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Pension Funds

Minnesota CIO layers on risk-focused approach to investing

The Minnesota State Board of Investment's leader is taking a risk-focused approach to its investment strategy, adding a stand-alone U.S. Treasury allocation.

The Treasury allocation, which will account for 8.9% of the board's $65 billion in assets managed for eight state defined benefit plans, was separated from MSBI's current 15.8% fixed-income allocation, said Mansco Perry III, executive director and chief investment officer. The board oversees a total of $93.5 billion in investments for state public pension and other retirement plans as well as other state funds.

"The difference we're trying to show is that there's less riskiness with Treasuries than there is with all other components of fixed income," Mr. Perry said in an interview. "There are two basic risks with fixed income: interest-rate risk and credit risk. The Treasury portfolio is trying to be more a reflection of fixed income with an interest-rate risk component while our core (fixed-income allocation), while it has interest-rate risk, it's also where credit risk is, so the other components like private credit are more credit-risk-oriented."

The new portfolio was established in January as part of the addition of a new strategic allocation system, is expected to be funded in the first half of this year.

Mr. Perry said the idea for the Treasury-specific allocation came after the financial crisis of 2008-2009.

"If we revisit what happened in 2008-'09, those organizations that had a Treasury bucket didn't suffer as much because they had a real diversifier," he said. "You've heard the term 'correlations were going to one;' well, Treasuries did not exhibit the correlation going to one. We had Treasuries in the core fixed-income (allocation), but how do most core fixed-income managers add value? They underweight their Treasuries and take more credit risk. What happened in 2008 is you had a lot of organizations raid their core fixed-income portfolios to get the liquidity the Treasuries provided, which probably upset the strategy they hired fixed-income managers to execute."

The new categorization system, with Treasuries as part of a protection allocation, doesn't replace the board's asset-class-based allocation — 60% public equity, 15.8% core fixed income, 13.8% private markets, 8.9% Treasuries and 1.5% cash — but instead gives a clearer picture of what the intent of each asset class is in the overall portfolio, Mr. Perry said. The categories are capital appreciation growth, with an asset range of 50% to 75%; income-oriented growth, 15% to 30%; real return and inflation protection, zero to 10% each; protection, 5% to 20%; and liquidity, zero to 5%.

"The strategic allocation category framework is just a different lens for us to look at the portfolio," Mr. Perry said. "And the purpose of that lens is so we get a better sense of just how risky we believe the portfolio is."

The growth appreciation category contains private and public equities, non-core real estate, and distressed and opportunistic investment. "Those are really more equity-like in nature," Mr. Perry said. Income-oriented growth contains core and other return-seeking fixed income like private credit; real assets are core real estate and assets like energy and timber; inflation protection will include Treasury inflation-protected securities and commodities; and the protection category will contain Treasuries. The liquidity category will comprise only cash.

Investment consultant Aon Hewitt Investment Consulting and Pension Consulting Alliance, the board's specialist investment consultant, assisted in creating the new categories.

The categories are "significantly less complicated than people are thinking," Mr. Perry said. "Right now, I anticipate we would do our asset allocation as we always would and then we would allocate the asset classes to the strategic allocation framework, so that would be kind of a risk lens. A lot of people look at public equities and private equities and say they were diversifiers, and I'm looking at it and saying, well, they're not really diversifiers. They really act in the same way as the same economic regimes. So think about it as just a different way of looking at the portfolio and grouping like-behaving asset classes together. The intent is to have a better understanding from a risk perspective how we have allocated our portfolio."

Looking at its allocations in a simpler manner is also reflected in its investment strategies in alternatives. The performance of MSBI's private markets program, which returned 4.6% for the quarter and 17.7% for the year ended March 31, is basically the result of being "a steady Eddy" and focusing on manager selection, Mr. Perry said.

"We've been very smart, very lucky," Mr. Perry said. "I'd say the key has been very good manager selection. We were just very fortunate. The roster of managers has grown over time ... but the key has been trying to find good managers that we understand, who have demonstrated good performance and consistently good organizational leadership, and continue to do what they've demonstrated they're good at doing."

That theme of simplification also holds true to MSBI's public equity allocation: 77% of domestic investments are managed passively in Russell 1000 and Russell 3000 separate accounts managed by BlackRock (BLK) Inc. (BLK) and 55% of international investments are run in passive developed and emerging markets separate accounts run by State Street Global Advisors. The rest is actively managed.

"We're an extremely large plan," Mr. Perry said. "We've had what I believe to be very good managers. However, my observation is the bigger you get, the more complex your active management program becomes in terms of the number of managers, the style approaches of managers, so you're looking at a lot of managers who unfortunately try to get diversification, and when one's up, the other's down. The larger you get, and this is particularly true with large-cap domestic equity, even good managers cancel one another out. What you end up with in most cases are well-constructed, slightly expensive index funds. It's difficult to give active managers large portfolios from a risk-management standpoint. With passive management, the larger you get, the less expensive it is. I can't control manager performance, but I can control what I pay for it. This is not to say there are no good active managers."

Mr. Perry also said there were benefits to having the assets managed by external firms as opposed to doing passive management in-house.

"My personal preference is to continue to do this externally because I'm able to get it very inexpensively. Whereas if I did this internally, in addition to personnel and infrastructure — and good personnel will exhibit turnover — I am not convinced (internal management) really is as cheap as I currently negotiate. It's scale. I need two passive managers at most, domestic and international. It's not that they're inexpensive, it's just that our scale makes them the least expensive given the size of the fund. For us, they're highly efficient."

Mr. Perry said that what MSBI has done since he became executive director in 2013 is build on the foundation established by Howard Bicker, the retired executive director of the board.

"The changes I've made since replacing Howard have been minor tweaks," Mr. Perry said. "Nothing was broken, so there was nothing to fix. I was extremely fortunate to have Howard Bicker as my predecessor and my mentor. The retirees of Minnesota owe him an enormous amount of gratitude, as do I."