CalSTRS preps for downturn with risk mitigation strategy

CalSTRS is nearing the end of a three-year process of investing 9% of its portfolio into a risk mitigation strategy aimed at protecting the plan in the event of another sustained stock market decline.

But pension fund officials won't know whether their bet will pay off until there is a long bear market. In the meantime, the pension plan is staying the course during a time when equities have handily outperformed components of the plan: U.S. Treasury bonds and trend-following strategies.

Investing about $20 billion of its $219.2 billion portfolio in the strategy hasn't won the West Sacramento-based California State Teachers' Retirement System any popularity contests, said Chief Investment Officer Christopher J. Ailman.

"Peers criticize it," Mr. Ailman said. "They don't think it will work."

The idea came out of the global financial crisis, he said.

"In 2008, almost everything moved together. Fixed income, U.S. Treasuries and cash were the only things with positive returns," Mr. Ailman said. "So the innovations team dived into what could diversify the plan. The seeds gave us the risk mitigation strategies that complement the diversity of the plan."

Beginning in 2010, CalSTRS' innovations team began studying various strategies to mitigate risk in the event of a deep recession.

"Everyone has been and remain worried about interest rates going up. That's not a positive for long Treasuries," explained Neil Rue, Portland-based managing director of general consultant Pension Consulting Alliance LLC, one of CalSTRS' general investment consultants who helped develop the concept.

What's more, U.S. Treasuries can experience short-term unrealized losses in a growing economy, especially when there are investor fears of rising inflation, he said.

"That has put general pressure on the implementation of risk mitigation strategies that utilize long Treasuries," he said. "Longer-term Treasuries can fluctuate dramatically while investors are waiting for `flight to quality' to happen."

CalSTRS' risk mitigating strategy earned 0.19% net return for the five years ended June 30, compared to its benchmark of -0.94%. It earned -2.92% for the three year-period and 1.78% for the one year period, compared to benchmarks of -2.54% and 1.73%, respectively.

CalSTRS and a handful of other asset owners that are employing the strategy are combining U.S. Treasuries with other strategies such as trend-following and alternative risk premium or alternative risk capture in a single portfolio, he explained.

CalSTRS' strategy uses hedge funds and other complex hedge fund-type investments, but each asset owner has taken a different approach, said Allan Emkin, Los Angeles-based managing director of PCA. Even the name of the strategy varies from risk mitigation to crisis risk offset to simply risk offset.

"No two (asset owners) have done it the same way," Mr. Emkin said. "There's no formula here. The key is to recognize why you're doing it."

"It's not an asset class," he added. "It's a strategy that will offset losses during a prolonged bear market."

However, investors that choose to employ the strategy need to invest enough of their portfolio to work as an offset, Mr. Emkin said.

"If you are not going to do at least 6% or 7%, it's probably not worth it," he said.

CalSTRS' decision to target 9% of its portfolio came after a series of conversations, Mr. Emkin said. But the pension plan's allocation to the strategy is far from the largest one.

For example, $16.5 billion Hawaii Employees' Retirement System, Honolulu, and the $2.9 billion San Joaquin County Employees' Retirement Association, Stockton, Calif., have long-term target allocations of 20% to their crisis offset programs.

Most asset owners ramp up their allocations slowly.

"Several of our clients start with an initial target allocation of 10% and are moving to a longer-term 20% allocation over time," he said. "A normal course of planning is to review the efficacy of a risk mitigating strategy during an asset-liability study, regardless of whether the strategy is relatively new or somewhat mature."

Hawaii started with a 10% allocation when it launched the program on April 1, 2017 and moved to 20% as of June 30, according to investment reports. In 2019, Hawaii officials plan to launch an asset-liability study.

CalSTRS' version of the strategy differs from most in that its risk mitigation strategy also includes global macro. Global macro can pick up uncorrelated returns from market movement that the other components of the risk mitigating strategy may miss.

CalSTRS' target weights of each component of its risk mitigation strategy are 40% long-duration U.S. Treasuries, 45% trend-following, 10% global macro and 5% systematic risk premium, according to CalSTRS' most recent risk mitigating strategy report. As of June 30, the $20 billion portfolio had $9.2 billion in U.S. long Treasuries, $8.4 billion in trend-following, $2.4 global macro and zero in systematic risk premium. However, CalSTRS is expected to hire two systematic risk premium managers this year, most likely in closed session.

The strategy reached its 9% target allocation in the first quarter of 2018 with an additional $2.5 billion investment, with half of it to Treasuries.

This fiscal year is the first in which all five of its clients using the strategy had their programs in place for a full year, Mr. Rue said. He declined to name the other clients other than to say that PCA clients with credit risk offset/risk mitigating strategies investments ranged from about $350 million to about $20 billion.

Fiscal-year 2018 was a "pretty good risk-on market. Investors were rewarded for taking risk in that market and we would not expect (a risk mitigation strategy) or (crisis risk offset) to perform very well during such a benign, low-volatility market environment," Mr. Rue said. "We'd be satisfied with this strategy during such an environment if it is able to maintain its purchasing power (i.e., grow with inflation) and/or protect its principal."

Investors with the strategy could consider it a success if they made a little bit on their initial investment during such benign environments, he added.

"It's important to remember that this is a protection class that is geared largely toward protection during extended tough times for risk-taking investments," Mr. Rue said.

Mr. Ailman likens the portfolio to an insurance policy.

"In life, you buy car and house insurance to protect yourself," Mr. Ailman said. The risk mitigation strategy is to "protect ourselves against left-hand tail events."

PCA found that on average all five client portfolios performed in-line with expectations.

All five of the portfolios matched or outperformed the Bloomberg Barclays US Aggregate Bond Index in the year ended June 30. Four of the five client portfolios earned positive returns, averaging 1.8%.

"It's not going to outperform equities every year … It's a protection class that waits around for the tough times."