Just four years after the untimely passing of David Villa, longtime executive director and CIO of the State of Wisconsin Investment Board, his successor Edwin Denson talks about carrying and building on Villa’s legacy overseeing one of the most well-funded retirement systems in the nation.
SWIB manages $162.8 billion in assets including the $139.5 billion Wisconsin Retirement System.
In an interview at the board’s Madison-based offices, Denson discusses his own point of view as an economist, overseeing and increasing the retirement system's allocation to private markets and public fixed income and lowering its exposure to public equities. Answers have been edited for conciseness and clarity.
Q: How did your experience at organizations like UBS and the Canada Pension Plan Investment Board make you a good fit when you joined SWIB in 2018?
A: When I look back at my career, I see that it had three phases. The first phase was developing my underlying skill set. That happened through going to graduate school in economics and then working for Lehman Brothers as an economist, and then moving over to an asset manager, Putnam Investments, again working there as an economist but directly supporting a wide range of investment strategies and different asset classes.
That’s where I really developed an affinity for asset allocation and currency.
Then in the second phase of my career, it was the training ground for actually applying that underlying skill set in a very specific investment dimension. At UBS, I built on that interest in tactical asset allocation and currency and worked as an investment strategist setting the active asset allocation and market strategies for multiasset class or balanced strategies.
When I started at UBS, the person who ran the area said, “I need you to stop acting and thinking of yourself as an economist, and act and think of yourself as a strategist.” There was a clear demarcation there. The other experience that I found useful was being in an environment where we had to present several different flavors of our strategy over and over again to all different types of clients and prospects from individuals and institutions that had only a very rudimentary understanding of capital markets and investing, to very sophisticated people who knew more than me. So that was very beneficial.
Through those two phases there were a lot of opportunities for the market to provide lessons learned. That started in the mid-‘90s with the peso crisis, the Long-Term Capital Management situation, the building of the TMT (tech-media-telecom) bubble, and then the actual deflation that most people forget was slow and painful.
We had the Great Financial Crisis, European debt crisis, and other bumps and hiccups along the way. So there's a lot to learn in those in those two phases.
The third phase of my career, which is where I am now, was transitioning from that for-profit asset management environment to the mission-based public-sector asset owner. The Canada Pension Plan Investment Board was a great place for making that transition to an asset owner as it's very well resourced — more like a for-profit asset management firm in that regard — yet it benefited from the advantages that an asset owner has, in particular the long investment horizon.
First (at SWIB) it’s the mission. It’s who we’re serving and why, what it is we’re providing. Second, it's the certainty of capital that facilitates that longer-term investment horizon that allows for a different and more productive mindset for investing. So that's refreshing. We can not only stick with strategies over the long term, but there's much more organizational stability.
There's no pressure to reduce headcount or put longer-term strategic projects either on hold or to scrap them because of a drop in the market or bad performance from one investment team. That's a big difference. We're free of the dynamics in the for-profit asset management environment that ultimately compress the actual investment horizon.
Now, why the move to SWIB? Well, different from my role at CPP, the opportunity at SWIB really offered me the ability to have even more of a meaningful impact on and control over the investment structure of the fund. I was brought in as head of asset and risk allocation and in that role, you're not only helping to determine the overall strategic asset allocation of the trust fund, but also putting together the active risk budget. So that means: Where are we actually going to put the capital? How much risk do we want the risk takers to be taking in each of those areas? Do we manage money internally or externally? Or whether to be active or passive in any particular market?
I did not have any ties to Wisconsin, but had known David Villa for well over 15 years when he started to recruit me. I was born and raised in Chicago, and I have a sister who is a public school teacher there. She's worked for the Chicago Public School System for her entire career. So for me, that put front and center the importance of pension benefits for retirement security for the people who dedicate their working lives to public service.
Q: Can you talk about what you took from David Villa, from the time you knew him before SWIB and afterward?
A: He was an ideas guy. He helped SWIB be a pioneer in what he called investment modernization for public pensions. These are things like policy leverage, alpha/beta separation, or portable alpha, an emphasis on internal management of assets where possible, and also pushing the investment decision-making down to staff, so a lot of delegated authority while maintaining appropriate oversight. He had ideas, but a really nice thing was that he let the experts do the implementing and let them have their hour to shine. And as an example, one of the first things I did was to find a simpler and less constraining path to achieve an effective outcome, that David wanted, regarding the flexibility for staff to deviate from the strategic asset allocation if warranted by market conditions. He had the right idea, I just thought, of a simple, straightforward and efficient way of getting to that outcome in the context of our governance.
Q: During your first four years at the helm of SWIB, what have been your primary short-term and long-term goals for the organizations, and what kinds of investment-related initiatives have you prioritized?
A: I'll take the organizational leadership on first. In the short term, just the need to provide stability, and then assembling the senior management team that I wanted to go forward with, because unfortunately, we didn't have the luxury of having a period of overlap and parallel for the transition, as you referenced his passing was indeed untimely. I needed time to determine who internally and who externally I could assemble for the senior management team to take us forward, but definitely building on David's legacy and the path he had set out. Of course, with some finer points and nuance coming from myself. It was nice that I had no disagreement with where David wanted to go philosophically at all. Philosophically we came from the same place. Of course, I’m a different person, so there might be a different implementation path.
One of the longer-term investment objectives that we’ve been working on dovetails with something that David had put in place. I referenced earlier policy leverage and alpha/beta separation. Along with that is capital efficiency, and that's something we’ve really been striving to improve and enhance.
We have an implementation working group that is across investment divisions thinking about how we can make our dollars work harder for us. So we've encouraged some teams to take higher active risk with the same capital that they have. There are others where we've asked them to deliver the same dollar returns, but with a smaller capital allocation. Both paths in effect increase the active risk on each dollar we have deployed because we do have a large, stable balance sheet. We want to take advantage of that as much as we can.
Q: According to P&I data as of Sept. 30, SWIB managed $53.6 billion internally. How has the structure of the internal investment staff evolved in your first four years at the helm? And what if any, are some of the enhancements you're hoping to make in the Investment staff?
A: I'd say the major developments are first, we have meaningfully increased our footprint in private markets. (In December, SWIB's target to private equity/debt increased to 20%, up from 2021 when the target was 11%). That was always part of the strategic plan going back to about a year before David passed away. In private markets, you have to be very deliberate and careful in your pacing when you're increasing your footprint. We've done that to good success.
On the internal management side, we’ve made a big investment in managing fixed income internally. We have added mortgage-backed securities and leveraged loans to our investment policy and launched internal active strategies in both. In addition, we've in-sourced most of our high-yield allocation to be managed internally. In general, we’re modernizing what we do internally in fixed income using asset-backed and structured-product type instruments.
Longer term, we’ve started to focus on resilience for the investment teams. And what I mean by that is building out the teams by focusing more on junior resources, who we would want to be the next generation of risk takers and leaders for SWIB and moving away from having top-heavy teams. We would rather build and develop the human skill set for that next generation of risk takers and leaders, than be in a constant cycle of having to go out and buy that talent on the open market.
Q: What changes have you been making, both from an asset allocation standpoint and investment personnel, which you kind of addressed during this time as a result of changes in rates? What are you anticipating from rates?
A: We have increased our allocation to fixed income a bit, both in the public space and as I mentioned, our private footprint has been increasing as well including private credit. It’s just fortuitous that we've been building and broadening out our internal expertise in fixed income at the same time that we've had this pretty meaningful change in the rate structure. On the rates question, I will answer as somebody who never believed that real interest rates could stay at zero or below for an extended period of time. That wasn't a sustainable equilibrium. We are now seeing something that's more normal in terms of a rate structure and given what's happening around the world in terms of government debt dynamics and inflation, I think that we're much more likely to have higher for longer.
Q: In a December 15, 2021 memo you said the key theme from the review and discussion of other strategic issues was that the next 10 years will be challenging for the fund from a total return perspective, as returns on assets are generally expected to be low relative to longer term expectations. That's in part because of higher than average realized returns from risk assets over the last few years. Does this generally still hold true?
A: I believe it does but less so than at the end of 2021; 2022 brought asset valuations back to more reasonable levels, both in equities and fixed income, which in this rare event both sold off. But what that means is, when things sell off, their long-term prospects actually improve a bit. But since then, of course, the U.S. equity market continued to reach all-time highs, at least until recently. And credit has not really been cheap on a relative basis either, but the underlying cash rates for all flavors of fixed income are higher than the end of 2021, which does help. In the end, it's really the valuation of large-cap U.S. equity, which is a large part of the global capital market, that remains challenging.
Q: The executives I've been speaking with this year expressed quite a bit of excitement because they see diversification coming back. Would you also echo that sentiment?
A: What was tough about 2022 was there was no diversification benefit from any part of the fixed income market. That was tough and talking a little bit theoretically, all else equal, the higher the stock/bond correlation is, or the less negative is it is, then the riskier any portfolio with a balance between equity and fixed income is going to be. So it's just better for everybody if we have more of that diversification benefit coming from fixed income, and we have seen more of that this year.
Q: SWIB has a Funds Alpha program which consists primarily of hedge funds, which doesn’t appear as an asset class in your core trust fund asset allocation. Can you talk about how you utilize hedge funds?
A: We don't consider hedge funds to be an asset class. That's why they're not in the asset allocation. We see them as active strategies in the active risk budget. That's part of that alpha/beta separation that I referenced. We replace public market betas through derivatives or through borrowing to free up the cash to put into hedge funds. You can think of the hedge fund being overlaid onto the market beta. So again, that's how we think of hedge funds. They're potentially a really good source of active return. And then what we've been doing over the last couple of years is refining that book by concentrating more in the managers that the Funds Alpha team has conviction in. There is an overall ask of that hedge fund portfolio that it does not have any market beta in it, in effect, because it's supposed to be an overlay onto the market betas that we want from an asset allocation perspective.
Q: What tactical, opportunistic moves have you been making over the past four years?
A: Remember that 90% of the difference in the long-term returns between pension plans can be explained by their average asset allocation over the period, and that can be interpreted as the strategic asset allocation. So that's really the most important thing over the long run. But that said, when you're running $130 billion in assets like we are in our core trust fund, tactical moves can add value.
I'll go back a little bit further than four years. In March of 2020, at the height of the scare over COVID in the capital markets, we deliberately and meaningfully moved our fund to be overweight vs. the strategic asset allocation in both equity and high yield, and that ended up helping us achieve one of our best relative performance years since 2009. Then jumping to much more recently, in July of last year, we reduced our outright exposure to U.S. equity vs. policy." (For the year ended Dec. 31, 2020, the WRS Core trust fund returned a net 15.2%).
"Prior to that, we had been tilting away from the U.S. in favor of other areas of the equity market on a relative basis. But again, at that point, in the middle of last year, it just seemed like enough was enough in terms of the valuation of the overall equity market. We reduced our public equity exposure vs. the strategic asset allocation. And as you can imagine, that has paid off since January.
Q: Artificial intelligence is dominating a lot of discussions among asset owners. Can you talk about any initiative SWIB currently has involving AI, and more broadly technology and data?
A: I'm really excited. We hired a new chief technology officer just about a year ago who came with a very strong asset management background. He is very interested in helping enable us take advantage of artificial intelligence. The way I think of it, it's like any other productivity enhancing innovation. It's something that will not replace people, but it could make them more productive and hopefully free them up to spend their time on more high-value activities. So, for example, we're experimenting with having AI deal with the quarterly letters we get from our external partners to tease out common themes.
But we have to do it in a very controlled way. We have to make sure that none of our proprietary information is somehow making it out into the public domain in some unintended way. So we immediately put in an AI policy as part of governance, so that we are very deliberately moving into a spot where we're just exploring how much we can take advantage of the new technology to make us more effective.
Q: What has been the biggest challenge for you as executive director and CIO over the past four years? Both from an internal standpoint and a macroeconomic standpoint, what is keeping you up at nights?
A: There’s a couple of things. First, internally is building and maintaining our culture over time, as we grow, develop and evolve. Right now, about 60% of our current staff has joined SWIB since COVID, so that's not that long ago. On the other side, we also have staff members who've been around for decades, and it's really important to mesh those two cohorts together. But the culture is also evolving in ways that are critical to our future success. We're focused on a culture of excellence and innovation that keeps up with the pace of changes in the markets, and we couple that with a daily focus on what is in the best interest of the funds that we are entrusted to run. Again, that’s the mission. And I see the combination of excellence, innovation and dedication to the mission as critical to our future success, and it's an ongoing challenge to manage that successfully. When we think about culture, I say to our board repeatedly, culture is not a project that you work on for six months or a year. It's an ongoing exercise.
On the investment side, in isolation, the prospect for mediocre returns on risky assets and the deterioration of the fixed-income diversification benefit makes portfolios riskier. That's something I continue to worry about.
