CalSTRS preps risk-mitigation portfolio

CalSTRS will move a $16 billion portion of its investment portfolio into a new risk mitigating strategies portfolio and is interviewing 25 managers in coming months to select which firms will manage it.

The move by the $178.7 billion California State Teachers' Retirement System is part of what is expected to be a three-year transition to reduce the impact of another economic downturn by shifting money away from some equity and fixed-income holdings. Instead, CalSTRS will move 9% of its portfolio into hedge funds, other complex hedge-fund-like investments and long-duration U.S. Treasuries.

The trade-off for restructuring the overall portfolio should be downside protection — lessening portfolio losses in years the equity markets are down — but also giving up top-tier performance in years when markets are way up, said Christopher J. Ailman, chief investment officer of the West Sacramento-based pension fund, in an interview.

“It's the recognition that if you want to reduce the drawdown in your negative years you are not going to be able to receive the top-side extreme maximums”, Mr. Ailman said. “What we're trying to do with RMS (the risk mitigating strategies portfolio) is dampen the entire volatility. What happens is, when you lose less money in negative markets, and the market begins to rebound, you're rebounding with a bigger pool of capital.”

CalSTRS, like many of its public pension fund counterparts throughout the U.S., saw massive losses in 2008 and 2009. CalSTRS itself saw its assets decline by around a quarter in the fiscal year ended June 30, 2009.

The retirement system's funding level is 68.5%. CalSTRS was scheduled to run out of money to pay retirees by the mid-2040s before the state Legislature and the governor agreed to a package in 2014 that increased contributions from school districts, the state and teachers.

But that plan to reach full funding is dependent on CalSTRS meeting its annual expected rate of return of 7.5%, a goal that pension fund officials say can still be met but with less volatility under the RMS approach.

Critics have said a 5% expected rate of return is more realistic long term.

The pension fund earned a 4.8% return for the fiscal year ended June 30, but had an annualized 7.8% for the 20-year period ended June 30.

CalSTRS said in a November report that it back-tested its RMS strategy looking at the 20 worst months for the S&P 500 in the past 21 years. It said the average S&P return during those months was -8.6% while the RMS portfolio generated an average positive return of 2.98%

Under the RMS plan, the retirement system will reduce equities to 47% from 51% of the total portfolio and fixed income, to 15% from 17%. The $16 billion risk mitigating strategies portfolio would consist of 35% long-duration U.S. Treasuries, 40% trend-following strategies, 15% global macro hedge funds and 10% systematic risk-premium strategies.

Mr. Ailman said CalSTRS will be placing its money in separate or managed accounts as part of a plan to get substantial fee reductions.

CalSTRS certainly isn't the only pension system looking to reduce the impact of another downturn using various volatility management strategies.

A report by Lyxor Asset Management, CalSTRS' hedge fund consultant, found that around the world, large public pension funds were very active in global macro and trend-following investments in 2015.

The report found that last year:

nin Sweden, the $35.8 billion AP3, Stockholm, allocated $1 billion to global macro strategies for the first time;

nKorea Post Savings, Seoul, with $60 billion in assets, has been looking for global macro and market-neutral strategies and issued two RFPs, with a target allocation of $1 billion;

nthe $42.3 billion Teachers' Retirement System of the State of Illinois, Springfield, invested $588 million in global macro and managed futures strategies;

nthe $8.7 billion School Employees Retirement System of Ohio, Columbus, hired William Blair & Co. to run a $50 million global macro strategy and the $9 billion Municipal Employees' Retirement System of Michigan, Lansing, invested $300 million to run a similar allocation; and

nthe $27.7 billion Iowa Public Employees' Retirement System, Des Moines, issued an RFP in August to select a managed account platform provider to build an allocation to trend-following and global macro funds.

What makes the CalSTRS' approach different is that it is bundling four different approaches in its RMS portfolio, each of which would act as an insurance policy for the others, ione of the strategies doesn't work, Mr. Ailman said.

Two smaller pension funds are using a bundled approach, and committing even more to it than CalSTRS plans to allocate. The $14 billion Employees' Retirement System of the State of Hawaii, Honolulu, and the $2.6 billion San Joaquin County Employees' Retirement System, Stockton, Calif., each are moving 20% of their total assets into new crisis risk offset strategic portfolios.

The three pension funds have the same general consultant, Pension Consulting Alliance, Portland, Ore., which has been pushing the bundled risk mitigation approach.

PCA Managing Director Neil Rue said bundling alternative strategies as part of a risk-offset strategy offers a dynamic approach, but one that plan executives have to manage proactively.

“All the individual components can be quite volatile,” Mr. Rue said. “It's not like buying an index fund and putting it on autopilot.”

Vijoy Chattergy, CIO for the Hawaii Employees' Retirement System, said the pension fund plans to move 10% of total assets into the new portfolio by the end of 2016 and 20% by 2020.

Mr. Chattergy said the aim is to reduce equity exposure from around 64% of the portfolio to 45%, investing the money instead in long-duration bonds, systematic trend followers and systematic alternative risk premiums that can help reduce the impact of an equity downturn.

“We do believe the world periodically experiences financial crises,” Mr. Chattergy said.

The San Joaquin County Employees' Retirement System approved a 20% allocation to its crisis offset risk portfolio in October, composed of long-duration Treasuries; systematic trend-following and alternative risk-premium strategies, documents on its website show.

The purpose of this new (crisis risk offset) class is to provide significant return during a growth crisis using liquid instruments available at scale for reasonable cost,” said plan CEO Annette St. Urbain.

But CalSTRS' $16 billion move dwarfs other pension funds.

Mr. Ailman also sees the RMS portfolio becoming bigger over time if it proves successful in reducing volatility in lean years. He said the portfolio could be increased to 12% of CalSTRS' total assets once the initial three-year period is over.

The new strategy comes with some risk. A February report from the pension fund's investment staff noted that trend followers generally benefit as markets become severely stressed following a financial crisis, but the strategy will suffer if a mild market correction does not extend and markets quickly reverse course.

Systematic risk-premium strategies should add uncorrelated value when markets are stable and after mild market corrections, the report said.

But it noted that while the thesis is supported by academic research, live strategies have been developed only recently and have no long-term track records.

The biggest risk might be staying with the strategy in good equity markets. The report said that based on capital markets assumptions, U.S. equities are expected to outperform risk-mitigating strategies over a five-year period by about 2.8 percentage points annually on average and by 9 percentage points or more about 25% of the time over the next two decades.

CalSTRS isn't entirely new to the approach; it has been test-driving a combined $1.8 billion portfolio composed of global macro funds since late 2011 and trend-following strategies since 2014.

CalSTRS data show that its portfolio of global macro funds and trend following had a 5.4% rate of return between Jan. 1, 2014, and Feb. 29, 2016, a period when the S&P 500 was down 3%.

Mr. Ailman said existing managers will get larger amounts of money as part of the RMS allocation before the retirement system hires new managers. But the current managers will need to give the pension fund lower fees, he said.

“We are putting on the boxing gloves, we're going to renegotiate some of those fees,” he said. n