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After a year that saw public pensions derided as legacies of quasi-socialism, for being unable to meet their target investment return, and for being bastions of unsophisticated management, reality set in midsummer: Public funds, lo and behold, had impressive investment returns in fiscal 2011. To celebrate this achievement, aiCIO sought out two of the most influential chief investment officers in America: Chris Ailman of the California State Teachers’ Retirement System (CalSTRS) and Joe Dear of the California Public Employees’ Retirement System (CalPERS). Despite their offices only being separated by the Sacramento River, their schedules rarely see them in California’s capital simultaneously—so, aiCIO conducted numerous interviews over a series of July weeks on the topics of asset allocation, tail risk hedging, public fund structure and, humbly, their stellar annual returns.
Dear: Honestly, and not taking anything away from the team here, our 20.7% returns in fiscal 2011 were largely the result of market beta. Public equities are about half our $234 billion portfolio, and it is no secret that public equities significantly increased in value over the past year.
Ailman: Last year, the key to investment returns was definitely the beta. Historically, it’s always the beta exposure that’s key. In all large institutional portfolios, the beta exposure is large, and is driven largely by asset-allocation decisions. Breaking it down, the driver was first and foremost global equities. Some managers added value; some did not add value, as always. Last year, our U.S. active managers added a fair amount of value. However, for once, so did our non-U.S. developed equity managers.
D: We also saw strong returns with our private equity program. About 14% of our assets are in private equity, and we beat our program benchmark by about 500 basis points. In terms of inflation-linked assets—including infrastructure, commodities, forestland, inflation-linked bonds—the only detractor was real estate, which was 970 basis points under its benchmark. It still earned 10%, however. We maintain a slight overweight in equities, underweight in real estate, so that helped.
A: I’ve been quoted as saying diversification failed in 2008—it didn’t fail, but it didn’t work perfectly well either. 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. With portfolio construction: We have +/-3% bands around most buckets, with a +/-6% band around global equities. This is lower than most funds—but then again, we are not a jet ski. We’re a giant cruise ship. So it comes down to asset allocation.
D: The takeaway from this year is twofold. One is that we benefited from what we didn’t do. For example, we didn’t do a major reduction in risk assets after the financial crisis. The second is a note of caution: A lot of the equity performance is due to governmental action. In the near term, monetary policy is relatively straightforward, but fiscal policy is very concerning. So, while we are pleased with 20% returns, we don’t want to inflate their significance.
A: For fiscal year 2010/2011, we’re obviously happy with it, but it’s only one year. Looking forward, we need to continue to innovate—something we try to do with our Innovation and Risk unit. Right now, the Board is interested in commodities. They’ve been interested before, but they’re looking at them closely now. In 2009, we needed an inflation hedge. What drives inflation? It’s varied, but we wanted to look into that. TIPS are the most obvious, with infrastructure and real estate also often helping. However, with commodities, there are lots of questions, and some [people] can be uncomfortable with them. Being a public fund, sometimes commodities can be viewed as speculation, like betting on pork belly futures.
D: Regarding fund governance and structure, we manage a significant majority of our assets internally—77% of public equities, 91% of fixed-income—which is not all that common at American funds. It’s much more common outside America, of course. The costs of these programs are significantly lower than external managers.
A: That’s the big debate: How to structure these funds? We can’t be nimble at this size—so how do we structure our teams? Yes, I’d like to expand internally. I was talking with [Alberta Investment Management Company’s] Leo de Bever—a real pioneer here—and he’s aggressively expanding. It absolutely makes sense to do it cost-wise. Hopefully, what he’s doing, what others are doing in Canada and overseas, will spur an active discussion. If I were to create a $155 billion fund structure from scratch, I’d follow his model, not ours, frankly.
D: We can’t entirely duplicate the Canadian model, their internal management of private assets, the primary reason being that we don’t have the compensation structure required to compete. It’s not politically feasible, so we don’t spend a lot of time pursuing it. What is feasible is an expansion of our co-investment program, and direct investments. Other than that, we have to go external and, if there is a secret to external manager selection, I’m not telling you—mainly because I don’t know it. It’s a strategy of portfolio fit, and an incredible rigor of due diligence in selection. The question emerging now is whether, in our allocation, we should be spreading our relatively large portfolio around the managers, or concentrating higher amounts among a fewer number of firms. We’re working on that question today.
A: A question Steven [Tong, head of CalSTRS’ Innovation and Risk unit] and I are working on is tail-risk hedging. As I said, diversification didn’t work well to a large degree in 2001/2002 and 2008, and that was really our only tail-risk tool. We need more tools. Tail-risk tools are out there, of course, but they are expensive when you want it the most. We want to be dynamic with it—look at market conditions and decide when to put it in place. Given the size of our plan, there is a dilemma. In response to this, we must be creative in protecting our left tail. We will have to use multiple strategies and tools, and it has to be dynamic in nature.
D: Yes, one change you saw coming out of 2008 was the increasing acceptance of the idea of risk-weighted portfolios versus capital-weighted ones. We’re not just thinking about it—we’re doing it. We still manage our assets in the asset-class structure of old but, for portfolio strategy and risk management, we’re working under this new structure adopted in 2010. This [risk-focused] framework raises the question of whether you want an equal-weighted risk portfolio. It’s not a simple question, and we are not in a rush to come up with an answer. We need to approach it carefully. It’s part of a discussion we’re having with academics and asset management firms on how to solve the problem of having better risk management while still getting our return.
A: I spoke of risk management earlier, and we’ve been using modern portfolio theory like everyone else for decades. However, more recently, we looked at what the Alaska Permanent Fund had done, what ATP in Denmark had done—where they created the risk buckets and divided up assets. We thought it 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 were 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.
D: Obviously, a 20% return undermines the statements of public pension fund critics—that we are unable to reach our target. I think that’s important—that there is still a lot of earning power in these assets—but let’s be clear: There won’t be a string of 20% years in a row. However, it definitely should boost confidence in the ability to operate a sophisticated portfolio successfully within the public sphere.