Oregon State Treasury, which runs $80 billion worth of state investments including the $62-billion Oregon Public Employees Retirement Fund, is preparing the portfolio for a new dawn.
John Skjervem, chief investment officer of the treasury’s investment division, sees the speed and extent of the recent sell-off in fixed income as “a shot across the bow” that the benign bond environment is coming to an end.
“The secular bull market in bonds, over three decades old now, is over,” says Skjervem, who joined Oregon last November from Northern Trust Group, the Chicago-based bank.
He’s just overseen an adjustment in asset allocation at the fund to better protect the portfolio against inflation and the anticipated lag in bond market returns.
Newly approved asset targets include a 20-per-cent allocation to fixed income, pared from 25 per cent, a 37.5-per-cent allocation to public equity, down 5.5 per cent, an increased 20-per-cent allocation to private equity, an increased 12.5-per-cent allocation to real estate and 2.5 per cent each to absolute/return, commodities, infrastructure and other real assets, to which money liberated from bonds will flow.
The tweaks to Oregon’s asset allocation also show the fund unwinding investments it put in place to capitalise on dislocations created during the global financial crisis. These adjustments better reflect today’s changing economic climate, explains Skjervem.
“As the 2008-2009 crisis unfolded, Oregon increased its exposure to credit-sensitive fixed income, which subsequently generated several consecutive years of strong returns. But financial markets in general and credit markets in particular have recovered, so we think now is a good time to unwind at least part of that bet.”
He applauds his predecessor’s initiative and perseverance since these credit-sensitive investments benefited greatly “when spreads compressed by over a 1000 basis points” after the financial crisis. Now he believes the strategy’s risk-return profile is “no longer as attractive” and the tactical element of the strategy has largely “played out”.
Eye on the ball
Although Oregon was hit hard by the financial crisis, Skjervem says it was these kinds of strategies that helped the fund recover well. The board and staff didn’t “blink and commit the ultimate sin” of selling risk assets into a bear market.
Instead, led by Skjervem’s predecessor Ronald Schmitz, who now serves as chief investment officer for the Virginia Retirement System, the fund made tactical credit investments, specifically in high yield bonds and bank loans.
“I think it probably took real courage to increase the fund’s credit-sensitive exposure and buy all the way through the bear market.”
Warming to his theme, Skjervem explains that Oregon showed the same fortitude with its private equity allocation. It got board approval to actually increase its commitment in one particular case by providing rescue financing. It was a strategy, he says, that has “been vindicated by the generous private equity returns we’ve recently enjoyed.”
The fund currently has a 22-per-cent exposure to private equity, overweight its increased 20-per-cent target allocation but in “a fast and furious” stream of realisations this will soon fall back to target. Oregon was the first investor in private equity manager Kohlberg Kravis Roberts in 1981.
Back then a seminal investment when the industry was still in its infancy via a leveraged buyout of a local retailer generated six times multiple. “This was the beginning of what is now a big and robust private equity portfolio,” says Skjervem.
It’s an expertise that now informs all the fund’s private market allocations, like its newly increased 12-per-cent real estate portfolio, what Skjervem describes as Oregon’s “other success story”. To ensure the corresponding returns exceed liquid public-market alternatives, Skjevem applies certain criteria.
“First, we need to see evidence of a return premium net of fees and transaction costs and second, we need confidence that this premium will persist over time. Finally, we need access to top managers in these markets to make sure we actually capture these persistent return premiums. Medium private-market returns are usually no better than the liquid public-market equivalents.”
Getting to the real
Money from the reduced bond portfolio will be portioned to real assets, including infrastructure. It’s an asset class where the fund only has “a toe in the water”, but will now make an area of emphasis, although Skjevem notes that there are few well known funds through which to invest.
He likes infrastructure for its inflation sensitivity and the way it matches the plan’s intermediate liabilities.
“In these shorter time periods, inflation can be really corrosive to traditional equity returns,” he says. Last January the fund, which seeks high single-digit returns in the asset, committed $100 million to Stone Peak Infrastructure Fund, focused on US utilities, energy and transport.
Skjervem says Oregon is also exploring infrastructure investment collaborations with neighbouring states.
Domestic equity investments include a passive allocation to various domestic and international benchmarks as well as a set of “judiciously selected” active managers running quantitative strategies that are focused less on stock picking and more on exploiting return anomalies associated with risk factors such as size and value.
Elsewhere in the public equity allocation, a developed-markets portfolio is split between a passive MSCI World Ex-US IMI Index fund and active Europe, Australia and Far East mandates. An emerging market allocation is invested in an MSCI Emerging Markets Index fund.
Although Oregon has a 2.5-per-cent target allocation to absolute return strategies, Skjervem says he shares his staff’s and governing board’s hedge fund scepticism.
“If you apply empirical tests to hedge fund-return histories, you often find high correlations with common market betas that you could otherwise replicate with various ETFs or index funds for 20 basis points instead of paying the traditional two-and-20 fee structure. I think there are other, usually more cost-effective ways of building these types of return streams. It’s good to apply this level of rigour because it also helps you identify those hedge fund managers that are doing something truly unique and accretive.” He doesn’t believe hedge funds have an edge when it comes to market timing either.
“If they could do this consistently, fine, but I haven’t seen it.”
Lean and mean investment team
Along with the Retirement Fund, Oregon State Treasury oversees assets for the Oregon Short Term Fund, the Common School Fund, the State Accident Insurance Fund and the Intermediate Term Pool.
There are no plans yet to build a bigger internal team – for now a “lean and mean” staff include 12 investment professionals and five administrative assistants, with the team divided between offices in Tiger, which deals with the risk allocations, and Salem, where fixed income and cash allocations are managed.
“Ultimately we’d like to bring everyone together,” says Skjervem.
The fund, which is 84 per cent funded, has an assumed earnings rate fixed at 8 per cent since 1989. The latest adjustments will leave Oregon more reliant on private markets, private equity and real estate, as well as real assets such as infrastructure, to meet that goal. “Our strong brand, ability to write big cheques and continuity of staff and governing board make us a sought-after partner,” says Skjervem.
