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Pension Funds

CalSTRS posts 9% fiscal-year gain, working toward private equity portfolio changes

Pension fund will also initiate study on whether to stay invested with private prison companies.

CalSTRS posted a net return of 9% for the fiscal year ended June 30, outperforming its benchmark return of 8.6%, said Christopher Ailman, chief investment officer, at the pension plan's investment committee meeting on July 20.

The $223.8 billion pension plan outperformed its benchmark for the three-, five- and 10-year periods, earning a 7.8% annualized return for the three years, 9.1% for five years, 6.3% for 10 years and 6.5% for the 20 years ended June 30. By comparison, the benchmark returns were 7.7% for the three years, 9.3% for the five years, 7.15% for 10 years and 6.5% for the 20 years. CalSTRS earned a 13.4% net return for fiscal year 2017.

The asset class with the highest return for the fiscal year was private equity, earning 13.8%, although it underperformed its 14.7% benchmark return. The next highest returning asset class was global equities at 11.7%, slightly underperforming its 11.8% benchmark.

Innovative strategies earned 11.4%, outperforming its 6.5% benchmark; real estate returned 10.4%, vs. its 7.1% benchmark; inflation sensitive produced 8.5%, compared to its 4.5% benchmark; risk-mitigating strategies earned a 1.8% return vs. its 1.7% benchmark; and fixed income returned 0.3%, outperforming its -0.2% benchmark.

The risk-mitigating asset class was established in 2016 to protect against equity market downturns and includes long-duration U.S. Treasuries, trend following, global macro and systematic risk premiums.

CalSTRS' actual asset allocation as of April 30, the most recent data available, was 53.7% global equities, 12.3% real estate, 12.2% fixed income, 8.9% risk-mitigating strategies, 8% private equity, 2.9% cash and 1.9% inflation-sensitive.

Mr. Ailman also discussed the 10-year business plan, which he called a "road map" for the pension plan that could approach $400 billion in assets in 10 years. The business plan expects lower returns because assets are expensive these days, but also lower costs in the future, in part, as a result on CalSTRS' becoming less reliant on external managers, he said.

The California State Teachers' Retirement System, West Sacramento, is in the midst of studying how it can use a collaborative approach to investing including making direct investments either alone or together with other asset owners in each of its asset classes. Projected lower costs is consistent with the collaborative model, Mr. Ailman said.

Staff expects to return to the investment committee in September with a recommendation regarding the collaborative model and how pension officials can implement the approach.

Among the challenges reflected in the road map is hiring talent, Mr. Ailman noted. Hiring investment executives, motivating them and retaining them as they move up the ladder is part of what Mr. Ailman said he considers CalSTRS' succession planning. The 10-year plan across asset classes includes training junior staff for relationship transfer and succession planning.

Still, Mr. Ailman noted that "it is more and more a challenge to recruit."

In private equity, for example, CalSTRS has been looking to hire investment professionals with more transaction experience, said Margot Wirth, director of private equity, at the July 20 investment committee meeting. The private equity team has been "drifting toward" hiring more deal-focused professionals but that should accelerate as CalSTRS moves toward the collaborative model, she said.

Currently, 93% of CalSTRS' $18.2 billion private equity portfolio as of March 31 was invested with external managers, with the remaining 7% internally managed, Ms. Wirth said.

She said that it would "not be overly ambitious" to expect that 20% of the portfolio could be internally managed in co-investments in three years.

As part of its fiscal year 2019 business plan, CalSTRS' private equity team expects to work to establish joint ventures with other like-minded and complementary investors as well as to consider investing in money managers "when strategic for the program."

Also at the meeting, the investment committee got a first look at a revised private equity investment policy statement in which it would establish a subasset interim target allocation of 2% and a long-term target of 4% of the private equity portfolio for what it is now calling a multistrategy subasset class. (Interim targets are allocations expect to be achieved in 12 months to 36 months.) Last fiscal year, CalSTRS transferred the strategy it had then called tactical opportunities to the private equity portfolio from its innovations portfolio, where the strategy had been incubated. The new subasset class currently consists of 1.2% of the private equity portfolio but staff believes that some existing investments might logically reside in this subasset class, according to a staff report to the investment committee.

In addition to adding the new allocation, CalSTRS would increase its interim target to buyouts by 3 percentage points to 69% within the private equity portfolio, while retaining a 69% long-term target to buyouts, and trim the interim allocation to debt-related strategies by 5 percentage points to 10%. CalSTRS' long-term target allocation to debt-related strategies is dropping to 11% from 15%. The interim and long-term targets will not change for venture capital (10% and 7%, respectively,) longer-term strategies (2% and 5%) and special situations (7% and 4%).

The new private equity investment policy would reorganize its two main categories — traditional and opportunistic — by moving longer-term strategies (formerly "core private equity") and special mandates to opportunistic from traditional. The traditional category would then consist of buyouts, venture capital and debt-related investments. Opportunistic would consist of longer-term strategies, special mandates and the new multistrategy subasset class. The revised private equity investment policy would also allow staff to make co-investments alongside all of CalSTRS' general partners across asset classes, not only private equity general partners.

Staff is expected to bring the private equity investment policy statement back to the investment committee for adoption in September.

Mr. Ailman noted that longer-term strategies, which include investing in longer-dated funds that can last 20 years, is at the early stages with a lot of managers "stepping in" to the strategy. He added that private equity is undergoing "big changes." He mentioned that CalPERS is considering creating a separate entity to make direct private equity investments.

"I don't think you would … replicate that but good luck to them," Mr. Ailman said. "That's my pension plan."

Separately, Mr. Ailman said that he was starting a study of whether to keep investments in private prisons because they are posing an increased risk to CalSTRS' portfolio. The new risk factors are in respect to violations of human rights by private prisons that are now being used to house immigrants and children of immigrants who have separated from their parents. CalSTRS staff have already been speaking to company executives but this process increases resources to staff. CalSTRS has $120 million invested in three private prison companies: CoreCivic Inc., General Dynamics Corp. and GEO Group Inc.

Mr. Ailman noted the University of California Regents has already divested from private prison investments. The UC's investment office oversees the Berkeley-based university system's $66.7 billion pension fund and $11.9 billion endowment.

A spokeswoman for UC said that university sold some $25 million worth of indirect holdings in private prison companies in 2015. "As part of a comprehensive evaluation process for investments, UC assessed that these holdings were not a good long-term investment," she said in an email.

During public comment, a large number of CalSTRS' members asked the investment committee to divest from its private prison investments. Douglas Orr, a retired professor of economics and social sciences at City College of San Francisco, speaking on behalf of the American Federation of Teachers, suggested that CalSTRS collaborate with other asset owners to pressure private prison companies to discontinue its contracts to house immigrants and immigrant children with the federal government. California Federation of Teachers is also pressing the idea with CalSTRS and the $357.3 billion California Public Employees Retirement System, Sacramento, said Tristan Brown, legislative representative in the union's Sacramento office.

In other actions, CalSTRS' board on July 19 approved a compensation committee recommendation setting the incentive criteria for a new position of director of investment strategy and risk. The new director would implement and monitor the overall investment portfolio's strategy and risk profile. During the board meeting, Mr. Ailman also noted as CalSTRS develops its collaborative model, the new director would make connections with other asset owners.