16 June 2019

Adopting a New Investment Approach

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Institutional investors are coping with converging alternative investment strategies by creating new - and bigger - allocation buckets. Rather than keeping each asset in its own silo, investors increasingly are crossing asset allocation lines, bundling diverse types of investments into a single portfolio for a stated goal or theme. Lower-return market conditions are driving investors to take a hard look at their allocations and discard the old approach, which had failed to consistently provide the returns.

The Teachers' Retirement System of the State of Illinois, Denmark's PKA and M.J. Murdock Charitable Trust are among the investors that have ditched the traditional bucket system for a more wide-ranging asset allocation. A number of other investors — including Los Angeles County Employees Retirement System and New Mexico Public Employees Retirement System — have added asset-class-crossing portfolios such as opportunistic fixed income or real assets.

Trustees of the Illinois Teachers' Retirement System, Springfield, will consider adoption of a much simpler asset allocation model that acknowledges the many convergences among the strategies in its alternative investment portfolios. For a public pension plan, Illinois TRS has an unusually large allocation to alternative investments: 39%, or $17 billion of the $43.6 billion fund. TRS has maintained a traditional asset allocation in reporting to trustees regardless of formal asset class labels.

Currently, there are eight asset classifications with the following target allocations: domestic equity, 23%; international equity, 20%; global fixed income, 16%; real return, 10%; real estate, 13%; hedge funds, 6%; private equity, 11%; cash, 1%. The proposed allocation will have four categories with the following target allocation ranges and components:

  • global equity, 50% to 60%, domestic public equity, international public equity, private equity, opportunistic real estate;
  • global fixed income, 15% to 30%, core/core plus, short duration, floating rate, non-dollar emerging market debt, special situations, convexity strategies;
  • diversifying assets, 10% to 15%, hedge funds, global macro/global tactical asset allocation, risk parity; and
  • real assets, 10% to 20%, core/value-added real estate, Treasury inflation-protected securities, farmland.

As of March 31, the pension fund's real estate assets totaled $5.4 billion; private equity/venture capital, $4.6 billion; real return, $4 billion; hedge funds, $2.4 billion; and special situations/credit, $573 million.

Oversight of credit strategies likely will come from a combination of traditional fixed-income investment officers, as well as private equity and hedge fund specialists, because credit funds often use a hedge fund approach and/or have a longer lockup, similar to private equity funds.

Hidden risk 

Investors' concern with the risk lurking in their portfolios has caused them to organize their asset allocations around risk factors rather than traditional asset classes. Investors are looking for a customized combination of multiple strategies and learning that any product is a package of risk factors and labeling them in artificial containers may not be the best way to choose the options out there.

The $800 million Murdock Trust, New York, divides the world into three “risk buckets” — low, medium and high — and considers all types of investments, across asset classes, for any of these risk buckets. Last year, for example, the 194.8 billion Danish kroner ($35.55 billion) Pensionskassernes Administration A/S, Hellerup, Denmark, hired Acadian Asset Management to run a $450 million managed volatility strategy. The pension administrator, which is owned by five occupational pension funds, restructured its equity portfolio in 2012, adopting an investment process that allocates to 17 different risk premiums within the equity portfolio rather than using traditional strategic allocations to regions.

One theme the Teacher Retirement System of Texas, Austin, is focusing on is energy and natural resources. The pension fund established an initial 3% allocation last year. The allocation is likely to increase to 5%. The portfolio aims to include oil, gas, water, agricultural real estate, timber, mining and other related sectors in order to capture promising returns over the next 10 years and to diversify the overall portfolio.

Some investors are investing around themes such as water and food scarcity. Other institutional investors are investing around outcomes, such as inflation protection or interest rate increases. Another theme for the endowment is emerging markets.  Seven years ago, the pension plan started down the path of making its overall portfolio more like an endowment. The pension plan is in the midst of an asset allocation study that could add leverage to its $126 billion portfolio.

Opportunistic fixed-income 

Investors such as the $46.5 billion Los Angeles County Employees' Retirement Association, Pasadena, CA and the $36.6 billion Tennessee Consolidated Retirement System, Nashville, have created opportunistic fixed-income or credit allocations that include both publicly traded and private investments.

In May, the New Mexico Public Employees Retirement Association, Santa Fe, adopted an asset allocation that included several blending features. It added a 5% allocation for a new portfolio that includes public and private investments pension plan officials call “fixed income-plus.” Pension fund officials also increased alternative investments to 23% from 20%. This included increasing its “inflation hedging portfolio” — which includes real assets and real estate — to 12% from 8% and decreasing the absolute-return portfolio to 4% from 7%.

The idea is that fund officials will sprinkle absolute-return strategies across the entire portfolio, rather than keeping the investments within the alternative investment allocation.

Click here to access the full article on Pensions & Investments. 

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