VRS starts 'experiment' with strategic alliances

The $65.2 billion Virginia Retirement System, Richmond, is ready to join the growing ranks of public pension funds creating strategic alliances with external investment managers.

Officials on Nov. 20 announced the first managers for what Chief Investment Officer Ronald Schmitz is calling “the grand experiment,” its new strategic opportunity program. The program has two pieces: one, an innovation fund oriented more toward public markets and another for private investment partnerships.

Funding will come from taking 3% from each of the pension fund's six asset classes.

For the public markets segment, VRS committed $200 million to AQR Capital Management LLC for a multistrategy hedge fund; $151 million to Bridgewater Associates' Pure Alpha II global hedge fund; and $77 million to Bridgewater's All Weather global risk parity fund.

Meanwhile, one private manager is ready to go and another is in the pipeline, he said.

Mr. Schmitz, who is celebrating his third anniversary at VRS, planted the seeds for the program shortly after arriving, thanks to his comfort with the concept since his days as CIO of the $68.2 billion Oregon Public Employees Retirement Fund, Salem, from 2003 to late 2011.

The concept was approved by the Virginia Retirement System's investment advisory committee and board of trustees in 2012, and the board has since set the risk and return parameters.

“The idea of strategic partnerships is increasingly common, especially among the largest public plans,” said Timothy F. McCusker, chief investment officer of NEPC LLC in Cambridge, Mass. NEPC is not the pension fund's consultant, but Mr. McCusker has experience working with pension funds setting up strategic partnerships.

“They are using it as a way to get more efficiencies. They're paying these managers an awful lot of money, so they are looking to get as much as they can from them. Some are trying to get information and build capabilities (in-house). Some strategic partnerships are more about getting tactical insights.”

For Virginia, it is about insight and flexibility.

In the private markets, “the attraction is a chance for us to be a little bit more nimble. It gives us multidisciplinary views of things,” Mr. Schmitz said. He also expects it to lead to lower investment management fees and related costs.

The innovation fund “is just different ways of looking at risk” and different ways to manage stocks and bonds, Mr. Schmitz said.

Starting with small accounts has made it challenging to keep manager fees under the desired level, but he expects fees to drop down the line.

The new strategic opportunityprogram will increase the number of external managers at first, “but if (it) is successful, over time, it may well reduce the number of managers,” he said.

For the private partnerships, Virginia is hoping to hire one or two firms that Mr. Shcmitz said will function like general partners, with approaches that cut across multiple asset classes, such as private equity or private credit, and that preferably are global in nature. The idea is to use a single account where managers do not have to constantly return for new commitments. By committing to an evergreen capital concept, “the GP has the mandate to just go anywhere” and fees can be lower, said Mr. Schmitz.

He anticipates giving the program three years to prove the concept, and another four or more years for realized results. That makes sense for a public pension fund, “where you are really looking at five to six years or longer,” he said.

For now, the only internal change is expanding the mandate of an internal research team that so far has supported other asset classes but now will directly manage an actual portfolio and fund. If the strategic opportunity program grows dramatically, staffers are likely to come from the other asset classes, he said.

The new approach will allow VRS officials to relax risk parameters by giving managers a benchmark that allows them flexibility, but is constrained as to volatility.

By not constraining asset class exposures, “managers may vary asset allocation pretty dramatically,” said Mr. Schmitz. For example, a manager can double-weight an asset class while half-weighting or even zero-weighting another, as long as the total volatility is within the benchmark volatility. Managers could also use less risk in portfolio construction along with some leverage to reach a targeted volatility within the benchmark constraint.

Mr. Schmitz sees his “grand experiment” as a natural progression toward more real estate and private exposure —which VRS began in 2012 — and the in-house investment team's tendency to look at portfolios more broadly than investment staffs at many other public funds do.

The current asset allocation is 42% public equity, 12% private equity, 15% traditional fixed income, 15% public and private credit strategies, 15% real estate and 1% cash.

The opportunity fund approach worked well for Oregon, which allowed fund officials to get a toe in the water in areas new to the fund at the time — including real assets like energy and timber — and to learn more about the timing of markets. After several years, real assets became a star performer and its own strategic asset class for Oregon.

Public funds that have taken this approach include the South Carolina Retirement System Investment Commission, Columbia, which handles investments for the $29.9 billion South Carolina Public Employee Benefit Authority, and the $130.2 billion Teacher Retirement System of Texas.

This year marked the sixth anniversary of TRS' public strategic partnership program. Launched with $1 billion for each of four managers — J.P. Morgan Asset Management, Neuberger Berman, Morgan Stanley Investment Management and BlackRock Inc. — to invest globally across asset classes, today it is valued at $6.5 billion. The program was expanded to private markets in 2011, with Apollo Global Management and KKR & Co. managing private equity, real assets and credit market assets now valued at $1.8 billion. “These partnerships remain in their early stages, but are already proving beneficial,” said spokesman Howard Goldman.

The approach can prove controversial until results come in, and there is a learning curve for all parties. “Investors need to be realistic about what decisions they can make vs. delegate to the manager, and what they have to run by the board,” said Mr. McCusker of NEPC.