Innovation, Meet CalSTRS. CalSTRS, Innovation.

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Let us be frank with each other: American public defined benefit plans are not known for pushing the envelope of investment strategy. They are thought, wrongly or rightly, to often be the last ones into any asset class; One of the Texas Teacher Retirement System’s own staff is accusing the state’s Governor and fund Chief Investment Officer Britt Harris of allocating assets based on political connections rather than benefits to the portfolio; There were still some public plans barred from investing in equity markets as late as President Clinton’s second term. Yet, one public fund, the $141 billion California State Teachers’ Retirement System (CalSTRS)—the perennial second fiddle to its Sacramento neighbor, CalPERS—is quietly undermining this group’s staid image with a unit focused exclusively on testing new investment strategies.

Quietly is the appropriate adjective here, because Steven Tong, the press-shy man tasked with running CalSTRS’ Innovation and Risk unit, is loath to talk about the group in anything resembling grandiose terms. “It’s something we thought about for a couple of years before 2009,” he says from his offices in California’s capital. “[Its creation] was not due to the market crisis, but due to [Chief Investment Officer] Chris Ailman’s urge to create a unit that would be able to conduct independent research and look at opportunities to diversify our portfolio of assets.” Board approval for the unit came in 2009, Tong notes, and “what the approved policy allows us to do is use 1.5% of the total portfolio to find strategies that improve the risk and return of the total fund.” The unit can commit up to 0.5% of the total CalSTRS portfolio toward any one strategy, and let it incubate for a period of up to three years. “We’re committing a small enough dollar amount that we can see how it performs over a three-year period without having a detrimental effect on the total portfolio,” he says. “After three years, we go back to the Board with a report and let them know what our findings are.”

While Tong’s unit has yet to allocate capital, its first exercise in innovation is under way. “Starting a year ago, we brought global macro strategies to the Board’s attention. It was the first strategy that we wanted to consider. They have now approved us to go ahead and invest $250 million in three to six global macro managers in the hedge fund space.” The Board also directed Tong and the unit to find a consultant to work with CalSTRS on manager selection, risk, and valuations—a diversion that will be “completed shortly.” When the consultant is on board, the fund will start to search, and allocate. Besides global macro, the unit also is working with the Board to implement a commodities investment strategy that will act as an additional inflation hedge.

Global macro? Commodities? These aren’t exactly earth-shattering innovations. Indeed, the taciturn Steven Tong would be the first to admit this fact. The goal of the Innovation and Risk team—besides Tong, comprised of numerous risk managers and seasoned investors with non-public fund experience—isn’t to reinvent portfolio management’s equivalent of the wheel. Instead, “diversification and mitigated volatility” will be indicators of what a good strategy amounts to. “What we’re looking for, diversification, everyone talks about it, but how do I define that?” Tong says. “What this unit really looks for is how [a strategy] correlates with other betas that we invest in, and how does it correlate over different macroeconomic schemes and stresses?” Regarding volatility, Tong asserts that lower volatility is also the goal of any strategy the unit ultimately decides is worthy of a larger look. “If we find an investment option with the same expected returns as global equities, but it has a higher volatility, well, we don’t want to consider that,” he says. “On the other hand, if the opportunity has the same return as equities and lower volatility, that’s interesting to us.”

Perhaps the most important result of a unit such as this (a similar group exists at the Dutch pension giant ABP) isn’t so much a revolution in investing, but in the way investments are presented to a Board and, by extension, the general public. Tong is clear that the unit was constructed so that CalSTRS could “look at investments over long periods of time.” Put another, more blunt, way: By clearly labeling the unit and signaling to stakeholders that the new strategies are exploratory in nature, there will be less pressure to perform immediately. Faced with a dysfunctional government and a public hypersensitive to the effect such large plans have on the state’s finances, CalSTRS’ attempt to give novel investments the imprimatur of the Innovation and Risk unit likely will provide protection from such external vagaries— and prove to be the most innovative part of the entire proposition.