Turmoil in financial markets and the need for greater transparency has triggered a review of the $174 billion CalPERS’ existing governance and risk management framework, with a new ad hoc committee tasked with reviewing the risk management framework across the entire business.
The A$28billion (US$20 billion) AustralianSuper terminated several mandates with active equities managers last week and directed most of the freed-up capital to passive exposures bringing its passive management in equities to more than 50 per cent, in an effort to simplify its portfolio by trimming excess managers.
In this research insight MSCI Barra explores the mitigation of misaligned risk and alpha factors by modifying the optimisation process. Firstly it reviews how to decompose a set of alphas into two components – one that is related to risk model factors, and one that is not. Then it shows how penalising the residual alpha in portfolio optimisation may improve a portfolio’s exposures and ex-ante information ratio.
Investors should be wary of “new paradigm” arguments, according to the latest research by consulting firm Wurts & Associates, which reminds investors the forces driving capital markets rarely change, but the position within market cycles is ever changing.
Wurts & Associates’ philosophy on strategic asset allocation is that static portfolio structure is an ineffective means of managing risk and achieving return goals.
“So we believe that dynamic portfolios are necessary. The challenge of course is judiciously responding to changes in capital markets while avoiding fruitless market timing activities.
“Because capital markets conditions are ever changing, our opinions will be ever changing as well, meaning the markets dictates the pace of change of asset allocation policy, not any arbitrary timeframe.”
According to Wurts the cycle of capital markets falls under four stages, with the current conditions defined by a flight to safety as well as economic stimulus, forming the beginning of the cycle.
Capital markets then move into a phase where investors tip-toe into risky assets, the economic stimulus works, with high grade investments recovering first; before moving into a phase where a flight to risk ensues, real estate, equity and credit markets rise, and household balance sheets are repaired.
The final stage of the capital market cycle, which Wurts tentatively predicts will be 2019, is characterised by overvaluations and overconfidence, where downside risks abound and are ignored, and liquidity triumphs over reason.
“Whether or not we have seen the worst of the bear market clearly remains to be seen. Objectively speaking though, both history and an analysis of the fundamental forces driving capital markets may portend we have seen the bulk of the downside,” the research says.
“Without a doubt our largest concern for institutional portfolios is the risk of a strong resurgence in inflation. We cannot foresee likely scenarios by which inflation falls within currently implied levels over the next decade.
“When viewing both equity and credit investments through a 10-year time horizon, we are facing the most attractive risk adjusted returns in decades.”
With this in mind Wurts highlights a number of asset allocation implications: embrace risk in equities and credit markets; favour US large cap over US small cap; look at international equities and emerging markets (according to MSCI, US equities are the most expensive in the world); and high yield and corporate investment grade bonds, mortgages and illiquid credit.
The New Mexico Educational Retirement Board’s aggressive move into alternatives has not been without hurdles. Chief investment officer, Bob Jacksha, spoke to Amanda White about the plan’s alternatives strategy, the bumps along the road and his expectations of the sector.
Two years ago the $6.6 billion New Mexico Educational Retirement Board started looking for a chief investment officer with specific alternatives experience. The aim was that the CIO could bring relationships and also overall analysis and understanding of the asset class to the table.
Bob Jacksha, who has 25 years investment experience, most recently as deputy CIO of the New Mexico State Investment Council, has an MBA and holds a Chartered Financial Analyst and Chartered Alternative Investment Analyst designations, had the right qualifications.
Since Jacksha’s hire, the New Mexico Educational Retirement Board has been transitioning to a new asset allocation which will decrease its equities exposure from 65 to 45 per cent, and double alternatives to an overall allocation of 30 per cent.
“We increased alternatives from 15 to 30 per cent, doubling hedge fund and private equity allocations, with allocations coming out of equities and fixed interest,” Jacksha says.
That new allocation will be split 10 per cent hedge funds, 10 per cent private equity, 5 per cent real estate and 5 per cent real assets, including infrastructure, timber, and agriculture. An allocation to commodities was discussed but it was decided not to allocate at the time.
Jacksha oversees four investment professionals (the fund also has two internal investment staff on the operations side) and while he would like to expand the internal team, that would require an act of legislature, and so seems unlikely.
NEPC, the fund’s general consultant, has shown the asset allocation in the past quarter has contributed a positive 2 per cent to the fund’s returns, while manager impact has been -4.8 per cent.
Investments have been trickling in to meet the allocations, with a recent $25 million allocation in ORG Real Property’s secondary fund fulfilling the plan’s target allocation for real estate. A chunk of that allocation is in an internally managed REIT index fund and over time, Jacksha says, that allocation will be transferred into private real estate.
Some infrastructure and private equity commitments have already been made, and that will be ongoing, with Jacksha predicting a good environment for private equity deals.
“In the past few years the market for deals has been good, endowments have been selling and there are opportunities in the secondary market,” he says. “For the first time in many years private equity firms are going out and having to market their funds.”
The ERB has $745 million in private equity commitments in 25 different funds, which have a market value of $162 million.
In the time since the new asset allocation was made, the ERB has seen some dramatic turns which have somewhat derailed the initial investment strategy.
“In the past year, hedge funds didn’t do what we wanted them to do – they didn’t give much protection on the downside,” Jacksha says.
For the year to December 2008, none of the alternatives investments contributed much to the fund. In that time the absolute return composite delivered -23 per cent to the fund (the most dramatic return being the -28 per cent contributed by the Gottex Market Neutral fund), the private equity composite returned -13.3 per cent and the real estate assets returned a damaging -30.6 per cent.
And while not having a huge adverse effect on the investment outcome, because the allocation was small, the controversy over an exposure to one of Madoff’s investment funds, was also an unwelcome distraction.
In a statement the ERB said: “As part of our overall investment plan, ERB allocated approximately 10 per cent of our assets to hedge funds. One of our hedge fund managers has an investment in a fund managed by Bernard Madoff. As the press has widely reported, Mr. Madoff is alleged to have committed fraud in the management of several hedge funds. While the ultimate outcome of this investment is unclear at this time, we do know that our maximum possible exposure is $9.75 million. Although this is not an insignificant amount, it represents only 0.15 per cent of our total fund balance. Regardless of the outcome, it will not affect the payment of retiree benefits. It will not have an impact on the stability of the fund. We are examining all of our options in this matter with an eye toward maximising our return of capital on this investment.”
Jacksha has faced his fair share of controversy during his tenure at the fund, and most of it has been in the alternatives space. As recently as last week, the investment committee decided to suspend its private equity consultant, Aldus Equity, following the indictment of former New York state comptroller executives over claims of receiving kickbacks from an Aldus fund and other investments.
Aldus is also private equity adviser to the $14.1 billion New Mexico State Investment Council, which has put about $350 million in private equity funds.
The Dallas-based Aldus Equity has been paid $905,000 a year for advisory work for the State Investment Council and $750,000 a year for work for the ERB. While it is unclear what the Investment Council will do regarding its private equity advice, the New Mexico ERB has decided its general consultant, NEPC, will widen its scope to include private equity until a decision is made whether to replace Aldus permanently. Its other specialist consultants are ORG for real estate and timber, and Corkland Partners for infrastructure.
These adverse experiences in the past couple of years have taught the fund not to be complacent when it comes to its alternatives investments.
In particular, Jacksha is adamant when it comes to fees paid for alternatives that transparency reigns. He has no problem with performance hurdles, and almost always agrees with those that are proposed by investment firms. However he believes management fees could be a bit lower.
“Fee sharing, or fees from deals, should not exist,” he says passionately. “It is a perverse incentive to do deals.”
Fund Profile
The New Mexico Educational Retirement Board returned -28.1 per cent for the year to December 2008.
Asset allocation (at December 31, 2008)
| Domestic equity | 31.5% |
| International equity | 15.6% |
| Private equity | 2.3 % |
| Domestic bonds | 30.1% |
| Bank debt | 5.1% |
| REITS | 3.2% |
| Real estate funds | 1.6 % |
| Infrastructure | 0.2% |
| Cash | 1.4% |
| Absolute returns | 8.9% |
Board-approved asset allocation target
| Large cap equities | 23% |
| Small cap equities | 2% |
| International equities | 8% |
| Emerging markets | 10% |
| International small cap | 2% |
| Bank debt | 5% |
| Domestic bonds | 15% |
| Real estate | 5% |
| Private equity | 10% |
| Absolute return | 10% |
| Real assets | 5% |
| Global TAA | 5% |
This paper, produced by EDHEC Risk and Asset Management Research, presents an empirical analysis of the benefits of alternative forms of investment strategies from an asset-liability management perspective.
Using a vector error correction model that explicitly distinguishes between short-term and long-term dynamics in the joint distribution of asset returns and inflation, we identify the presence of long-term
cointegration relationships between the return on typical pension fund liabilities and the return of various traditional and alternative asset classes.
The results suggest that real estate and commodities have particularly attractive inflation-hedging properties over
long-horizons, which justify their introduction in pension funds’ liability-matching portfolios.
Overall, the results suggest that alternatives are very useful ingredients for institutional investors facing inflation-related liability constraints.