CalSTRS downplays equities in revamp of asset allocation

CalSTRS has adopted a new long-term asset allocation that increases its inflation-sensitive, real estate and risk-mitigating strategies at the expense of public equities in a move to diversify its portfolio and improve its risk-return trade-off.

After a nearly yearlong asset-liability study, CalSTRS' investment committee voted unanimously Nov. 6 to adopt the new allocations, despite a somewhat chaotic start to the meeting triggered by a spontaneous climate change protest aimed at persuading CalSTRS to divest from fossil fuels in its equity portfolio.

The demonstration led the committee to take up its closed-session agenda at the start of the meeting, rather than at the end. The open meeting continued after CalSTRS officials and the activists that included members of Fossil Free California agreed to first allow the investment committee to decide whether to adopt the new asset allocation uninterrupted, followed by a public comment period.

The $242.1 billion West Sacramento-based California State Teachers' Retirement System increased its real estate and inflation-sensitive assets' long-term targets by 2 percentage points each to 15% and 6%; and risk-mitigating strategies by 1 percentage point to 10%.

At the same time, CalSTRS reduced its long-term public equity allocation by 5 percentage points to 42%.

Rounding out the new asset allocation, CalSTRS retained its 13% private equity, 12% fixed income and 2% cash liquidity allocations.

The new long-term asset allocation is designed to shift the portfolio allocation to real assets for diversification benefits and more stable income from the economic growth risk of public equity, according to a report to the committee. Even though real assets returns are expected to be a bit lower than pub- lic equity, CalSTRS executives said they expect the relatively more stable income-driven returns will dampen portfolio risk.

Indeed, CalSTRS' largest source of risk and return is from economic growth, which comes from its allocations to public equity and private equity.

Currently, approximately 67% of the total risk in CalSTRS' portfolio is from public equity, compared to about 49% in public equity assets in the portfolio, according to Chief Investment Officer Christopher Ailman's report.

Equity risk has risen modestly since reaching a bottom in July, Mr. Ailman' report said. Public equity risk and private equity risk combined now comprise approximately 81% of portfolio risk.

During the presentation, board members asked about the added cost of moving a greater portion of the portfolio to alternative investments, which have greater costs and fees.

Scott Chan, deputy CIO, said that the expected return profile of the new long-term asset allocation was based on returns net of fees. Not included in this modeling is the expected cost savings of moving the portfolio toward a collaborative model, which includes joint ventures, separately managed accounts and co-investments, he said.

Even so, costs will go up, he said.

A separate cost report to the board showed that in 2018, alternative investments accounted for 80% of CalSTRS' portfolio costs: $248 million for public markets compared with $1 billion in private market costs. The report also noted that a 14% increase in total portfolio costs between 2015 and 2018 was due to an increase in plan assets, a shift to global equities from a home country bias and a ramp up of alternative investments.

However, the new long-term asset allocation provides CalSTRS a "better risk-return dynamic," he said. The new long-term asset allocation is expected to return 7% per year, in alignment with CalSTRS' actuarial investment return assumption.

Staff is expected to return to the investment committee with an implementation plan in January. The new long-term asset allocation is designed to be phased in over time.

CalSTRS' current short-term policy allocations consist of 51% public equity, 13% each in real estate and fixed income, 9% each in private equity and risk-mitigating strategies, 3% in inflation-sensitive and 2% in cash.

At the meeting, CalSTRS' alternative investment consultants weighed in on how the new allocations could be implemented.

According to pacing plans provided by private equity and inflation-sensitive program consultant Meketa Investment Group Inc., CalSTRS would commit an estimated $7.5 billion annually to vintage years 2020 and 2021 private equity funds, with commitments gradually increasing to $12 billion in vintage year 2030 funds.

John Haggerty, Meketa's managing principal and director of private markets investments, said during the meeting that the execution of the new long-term targets for private equity and inflation-sensitive asset classes is "quite feasible."

Mr. Haggerty said he expects the portfolio to reach its 13% private equity allocation between 2022 and 2023.

CalSTRS' asset mix as of Aug. 31 had 49.1% in global equities, 13.7% in real estate, 13.1% in fixed income, 10.1% in risk-mitigating strategies, 9.1% in private equity, 2.6% in inflation sensitive and the rest in cash.

Ben Maslan, Los Angeles-based managing director at RCLCO Real Estate Advisors, said that CalSTRS' real estate portfolio is currently above its 13% target by 67 basis points.

A RCLCO report presented at the meeting showed that the increased real estate allocation would translate to an additional $3.2 billion to the net asset value of CalSTRS' $32.6 billion real estate portfolio.

To bring the portfolio up to the new allocation, RCLCO recommended several scenarios, including reducing leverage, becoming a net buyer rather than a net seller, and investing in liquid real estate securities and open-end funds. Earlier this year, CalSTRS made its first allocation to REITs, up to $500 million through two managers, CenterSquare Investment Management and Principal Real Estate Investors. CalSTRS could increase its investment in REITs, according to the RCLCO report.

Right now, the majority of CalSTRS' unfunded commitments in real estate are separate accounts and joint ventures. This gives staff authority to sell properties at its discretion, Mr. Maslan said.

"There's no urgency to investing and staff controls the pace," which would allow staff to make the recommended alterations to the real estate portfolio, he said.

An infrastructure pacing model provided by Meketa, which consults on infrastructure as part of CalSTRS' inflation-sensitive portfolio, would commit an estimated $850 million to closed-end and $450 million to open-end infrastructure funds annually from 2020 to 2022, with the closed-end fund commitments increasing slowly to an estimated $1.1 billion in 2030. CalSTRS' commitments to open-end infrastructure funds will remain constant at $450 million a year during the period.

Meanwhile, its pacing plan for its farmland and timber portfolio — which is part of its inflation-sensitive program — calls for annual commitments of an estimated $40 million to closed-end funds and $40 million to open-end funds from 2020 to 2030.