To mark its 50th anniversary this year, Pensions & Investments sought out pre-eminent investor Christopher Ailman, CIO of the $316.7 billion California State Teachers' Retirement System, West Sacramento, for his thoughts on the energy transition, the outlook for private markets and navigating through the pandemic.
Questions and answers have been edited for style, conciseness and clarity.
A: Congratulations on 50 years, and I have to admit, I've been reading it almost that long!
When I look forward right now, there are some startling challenges in front of us. First and foremost, I really have focused my attention on this massive energy transition we have to undertake, not just in the USA, but absolutely around the world. We have used oil to function as our electricity, our mobility, we've used it in agriculture — you name it. We've got to change that and radically change that going forward, and that's going to be massive, and obviously along with that comes the variable weather that we're going to continue to see.
What we've seen in the last two years is just the precursor, kind of like the Hollywood quick film, but it's not the really scary stuff. The really scary stuff is coming up. Obviously we've got massive political issues, geopolitical issues that CIOs are facing now that they haven't seen since the Cold War, as well as political issues within our country.I don't recall our country being so divided in the last almost 150 years, and that's sad, but we've got to find leadership and work through it. So there are a number of big, huge challenges that are in front of us ... but like with any mega trend, it's timing that trend and timing that wave. That's really a challenge.
A: I really hope that we'll expand our language and get away from simple initials because to me, and I have said this numerous times, I'll say it again, E, S and G — environmental, social and governance — really just encapsulate long-term business risks.
When I talk to CEOs, they don't use those initials either, but when we talk about employee turnover or recruitment and retention of employees, they absolutely pay attention to that.
If you're an industry that has wastewater or physical waste, they talk about pollution, they talk about waste control, they talk about minimizing waste, and they, again, usually hire consultants and their board gets reports on that. Well, that's an E issue and certainly almost any company, when you talk to them about their energy supplies and where they get their electricity and how valuable and important it is or where they get their water and how consistent and clean that is, it's hugely critical to them.
CEOs are very focused on that. If you talk to credit managers, they pay attention to these long-term risks. Even private equity absolutely pays attention to these long-term business risks that can ruin a brand, destroy company goodwill and an image.I can categorize them as E, S and G issues, but I think we have to get rid of that. Larry Fink says he doesn't even want to use those letters anymore. Really think of it as long-term business risks and recognize it's absolutely an investment issue. It's part of our fiduciary duty as long-term investors. I'm investing for 30 to 40 years, so I want to consider these. I want companies to consider these and think of these so that they don't have catastrophic events that ruin their shareholder value.
A: I think engagement is absolutely the key. I have been very vocal that divestment is nothing more than an investment decision to sell a stock. Just because I sell a stock doesn't put that company out of business, doesn't stop people from doing things.
Currently, now, obviously we're seeing lots of pressure to divest of fossil fuels. If I divest, does that mean I don't drive my car? I'm thankful I have an electric car, but still, part of that electricity is coming, even in California, from fossil fuels. So the reality is, it's part of our life. We need to engage, we need to change behavior, not boycott, and it's a huge change that's really hard.
A: Great question and one that CIOs are debating constantly today because when I went to school there was no such thing as zero interest rates — that wasn't in the textbooks, was never supposed to be able to happen — yet it's happened twice in the last two decades.
The Fed has used that as a tool to, in my view, socialize recessions and push them off. Whenever you go to zero, then risk assets like public markets take off and that really has put a strain on the returns of private markets.
It should help them long term, but it's actually caused this wave and cycle.
I think right now when we look at the real estate market, and obviously COVID-19 has changed the way we use offices, and the way we look at private equity, people are absolutely debating what is that premium that we'll see — that illiquidity premium we'll see going forward.
Now, there's no question half of the companies in the USA are now private, so it's here to stay. It's a huge part of the marketplace, but what kind of a return differential will you see? I think they're going to be a big part of people's portfolios. I think they're hitting the natural limit on illiquidity as pensions continue to mature. So at least in the USA, we're at, I think, getting close to our top of how much private equity we want in our allocations.
We're still going to see an appetite out of the non-U.S. investors, the sovereign wealth funds, and keep in mind those sovereign wealth funds are five to as much as 10 times our size.
So even a little allocation to private equity is going to keep the appetite in that market, but it's an active debate in the asset allocation of what kind of return you're going to see going forward.
I think all the early industry gains that could be arbitraged, have been arbitraged away, and now in private equity they've got to buy and build a company, grow it organically. They can do better by being private than being public.
I think the arbitrage between short-term thinking that I see so often in the public markets — there's a value and a gain to being a long-term vision CEO and thinking longer term. I think that's the margin of gain we will see out of private equity, people who are able to make changes and for the better of the long term, so not the wide spreads we saw, certainly not the 500 basis points, maybe not even the 300 basis points, maybe closer to 150 basis points, which means you have to be really picky in private equity and the cost and that two and 20 (fee) structure really does matter.
And the same thing in real estate. I think we're going to see lots of challenges in real estate infrastructure ... because of that energy transition.But again, infrastructure is going to have slow steady returns, so again, it has to have a much more stable and lower fee structure. We can't see the private equity model in infrastructure and still get the returns.
A: First and foremost is the office market.
Hybrid and remote work is here to stay. There's no question about it. The technology affords it, it's terribly efficient.
Retail has been a real challenge in terms of malls and the consolidation of malls and the concentration of ownership, industrial (there's) huge demand, and apartments because of the lack of affordability in homes.
So I think you'll see more specialization. We've seen people go into student housing, we've seen people go into senior housing, life sciences, all these different angles on real estate, so it will continue to be in demand. It's a physical asset.It's one of the few physical assets like infrastructure that we can own, so there'll be a demand for it, but boy, the office market, which was gigantic, is really going to go through an interesting transition. So it is fascinating how quickly that marketplace changed and the perception of remote work changed.
A. Yeah, we're still running a hybrid work environment and think we will forever. We're in the office basically two to three days a week and what I've realized is to my amazement, we did really well.
What I (also) know for a fact is investments is a mentoring business. It is a business where you have to have somebody you can turn to, can share the experiences of bear markets, can help give you that advice. It's not in a textbook, it's from that interaction.
The other thing that just absolutely amazed me was moving to 100% remote. We actually produced a higher level of alpha when we were at 100% remote and there's a number of surveys that say people were actually more efficient at home than they were in the office.
But I know also when we're in the office, our culture comes to life and it is just wonderful to see the interaction.
So what we've done is tried to concentrate when the teams are in, not the whole staff, but the teams within an asset class. They're either in 100% or they're remote 100%. That seems to work the best.
The one thing I'll point out to the readers, and I found this so true, Zoom meetings are so efficient on mute and only one person's talking and most of the time they either end right on time or they end early. In-person meetings take forever. They always run over because everybody's talking and everybody is sharing. And now I realize that's actually really good to have that interaction to say, "Hey, how are you doing? How's the family?" Or to stop afterwards and say, "Hey, can I ask you some more questions about this part of the portfolio and understand that better. That dialogue and interaction is priceless and can only happen face to face.
A: Well, the biggest surprise was a global pandemic. I mean come on, a global pandemic where the world stopped the economy. The economics books I learned said that's actually a really bad thing and you want to be really defensive and underweight your equity portfolio.
And at the end of fiscal year 2021, I had to go to the board and said, who knew? Apparently pandemics are the best thing in the world for stocks, 27% return.
The amount of fiscal and monetary stimulus is just staggering and here we are in 2023, you're still seeing the tail end of it finally wear off.
So do we think they overstimulated? Probably. And they also socialized all that cost of not having a recession. So to me, the biggest shock has been this after effect.
It's no surprise that we had some inflation. I mean, amazingly you shut the world economy down, basically like flipping a light switch. In two weeks, the world stopped everything, just about. But then starting it back up was a lot of fits and starts and sputtering and then obviously outbreaks again and new COVID strains.
And boy, we just sputtered and stuttered in terms of an engine and the discontinuity in the supply chain caused inflation and we're still dealing with that effect. Now, we've seen an environment where the Fed has raised rates back to what is likely a normal level and yet we still haven't had a recession.
None of the classic macro econ is helpful in this environment because we have never seen it before.
So we just have to almost throw that out the window. It is staggering to try and figure out where is the economy, where are we going to go?
I think we're still dealing with kind of the hangover effects of the COVID crisis. We still have to worry about viruses, both digital and biological. That's not going to go away. And now when you overlay, as I said at the beginning, with the climate extremes, these are going to be challenging times ahead and diversification's going to be key.
So life is more complex than it was before in many ways and yet more efficient. Same thing with investments, more tools, but just a very difficult environment to forecast.
