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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>