CIO program, and the title is accurate on two counts. First, that, once some basic objectives and parameters are set, the five funds the APF eventually selected (Bridgewater Associates, AQR, Goldman Sachs Asset Management, PIMCO, and GMO) are free to invest the $500 million pretty much how they see fit. Second, despite their discretion, the external CIOs have to be transparent with their investments and explain why they make the decisions they do, just as a CIO explains investments to the board of trustees or a CFO. That means the external CIOs are in constant touch with Scott and his traders, and come up to Juneau approximately once a year to meet the APF’s board of trustees.
That board is composed of eight members, all of them appointed by the Governor, with two of the members coming from the governor’s cabinet. Although far from a perfect governance model, Alaskans, as a rule, are suspicious of political meddling with the fund, so members are appointed to staggered four-year terms to prevent any o’erhasty political maneuvering. Most members generally have some kind of business or financial experience, but are often former state politicians, business owners, or lawyers. So, for all the smarts needed to be appointed to the board, members don’t necessarily know the more arcane points of high-powered investment strategies or risk management. Thus, alongside Scott, it is the external CIOs’ jobs to bring the board up to speed on everything from specific risks to the portfolio to the broader economic picture.
As a result, every few months sees the likes of an Asness or El-Erian landing at the Juneau airport. On a typical daylong trip, about half the time is devoted to presentations from the external CIOs on how they’re investing the APF’s money and, more importantly, why they’re investing it that way. A perusal of the minutes from the meetings reveals not only a broad range of topics but—increasingly, as time has gone on—a deep examination of the issues and thoughtful questions from the members of the APF board.
“The trustees have invested a lot of time in self-education,” says Prince. “Jeff has gotten a lot of credit for the changes he’s instituted, but he wouldn’t be able to do it if the board weren’t putting in so much work. At Bridgewater, we’ve found that the most successful funds are ones that do a good job of communicating and educating whomever they answer to, and Jeff’s done a great job of that.”
“The board is full of smart people,” says Scott. “Our job is to educate them so that they can use their intelligence and backgrounds to really think about what the fund is doing….We’ve had people like Cliff Asness and Bob Prince come for meetings and really get their hands dirty looking at these issues. It gives our trustees a way to see how the best and brightest are doing it, as opposed to just how we’re doing it. It’s not a question of just copying, but looking for small kernels that could influence the way we do our thing.”
By educating the board about different risk-management strategies and the need to reduce corporate risk in the APF’s portfolio, Scott has been able to build widespread support for his reforms within the board—a major benefit when the state senate called on Scott and members of the board to talk about his new risk strategy.
In typical management speak, Scott’s style is called “coalition-building,” but jargon-filled cliches are cliches for a reason: there is usually some truth to them. By educating the board, Scott is in a better position to plan for the long term, reform the portfolio’s risk structure—and maybe improve his own understanding of the portfolio along the way. As Prince pointed out, the best institutional investors are usually ones that educate and communicate with their bosses, be it a board, CEO, state legislature, or some other oversight body. That’s not just because a good relationship gives chief investment officers more time to worry about investments and less about internal public relations and palace intrigue. It’s also because sometimes the best ideas about investing can come from relative outsiders to the field.
One of the most striking things about the financial crisis was the degree to which the savviest, best educated, most connected insiders proved completely blind to the brewing catastrophe, and how so many relative outsiders—bomb-throwers like Nassim Taleb and Nouriel Roubini, unknown hedge-fund managers like John Paulson, the oddball cast of characters in Michael Lewis’ The Big Short—saw what was coming. Markets and financiers are notorious for suffering bouts of Groupthink but, by making board members active thinkers, the APF can take advantage of their different backgrounds and perspectives. This, of course, is in addition to the views on markets and investing that the APF is already getting from the five external CIOs, who not only meet regularly with Scott and the board, but make their extensive research departments and computing power available to the Permanent Fund when they want to dig into a theory, or run market simulations to see how their portfolio will perform.
That brings us back to Scott’s perturbing discovery about the APF when he first took over: Nearly 85% of the portfolio’s risk came from corporate exposure alone. When Scott was hired as CIO, the financial world was in free fall, and the APF was taking its lumps alongside everyone else (though faring better than many funds). Scott had been hired to reform the fund, and the crisis mode of 2008 gave him something of a manager’s dream: the chance to drastically reform the system without many questions from the overseers. Yet now, two years after Scott inherited that mandate, the APF’s portfolio looks…basically the same. Why?
“It’s taken two years, but we’ve changed the whole culture,” says Scott. “At my first board meeting, we spent hours talking about individual managers, then those managers came in and did presentations, but there was no real discussion of risk. Now? We spend two hours discussing our risk dashboard, counterparty risk, company risk, some Value at Risk. The first year or two was all about educating the board about what risks the portfolio faced, and what kind of changes we needed to make. The next year is about actually starting to make those changes.”
The jury is still out on how well the APF’s external CIO program and view of risk will work out. However, in an investing climate where the old dogmas of risk management and asset allocation are being constantly called into question, Scott’s reforms provide solid models for other institutional investors. On the risk front, trying to look less at superficial categories and more at the underlying risks and exposures that come with different investments is now a no-brainer. Looking at how to manage these drivers of risk is not a single-use product like a tail-risk hedge or new risk metric, or a narrowly applicable technique. It’s a broader way of viewing the common problem of risk and what really causes it. Scott’s program of using external CIOs to educate and communicate with the board of trustees could be similarly helpful for institutional investors looking for more ideas and better advice on their portfolio.
It would be hard for a small fund to replicate the external CIO program—the El-Erians of the world probably aren’t flying to within arm’s reach of the Arctic Circle and giving daylong presentations to a fund with only 10 million dollars to invest. However, like looking at the drivers of risk, the point is not to replicate Alaska’s approach so much as being open to the ideas behind it: in this case, finding new ways of getting more value from hedge funds and asset managers. “The industry is paying a lot in fees,” says AQR’s Andrade, “and there’s some pressure to bring those down. There’s also a pressure to see if [institutional clients] are getting everything they can for those fees, and I think Jeff is really leading the way in looking at that.”
That’s a lot of innovation coming from America’s most isolated state but, according to Scott, it has less to do with him and more to do with the APF itself and the people the fund has surrounded itself with. Accepting the 2010 aiCIO Innovation Award for sovereign wealth funds last fall, Scott gave the credit to the fund’s external CIOs, many of whom were represented in the room, and to “six individuals who have committed themselves to making the Alaska Permanent Fund a better institutional portfolio. They’re not names you’re going to be familiar with. They’re six trustees, and we couldn’t get it done without them.”
From a lot of sources, that might sound like polite lip service. Coming from Scott and the APF, however, it’s more like an investing mission statement.
To contact the <em>aiCIO</em> editor of this story: Kristopher McDaniel at <a href='mailto:kmcdaniel@assetinternational.com'>kmcdaniel@assetinternational.com</a>; 646-308-2748.<br/> Follow on Twitter at <a href='http://twitter.com/#!/ai_CIO' target='_blank'>@ai_CIO</a>