It's challenging enough for any public pension fund CIO to find alternative investments at the best price from the best manager at the best time. However, the $145 billion New York City Retirement Systems presents multiple extra hurdles, ranging from the system's complex structure to regulatory restrictions to insufficient money to hire enough professional staff members.
“The complexity of the governance system does not help your asset allocation up front,” said Lawrence Schloss, who just completed a 45-month tour as chief investment officer of the system of five separate pension funds. “It's the way it had been conducted before I had arrived. It has a lot of different nuances to it.”
Mr. Schloss navigated the nuances. He made the pension funds' first hedge fund investments, restructured the private equity portfolio and increased commitments to these investment categories as well as to real estate and opportunistic fixed income. He presided over an increase in the investment staff, and he helped change the pension system's procurement practices to significantly cut the time for hiring investment managers and consultants.
Mr. Schloss recently spoke to Pensions & Investments about efforts to diversify the systems' portfolios, improve returns and lower their volatility through alternative investments, as well as to reflect on his role as CIO.
He said his greatest accomplishments were improving the process of manager selection and management of his department, increasing the size of the professional staff, and building a better relationship between the comptroller's office and the pension funds' trustees.
Mr. Schloss resigned in mid-October. He is now president of Angelo, Gordon & Co., New York, a manager specializing in private equity, real estate and credit. Seema Hingorani, director of public equities and hedge funds, is interim CIO.
Mr. Schloss said it took about 18 months to increase the alternatives allocation. “The implementation is ... very dependent on what's available at the time, your staff constraints and the markets in general.”
The goal is to raise the aggregate alternatives allocation to 20.5% among the five pension funds; it was about 13.2% as of June 30, and 9% just before he was appointed CIO.
As of June 30, the system had 6.3% in private equity, 3.3% in private real estate, 2% in hedge funds and 1.6% in opportunistic fixed income.
Mr. Schloss had to deal with five separate city pension funds with a total of 58 trustees, and each has a different investment philosophy and different appetite for alternatives. For example, although the pension system made its first investments in hedge funds in 2011, two of the five funds still don't invest in them.
Because hedge funds and other alternative investments invariably require higher fees than traditional stock and bond investments, Mr. Schloss said trustees are sensitive to expenses for new investments. “The simplest part of that conversation is that the only thing that matters is net return — period,” he said. “If my expected net return (for one investment) is higher than someone else who charges us less, we should pay more to get a higher rate of return.”
No internal management
All of the system's assets are managed externally, so it generally pays higher fees than if assets were managed by an in-house team. The CIO's department, known as the comptroller's Bureau of Asset Management,“is undercompensated and understaffed,” Mr. Schloss said.
The office had 22 investment professionals when he joined; the total was 38 when he left. Still, he said the bureau needs more investment pros. But with an average salary of about $100,000, it's hard for the bureau to compete for talent.
That means some potential strategies cannot be pursued. For example, the headquarters of the Teachers' Retirement System of the City of New York, one of the five city pension funds, contains “a plaque that says "owned by the Retirement Systems of Alabama,'” Mr. Schloss said. “They own our building. We own no buildings. To me, that makes no sense at all.”
He also mentioned a state law, known has the basket clause, which restricts the combined allocation to certain types of investments — including the alternatives favored by Mr. Schloss — to 25% of a pension system's asset allocation. Among other things, the basket clause covers private equity, certain high-yield bonds, senior bank loans, commodities and private placement fixed income.
“We have this rigidity, which basically suboptimizes your portfolio,” he said of the law that also affects other state pension funds.
For the fiscal year ended June 30, the pension system's $2.76 billion hedge fund portfolio returned 8.8% vs. 8.37% for its benchmark, according to audited figures in the recently published comprehensive annual financial report by the city comptroller's office. Approximately 83% of the hedge fund portfolio is in direct investments and the rest is in funds of funds, according to the report.
The system's $8.66 billion in private equity produced an internal rate of return of 9.4% for the year ended June 30, the report said. The benchmark was 17.2%.
Private equity should be a “double-digit return business,” Mr. Schloss said. ”The goal is an annual return of 12% to 13%, when all money is invested.”
When he became CIO, the private equity portfolio had “too many funds and too many managers with too many not-good managers,” Mr. Schloss. “It was something like 30% (of managers) in the top quartile, 25% second quartile, 25% third quartile and 20% bottom quartile.”
Mr. Schloss estimated 60% of the system's private equity managers now are in the top quartiles, and about 15% are in the second quartile. He attributed the changes to a portfolio restructuring that includes investing only in top quartile managers, not renewing with poor performers, increasing the size of commitments to top managers and selectively selling some funds on the secondary market.
12.5% for real estate
The pension fund's $4.48 billion real estate portfolio posted a 12.5% return for the year ended June 30; its benchmark returned 12.2%.
Long term, however, the real estate portfolio continues to suffer due to bad timing during the previous decade.
“The city ramped up its real estate investing in 2006 and 2007 and got crushed in 2008 and 2009,” Mr. Schloss said. “We haven't made much money in real estate.” The real estate portfolio's net return, from inception to the fiscal year ended June 30, was 4.9%, according to the city's financial report.
Mr. Schloss said the pension system's expansion of alternatives has been able to bypass the city's cumbersome procurement process. “You're not hiring a manager, you're making an investment,” he explained.
When Mr. Schloss joined the pension system, the procurement process — planning, issuing and deciding on RFPs — took about 17 to 18 months. He instituted a pilot project in May 2011 that cut the time to about five months.
The city's procurement policy board recently approved a regulation enabling the pension system to accelerate its procurement. Without such a change, “hiring a money manager was the same procedure as buying school buses,” he said.
“We worked on it for 2.5 years,” he added. “It's not a dramatic process. Other (public) pension funds use it, but it's not the process that we had used.”
This article originally appeared in the November 25, 2013 print issue as, "Schloss reflects on tenure at NYC".