Oregon investment success turns into complex problem

Oregon Investment Council was a victim of its investment success.

The council's investment portfolio had grown so rapidly and become so complex that operational and risk management problems put its long-term investment track record in jeopardy.

Now, it is boosting its compliance and risk management systems to better manage its portfolio — and maintain its top-quartile investment track record. Council officials also changed how the investment staff was organized.

The Tigard-based council, which runs the $68.1 billion Salem-based Oregon Public Employees Retirement Fund, hit roadblocks starting in 2011 when an Oregon State Treasury review revealed Oregon's returns could drop because the council lacked the necessary personnel, technology, procedures and risk management to support continued strong performance. Those findings were echoed in a subsequent 2014 review by an outside consultant.

In fact, one consultant that participated in the study for the Oregon State Treasury gave the council's abilities strictly as an asset manager a “would not recommend” rating.

Despite those issues, Oregon Public Employees Retirement Fund's portfolio has performed well. For the year ended Dec. 31, the pension fund earned 2.38%, beating its policy benchmark of 1.57% and placing it in the fifth percentile of the Wilshire Trust Universe Comparison Service of public pension funds with $1 billion or more in assets, according to a year-end 2015 performance report. The pension fund's annualized 9.15% return for the five years and 7.17% return for the 10 years, also ended Dec. 31, also ranked it in the fifth percentile.

But the reviews hit the mark. Council executives hired BlackRock Solutions in 2014 to provide the software and services needed to improve compliance and risk management functions, said John D. Skjervem, chief investment officer, in an interview.

The council also added new positions to help it keep track of its growing portfolio. They include a director of investment operations, a general counsel and chief compliance officer, new audit staff and a corporate governance officer.

And council officials are not done. With the installation of the new systems, they plan in a year or so to bring more of its passively managed equity and debt strategies in-house.

Some $6 billion, about 9% of the pension assets, are managed internally now, compared with $62.1 billion externally managed assets. Including short-term and other non-pension plan assets, the council manages $21.9 billion internally, leaving $67.7 billion managed by outside money managers, said James Sinks, council spokesman, in an e-mail.

Council officials also plan to seek additional funding from the state Legislature to add more investment staff members, Mr. Skjervem said.

The systems upgrade already is having a big impact on the council's ability to maintain the quality of its investment portfolio.

“It's not evident from the outside looking in, ... but it has been nothing short of a complete transformation,” Mr. Skjervem said.

The structural problems added a high degree of risk to the Oregon's investment program, he noted. The operating system was not automated, but required manual inputs from staff.

“We were running internal mandates that required lots of manual intervention, leaving us open to operating errors and compliance risks,” he said.

What's more, the council's most-experienced investment staff routinely had to devote afternoons to tracking down errant trade details, a task that should be performed by middle-office workers.

The need for updated systems has been increasing as the Oregon Investment Council added multiple alternative investment asset classes to its portfolio.

“We've been a private equity investor since 1981,” Mr. Skjervem said. “It's been an important ingredient of our success and has driven our top returns.”

But more recent alternatives additions have greatly increased the portfolio's complexity, he said, and the internal infrastructure and staffing was insufficient to support its overall portfolio.

For example, Oregon has a relatively new 12.5% “alternative” allocation that excludes private equity and real estate but includes infrastructure, minerals and mining, agriculture and timber. Currently, the portfolio has 1.4% invested in that alternative allocation, which means it expects to invest $6 billion more to get to its target, Mr. Skjervem said.

The remainder of the pension fund's strategic target asset allocation is 18.8% domestic equity, 18.8% international equity, 20% fixed income, 17.5% private equity and 12.5% alternatives.

The council was running a first-class investment program with small investment and had back-office staffs armed with rotary phones, he said. There are just two investment executives —of the total investment staff of 16 — in charge of the alternative allocation, he added.

Oregon's compliance and risk management programs were noted as deficient in both external consulting and internal auditor reports.

The increase in the size and complexity of the council's portfolio combined with its outdated operations and risk management process threatened the portfolio's performance, according to a 2014 report to the council by external consulting firm Cutter Consulting.

Indeed, the 2014 Cutter report called the investment division's operating system and technology “antiquated.” A year later, the council got the Legislature's approval to spend money for an updated operations and risk management system, BlackRock Solutions' Aladdin software.

Once staff is fully acquainted with the new operating and risk management systems, the council plans to bring more of its passively managed equity and fixed income portfolio in-house, he said.

“We have a strongly held belief that we have no business competing in skill-based (investment) mandates,” he said. “That's like bringing a knife to a gun fight.”

However, investment staff could manage more of its plain-vanilla, long-only strategies such as international indexed equities or long-duration, high-quality bonds, he said.

Oregon is not alone.

Many institutional investors have operations and risk management systems that were built for fairly straightforward fixed-income strategies, said Ivan Matviak, executive vice president and head of the Americas in the Boston office of State Street Global Exchange, the bank's data management and analytics division. The council is not a client of State Street Global Exchange. The old systems can't handle more complex portfolios that include such alternative investments as hedge funds, hedge fund of funds and private credit.

Expanding into alternative investments presents a number of challenges, Mr. Matviak said. They include collecting the data on investment holdings, which can be tricky especially from hedge funds and funds of funds; aggregating data from multiple sources to make sure the institutional investor knows if the same security is owned by more than one manager; and valuing holdings, especially with private equity and other private alternatives where there the investments are not valued daily.

Like Oregon Investment Council, a number of asset owners are bringing more investment management in-house, he said.

“There's a general trend across the board to bring some (investment) management in-house,” Mr. Matviak said. And it's not always plain-vanilla strategies. “Some clients are going very far in this direction and have in-house quant desks,” he said.

At Oregon Investment Council, the changes were not limited to new technology and a larger back-office staff.

Council officials also changed how the investment division was organized, Mr. Skjervem said.

In the past, the investment staff was divided between offices in Tigard and Salem. Now, everyone is in Tigard. Also, they were organized by asset class.

“It was very silo based,” he said. “It worked in the sense that performance continued to be good but it impeded discussions at the total portfolio level.”

It was more difficult to have discussions on topics like the best place in the portfolio to take equity risk, he said.

“We had a lot of equity risk embedded in our fixed-income portfolio in bank loans,” Mr. Skjervem explained. “Our conversations are moving beyond where to get the most attractive ex ante returns to conversations about where to play offense and where to play defense” in the portfolio.