Alaska blazes new trail in risk-based investing

Permanent Fund changing asset allocation criteria

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Changing: Michael Burns says the Alaska fund is using a 'fresh approach' to asset allocation.

Alaska Permanent Fund Corp.'s adoption of a factor-based approach to asset allocation could signal a major change in how institutional investors look at risk and return.

The $30.2 billion fund's new asset allocation strategy categorizes assets by risk and includes new allocations to cash and real return. One of the biggest changes is a new “company exposure” asset class made up of stocks, corporate bonds and private equity.

The sovereign wealth fund, located in Juneau, is one of the first investors to move away from traditional asset allocation methods and look at the underlying sources of returns.

Officials at the $179.7 billion California Public Employees' Retirement System and $117.4 billion California State Teachers' Retirement System, both in Sacramento, are said to be looking at adopting this approach, which involves determining the drivers of risk and return of asset classes and grouping those classes accordingly. Calls to CalPERS spokesman Clark McKinley and CalSTRS spokeswoman Sherry Reser were not returned by press time.

Experts said investors' move toward a factor-based approach was prompted by the failure of diversification to cushion the blows of last year's capital markets' returns, although the Alaska fund's CEO said that's not the reason for that fund's changes.

David Hammerstein, chief strategist at Yanni Partners, Pittsburgh, said he wasn't aware of any other funds adopting a factor-based approach. But he added, “Institutional funds have decided to rethink their asset allocation in response to post-October 2007 market events, when a lot of risk factors happened in tandem.”

Said Frank Nielsen, executive director at MSCI Barra, a New York-based provider of investment tools: “There's been a lot of discussion about asset allocation, and one of the main conclusions is these asset classes can become highly correlated, in particular during crisis periods.”

He noted, for example, that investors who own equities and bonds of the same company could find themselves in a bad position, because a drop in the equities could have an impact on the value of the bonds.

“Behind this approach lies a factor model that identifies the underlying sources of risk and return,” he said.

Michael Burns, president and CEO of the Alaska Permanent Fund, said in an interview that the fund largely will have the same asset mix as before, but it will be categorized differently. He said the changes will allow the fund to “dial up or dial down risk in a more uniform manner.”

“We're taking a fresh approach to how we view our asset allocation,” Mr. Burns said in a news release. “We're recognizing that some investments within an asset class may have more in common with other asset types with regard to expected risk and return. And since our goal at the highest level is to balance the risk and return of the total portfolio, it makes sense to segregate assets by their characteristics, rather than simply by type.”

The new asset allocation is: 53% in company exposure, comprising stocks, corporate bonds and private equity; 21% in an opportunity pool that includes absolute return, real return and distressed debt; 18% in real assets, comprising real estate, infrastructure and Treasury inflation-protected securities; 6% interest rates, comprising government or government-related bonds; and 2% cash.

The previous target allocation was 26% U.S. stocks, 19% U.S. bonds, 14% global stocks, 13% non-U.S. stocks, 10% real estate, 6% for both private equity and absolute return, and 3% for both non-U.S. bonds and infrastructure.

Mr. Burns said in the interview that the change was not made in reaction to the financial market meltdown. “It's a way for us to manage the risk of similar types of assets and balance the risks,” he said.

For the real return allocation, fund officials plan to hire four managers to invest in the same range of assets as the entire fund. Mr. Burns said managers will be given a set amount of money and directed to manage the money to a 5% real rate of return. The real return managers will run approximately $500 million each, according to the news release. Callan Associates will assist with the searches.

“This is a new approach to investing for us, in effect creating mini-funds within the Permanent Fund,” Mr. Burns said in the news release. “Not only will there be the benefit of a portion of the fund having the same risk and return profile as the entire fund, but we'll also be able to see their approach to asset allocation, how it differs from our approach and how our results compare.”

“We want to see what other ideas there are ... how they (the managers) approach it and what they're thinking,” Mr. Burns said in the interview.

He said the fund is adding the 2% allocation to cash to pay the dividend paid out annually to every state resident. “We've (traditionally) used the month of July to raise that cash,” he said, but relying on earnings from one month is “more risk than you want to put in a short period of time with this kind of volatility.”

Shaken to the core

Yanni's Mr. Hammerstein said he believes the market dislocations that began in October 2007 have “shaken investors' beliefs to the core” and the Alaska Permanent Fund will be the first of many to adopt the approach.

“I think it will shape the investment community for the next five to 10 years; I think it will lead to permanent changes in portfolio structures,” he said.

“They are doing the analytical work to reveal how their funds are positioned,” Mr. Hammerstein said. “Their implementation work is likely to follow. They are also evaluating their cash flow needs in light of the structure of their funds. Many institutional funds found they had to make liquidations from their portfolio to accommodate cash flow needs.”

Eric J. Petroff, director of research with Seattle-based investment consultant Wurts & Associates, said the factor-based approach is “definitely not a trend just yet, but I believe it will become more prevalent over time.”

Mr. Petroff said he's developing similar risk models at Wurts. “A corporate bond and a corporate equity are two different things, but you can make the argument that you are dealing with equity risk exposure,” he said.

He said diversification failed investors in 2008 because the statistics ignored valuation and macroeconomic risk factors.

“What it really boils down to is over the last year everybody is (complaining) that diversification doesn't work; you're being an idiot if that's your vision,” he said. “It would have worked fine if it was diversified among those risk factors.”