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CalSTRS considering new engagement push

Fund execs mulling direct investment with aim of boosting stock prices

Christopher Ailman, CIO, CalSTRS
Christopher Ailman, chief investment officer of the California State Teachers’ Retirement System.

The chief investment officer of the $202.1 billion California State Teachers' Retirement System, West Sacramento, says the pension plan will be examining the merits of a new engagement program that would be internally managed and make direct investments into underperforming companies with the aim of improving management and boosting the stock price.

CalSTRS, with one of the largest equity portfolios in the world, invests in 8,000 companies in its $118.3 billion stock portfolio, much of it in cap-weighted index funds.

CIO Christopher Ailman said that under the potential program, CalSTRS could make additional bets on stocks already in the indexed portfolio as part of an actively managed portfolio.

The program would be somewhat similar to the eight activist hedge funds that are part of CalSTRS' existing corporate governance program and that take concentrated positions in underperforming companies to increase the stock price.

Under the existing $3.2 billion program, fund managers attempt to force management changes and install new members on the targeted company's board of directors.

But Mr. Ailman said those activist funds also charge CalSTRS management and performance fees, costing the plan 1% to 2% on top of performance carry fees that can be as high as 20%.

“The advantage of direct investment is first off, cost,” Mr. Ailman said. “We can do it internally at much lower cost and no carry.”

With positions in multiple companies, CalSTRS' potential direct investments could be in the billions, Mr. Ailman said. CalSTRS currently manages about 50% of its portfolio in-house and the engagement investment program, if implemented, would be part of an effort to increase internal management to 60%, he said.

Seeking returns

The potential program comes at a time when CalSTRS' investment returns have been particularly challenged. In the fiscal year ended June 30, CalSTRS had overall returns of 1.4% and its global equity portfolio returned -2.3%. In the fiscal year ended June 30, 2015, it had overall returns of 4.8% and global equity returned 3.1%.

CalSTRS has an assumed investment return of 7.5% yearly.

Mr. Ailman said the system's investment committee will start what could be a yearlong review of the feasibility of the program in July. He said if the board decides to go ahead, the program likely would be implemented in the fiscal year beginning July 2018.

One key difference between the activist hedge funds in CalSTRS portfolio and the potential new program might be the approach. Mr. Ailman said he does not see CalSTRS using all of the hard-edged tactics some activist hedge funds employ to persuade company management to change.

For one thing, CalSTRS does not have the authority under California law to take seats on companies' boards of directors, as an activist hedge fund might.

“I think we would not be an activist fund,” he said. “We would be an engagement fund. Our approach would be more of a dialogue with companies. We're not going to pull off anything that's confrontational at all. We've been doing engagement with companies and seeing the benefit in the stock price for a couple of decades. The question is, is this something we could grow and become a bit more intentional in terms of size?”

CalSTRS already has been engaging in occasional side bets beyond its initial investment in activist hedge funds. Those additional positions are taken jointly with the fund manager to improve governance at select companies.

In one of its latest such investments, CalSTRS in January joined one of its activist managers, Legion Partners Asset Management LLC, Beverly Hills, and invested approximately $25 million in buying about 5% of the stock of the Banc of California.

In April, CalSTRS praised the bank for adding two new board members, noting it had worked with Legion Partners and the bank to identify the candidates. Since CalSTRS announced its investment with Legion on Jan. 24, Banc of California stock has increased more than 40%.

CalSTRS spokesman Ricardo Duran said the pension fund continues to hold its investment in the bank, but he could not provide how much CalSTRS has earned on that investment.

Scale an issue

CalSTRS' investments, however, are relatively small under the current program with hedge fund mangers. Mr. Ailman said CalSTRS guidelines limit any single equity investment to $75 million.

He said for CalSTRS to run its own engagement investment program, it must take much larger stakes in company stock to have a meaningful effect on the portfolio.

“The reason we'd be doing it is because we could scale up, though just how large a stake still needs to be worked out,” he said.

Ultimately, Mr. Ailman said the decision on implementing the program will come down to the bottom line — how much CalSTRS can make from the program.

“It all comes back to net return,“ he said. “Are we able to demonstrate that through our engagement we're able to add value?”

Mr. Ailman said part of the review will be determining just how big CalSTRS' governance staff would have to be to implement the program. He said CalSTRS has a corporate governance staff of 12, but that includes staff to monitor proxy voting and sustainability investments.

He said successful activist managers have staff members who develop top-notch expertise in the companies they challenge, so much so that, “they have drilled down more into the operational business of the company better than the CEO and their own staff. Right now, we don't have the level of resources to be able to do that, but could we?”

Regardless of what happens with the direct engagement investment program, Anne Sheehan, CalSTRS director of corporate governance, said the pension system remains committed to its activist portfolio.

Activist hedge funds “all use various, unique approaches, but they do a very deep dive into the company based on public information, about where they see changes could be made to improve the performance,” she said.

Activist hedge funds have been criticized by some investors for encouraging short-termism in investments. But Ms. Sheehan said CalSTRS is a long-term investor, with an average activist manager in its portfolio holding a company for three years and some holding investments for up to seven years.

“I would defy you to look at our managers and look at the changes they've made over the long run in these companies and say it's short-termism,” Ms. Sheehan said. “It doesn't bear out. And their holdings don't bear out. When you look at the churn of the S&P 500 over the last seven to eight months, three- to five-years holdings is a long time in the markets these days.”

But as CalSTRS has seen lackluster equity returns over the last several years, it has also seen lackluster performance in its activist hedge fund portfolio.

CalSTRS data show the eight funds collectively had slightly less than a 2% return in 2016, slightly underperforming the pension fund's custom equity benchmark.

The last time the activist hedge funds beat the benchmark was 2013, CalSTRS data show.

“The performance has been very volatile the last couple of years,” Ms. Sheehan said. “It's been challenged because of the way the markets have been.”

This article originally appeared in the May 1, 2017 print issue as, "CalSTRS considering new engagement push".