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Benchmark quandary unresolved

Investors make changes to better reflect portfolios

Meketa Investment Group’s Allan Emkin

Benchmarks for assessing the performance of private market assets leave much to be desired, industry insiders said, prompting institutional asset owners to tweak or even overhaul existing benchmarks to better reflect their evolving portfolios.

"Of all of the illiquid markets, the only one with a reasonable benchmark currently is real estate," said Allan Emkin, Los Angeles-based managing principal at Meketa Investment Group Inc.

"Here, (in real estate) there's a large number of open-end commingled funds that offer quarterly liquidity and — because of this — have their assets appraised frequently. There are abundant market comparables for most institutional properties," he said.

Alternative investments are long-lived and for that reason are infrequently bought and sold, which makes them difficult to measure, industry insiders said. Investors do not really know the value of an investment until there is a transaction, they noted.

The benchmark topic has become

more urgent as capital continues to flow into the alternative investment asset classes. Alternative investment assets worldwide under management totaled $5.8 trillion as of June 30, an all-time high, up 12% from $5.2 trillion as of Dec. 31, 2017, and $2.3 billion as of Dec. 31, 2008, according to McKinsey & Co.'s private capital report released in February.

While benchmarking for private equity is improving, it still has a long way to go, Mr. Emkin said. "Private market natural resources and infrastructure benchmarks, in particular, tend to be far less robust."

Appraisals for certain unique assets such as airports are more challenging because they are priced less frequently, so it's harder to know what they're worth, he said.

Making changes

In the past 12 months, a number of asset owners have updated their benchmarks. Some institutional investors are accepting a lower premium over the public markets, others are changing the public market index and several are doing both.

Count the $359.7 billion California Public Employees' Retirement System, Sacramento, the $226.5 billion California State Teachers' Retirement System, West Sacramento, and the $56.6 billion Los Angeles County Employees Retirement Association, Pasadena, Calif., as among the pension funds that have changed some of their benchmarks. And the $26.9 billion Texas Employees Retirement System, Austin, is in the midst of a benchmark overhaul. Pension plan officials expect to bring recommendations to the board at its May meeting, said Sharmila Kassam, deputy CIO of Texas ERS, in an email.

NEPC LLC, the pension plan's investment consultant, is suggesting the board consider switching the private equity benchmark to Wilshire TUCS Peer Universe Benchmark from MSCI ACWI IMI plus 3%, which would change Texas ERS' benchmark to a peer-based index.

"It's very complicated," said Steven Kaplan, the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business. The most difficult decision is the asset allocation mix choice. Then investors turn to questions of how the asset classes are performing, he said.

Mr. Kaplan is the co-creator of the Kaplan-Schoar private market equivalent, which measures private equity performance compared with the S&P 500. Mr. Kaplan also assists and advises investment bank Lincoln International LLC on its Lincoln Middle Market (private equity) index.

Private equity is one of the easiest of the private asset classes asset classes to measure due to public market comparisons, he said.

"If you're not beating public equity, then why are you doing it?" Mr. Kaplan said. Then the decisions come down to which public equity market index to choose, such as the S&P 500 or the Russell 2000 or the Russell 2000 Value.

"On the buyout side, do you want to factor in leverage or not?" he said. On the other hand, it's harder to choose a benchmark for credit because "there is not a lot of data."

For example, should an investor select an equity index because credit investors are likely taking the same risk as stocks or a bond index because investors are getting the same maturities?

CalSTRS has two private equity benchmarks for its $20.1 billion private equity portfolio: one long-term measure for strategic asset allocation and a short-term measure for implementation and compensation. The long-term benchmark is the Russell 3000 plus 300 basis points. The short-term benchmark is a custom State Street Global Exchange Private Equity index, measuring periods of 10 years or less.

LACERA recently changed its private equity benchmark to a global public equity benchmark plus 200 basis points from a U.S. benchmark with a higher premium, said CIO Jonathan Grabel.

"We believe this steers us to invest in the context of our portfolio as a whole, identify global opportunities and not to take excessive risk in the process," he said.

Goals matter

The best portfolio-level index is the one that aligns most closely with the goal of the portfolio, said TC Rolfstad, a vice president on the real assets team at alternative investment money manager and consultant Hamilton Lane Inc.

"In certain areas (of real assets) it is well-defined, with industry-accepted indexes and methodologies, while elsewhere the industry is striving to catch up as new investment options crop up and plan sponsors evolve their portfolio structures and objectives," said Mr. Rolfstad, who is based in Portland, Ore.

On March 28, for instance, CalSTRS modified its inflation-sensitive asset class benchmark to include the implementation of timber, agriculture and U.S. Treasury inflation-protected strategies. LACERA recently adopted new benchmarks for credit and real assets due to asset allocation changes.

"As long as there is more than one fund in a category, there is some data to analyze performance on a relative basis. Obviously, the larger the data set, the more meaningful the analysis," Mr. Rolfstad said.

While benchmarks for infrastructure credit and infrastructure equity "are thin," Mr. Rolfstad said that the industry is evolving. Real asset managers are starting to understand the value of sharing data, which will improve benchmarks, he said.

Benchmarking private infrastructure as well as real estate held in closed-end funds has been a challenge due to the lack of transparency, said John Vojticek, Chicago-based head and chief investment officer of liquid real assets and co-head of equities in the U.S. at DWS Group.

DWS recently launched a family of infrastructure debt indexes in collaboration with IHS Markit on the development of the Markit iBoxx infrastructure debt indexes. A subset of the iBoxx corporate debt indexes, they track listed infrastructure corporate bonds, excluding project bonds and private loans due to limited data availability and market size.

There is not an equivalent for the NCREIF Open-End Diversified Core Equity index — a capitalization-weighted, gross of fee, time-weighted return index for real estate — for infrastructure, said Mark Roberts, New York-based head of research and strategy for alternatives and head of multiassets in the Americas for DWS. "I have index envy over what is available in the listed markets … The listed markets are way ahead of measuring performance."

"There is not a lot of good data and history" in closed-end infrastructure as well as real estate funds, he said. Even in real estate, the benchmark world is evolving. On April 3, European real estate trade group INREV, the European Association for Investors in Non-Listed Real Estate, released the INREV European Open End Diversified Core Equity Fund index.

"U.S. clients are very interested in that (new index)," Mr. Roberts said. "It's a major event."

Investors' real estate portfolios are global and the new index "expands the market basket," he said.

Before the new INREV index was released, investors could not get vacancy rates of certain property sectors in Europe, he said. Markets were informed by the prime survey of rents and yields of the top 5% of buildings in key locations in certain cities, Mr. Roberts explained.

Credit concerns

Aside from the leverage issue, private credit encompasses many strategies from senior loans and junior loans to investments holding companies in a variety geographies and investment sizes, industry executives say. These investments also vary in the amount of risk investors are taking. But most investors use a single benchmark for the asset class, they say.

The best way to measure credit performance is to look at the investment's default and loss history, said David Brackett, the New York-based co-CEO and senior managing partner of credit manager Antares Capital LP. The firm is owned by the C$368.5 billion ($276 billion) Canada Pension Plan Investment Board, Toronto.

Many asset owners use a benchmark that adds a premium to the public markets. For example, LACERA's illiquid credit benchmark is the Barclays Bloomberg U.S. Aggregate plus 250 basis points annualized.

Private credit has been considered an asset class by investors for only five or six years, said Theodore L. Koenig, Chicago-based president and CEO of credit manager Monroe Capital LLC.

"Before that we were a J-curve mitigant for private equity," Mr. Koenig said while speaking at a panel at the Pension Bridge Annual conference in San Francisco.

Benchmarks continue to be a 300-basis-point to 400-basis-point premium over high yield, bank loans and Bloomberg Barclays aggregate indexes, he said in an interview. These benchmarks are designed to roughly estimate asset returns, he added.

"There are no good indexes today," Mr. Koenig said. "More work has to be done."

Peter E. Ehret, director of internal credit and high-yield portfolio manager at the Texas Employees Retirement System, said that benchmarking private credit is a "tough topic."

Texas Employees officials look at the high-yield index, he said speaking on the panel with Mr. Koenig.

"It's not perfect," he acknowledged but it's a well-developed index with a lot of information.

Another panel participant, Greg Lippmann, partner and CIO of credit manager Libremax Capital LLC, said that trying to invest to a target return could cause managers to make investments they might not otherwise make because the manager is trying to hit the benchmark.

"We are aware of a variety of metrics ... Trying to track them makes you a closet indexer," Mr. Lippmann said. "How you invest increases risk or mitigates risk."