The S&P 500 Index was continuing its gradual ascent on May 16, when a group of nine pension, endowment and foundation investors gathered to share the challenges of investing large institutional portfolios. Even though financial markets have been delivering positive returns to the investors’ funds, the overriding mood of the roundtable discussion was hardly sanguine.
When questioned about the uncommon circumstance in which good overall fund performance is met with a lack of investor enthusiasm, Paul Doane, outgoing CIO of Minnesota’s St. Paul Teachers’ Retirement Fund Association, answered, “It’s our job to worry.” The eight other group members nodded in unison.
What is worrying investors right now? Most troublesome, many of their once-hallowed investment principles have to be rewritten. The trouble is, no one knows exactly how. The long-standing concept of portfolio diversification has been under fire ever since it failed to deliver in the 2008–’09 financial crisis. Investors no longer trust markets’ ability to climb out of crisis mode or asset managers’ ability to get them there.
The annual breakfast roundtable, hosted by Institutional Investor at the Union League Club in New York, provides a cross-pollinating idea exchange for investors from different corners of the investment universe. With substantial assets to shepherd and constituents that include pensioners and grant and scholarship recipients, the investors — all winners of II’s 2014 U.S. Investment Management Awards — took full advantage of the opportunity to share ideas with their colleagues in arms. In addition to Doane the group included William Atwood, executive director of the Illinois State Board of Investment (ISBI); Robin Diamonte, CIO of United Technologies Corp.; Adele Gorrilla, CIO of Denison University; John Hull, CIO of the Andrew W. Mellon Foundation; Carol McFate, CIO of Xerox Corp.; William McLean, CIO of Northwestern University; Kristen O’Connor, CFO of the Ahmanson Foundation; and D. Ellen Shuman, former CIO of the Carnegie Corp. of New York and founder of Edgehill Endowment Partners.
Editor Michael Peltz and Senior Writer Frances Denmark facilitated the freewheeling, collegial discussion.
Institutional Investor: The expectations of economic growth at the start of this year have been replaced by a general feeling of uncertainty. Where will growth come from, and what as an investor can you do to find it?
Robin Diamonte: Everything seems expensive, and everybody’s complacent, so it’s worrisome. The complacency is more worrisome to me than any bubble risk. What do you do? Without taking a lot of additional risk — leveraging, getting into highly illiquid assets — you’re not sure where to go. It’s a real issue, mainly because there’s so much money and capital out there looking for yield, and cash and some bonds are not going to give it to you.
D. Ellen Shuman: It is a very tough time. Trying to spread your bets seems like the best strategy right now. Diversification is tricky because we all know that when there’s a panic, the diversification becomes highly correlated. We’re trying to look for strategies that are not necessarily market-driven, so that you could do tolerably well in a downturn. That might include having a number of different assets — whether they’re geographically distributed or a wide range of strategies, and a hedge fund portfolio, for example, that is less correlated to the market — to try not to make bets now.
We think you have to have some Treasuries as an insurance policy. They’re probably going to be shorter in duration at this point because when interest rates go up, there’s a real asymmetric risk to Treasuries.
Paul Doane: Do you think there are vehicles that aren’t related to the market?
Shuman: Yes and no. A long-short fund should have a lower beta. Event-driven strategies and bankruptcy liquidations where there’s some catalyst — those are still going to be affected if there’s a downturn, but you hope just a little less so than a long-only equity.
Doane: I struggle with the issue of making these adjustments, based on the 2008 experience, when everything became correlated that was supposedly uncorrelated. We broadened the mandates to our managers so that they can be more nimble. I try to bring in areas that may be less correlated even within one asset class and added areas that supposedly would be somewhat beneficial in a rising-rate or inflationary market. But all of that done, I wonder or worry that when things hit the fan, all of this that we’re going through will still end up in a bag of worms.
William Atwood: I’m concerned that we back into a bet, that we place a bet without knowing we’re making a bet. For example, the dollar bet. We existentially had a dollar bet on. At ISBI we’re trying to prudently diversify away from the dollar.
Can you explain the dollar bet and what you can do to hedge against it?
Atwood: ISBI’s assets have the propensity to be dollar-denominated, so we diversify away. We expanded our non-U.S. exposure and our non-dollar-denominated exposure. We’ve added emerging-markets bonds. We’ve added small-cap international and small-cap emerging markets. We keep adding to these. The interesting conversation I always have with these managers is that they often want to hedge back to the dollar. And of course, that detracts from our broader issue to diversify away from the dollar.
Adele Gorrilla: We operate with the idea that we try to find the best partners that we can in managers. We have an established, concentrated portfolio of managers that are fantastic and hopefully will be the first to respond to an opportunity that emerges. Most of those are going to come out of troubled times. Something falls out of favor or gets dislocated, that’s when we’re going to make money. That’s why we’ve selected these managers. We’re largely in alternatives with long-short positions, and we have event-driven managers. With our governance structure we also have flexibility to execute very quickly.
Carol McFate: I think the issue of governance is critical, and it’s a challenge — having more-flexible governance in this type of environment, where you’ve got the delegation to do what you think is right. We have to deal with the fact that we’re governed by ERISA. If you are not a financial-market-savvy person on an investment committee, that can make you just a wee bit more conservative and want to move a tad more slowly.
It’s been almost constant change since I’ve been at Xerox. I’ve spent a lot of time educating the investment committee over the past couple of years, including writing a white paper. It’s up to me to help them understand so we can be much more realistic about what’s achievable. The governance issue is so important, and the folks who have more-flexible governance, particularly a higher degree of delegation, are truly fortunate. I hope you appreciate it.
Diamonte: Good governance includes good communication with investment committees. We also have delegation and the ability to move quickly; however, we communicate very clearly the risks. You take bets, but you set the expectations appropriately so that your committee understands this is how we’re going away from our liabilities or this is a bet that’s illiquid or whatever type of risk premium you’re trying to achieve.
John Hull: I think part of it is the structure of the organization and not governance. Having been at a public pension fund and now the foundation side, the foundation model is very, very different. We don’t have true liabilities as do pension plans. We give away 5 percent of our base every year, so if it’s a really bad year, we can adjust the grant budget. It’s why foundations particularly have a huge allocation to private equity or hedge funds or any alternative strategies — other than the liquidity. We all learned it can be a little tricky in the ’08–’09 period; I think we’ve all gotten smarter about the level of allocation we’re making to illiquid investments.
I don’t have to worry about going to my corporate parent and saying, “You need to make a contribution because we had a bad year.” Or going to state government to make up for bad years. The assets we have are all we’re ever going to have. The whole portfolio is geared toward capital appreciation. We have less than 3 percent today in bonds and another 6 or 7 percent in cash. Everything else is an equity-related allocation, and we feel as though we can take that risk.
William McLean: It’s interesting to hear some of the themes being expressed around the table. One that comes out is, How much should we be tactical? “Market timing” has always been a bad word. How much should we be bold? Versus having our managers do it for us and trusting that they’re going to do the right thing. I think we learned in ’08 that that was not enough. We were hoping they would do some things, but you had to be either contrarian or bold. And that’s hard to do.
When it comes to bonds, the contrarian bet is being long. It would have been at the beginning of this year, and it remains so. Those are the kind of discussions we’re having around our own table because we have some cash now from a couple of different, unique sources. We’re trying to judiciously find other things to do with it that are not equity-related because I think we have sufficient risk in equity. We’ve been looking at different absolute-return strategies and commodity strategies. You have to be willing to take an unpopular position on that.
Hull: One of the challenges we have today is we have a huge bias toward the United States, primarily because we’ve got 25 percent in private equity. It’s very hard to get private equity exposure outside the U.S. in any meaningful way. It’s amazing: Our exposure to Japan is in the single digits because we had a public equity portfolio with one international manager that has some exposure to Japan. That was it.
We added to Japan in public equity because we knew it was the only place we could add to Japan in a meaningful way. I think we’re facing the same dilemma in getting sufficient emerging-markets exposure. The only way to get it is overweight public equity in emerging markets.
Kristen O’Connor: We don’t try to be overly tactical. We stick to our long-term asset allocation. We were concerned about rising rates and created a fund that offered a solution to that concern: bank loans that reset to Libor every three months. We have a 7 percent allocation to the fund we created. We also hold some more cash than we normally do. We used to have 50 basis points in cash. Now we have 3 percent, which is more in line with our peers. We actually took the grant budget that we know we’re going to spend between now and October and put it in a money market–like vehicle with some yield.
We also have an allocation to a diversified inflation hedge fund portfolio. Other than that, we don’t know where the next problem is going to come from. We feel like it’s best to be diversified. If you overprotect against one thing, then you’re underprotected against something else. If we stick to our asset allocation, hopefully we’ll be appropriately protected.
Diamonte: We do something called structured beta. It’s not smart beta; it’s structured beta. We get exposure to a market through futures, and then we have a portable-alpha portfolio on that. “Portable alpha” was a nasty word after 2008, but we’ve had it since 2005, and it’s worked very well. It’s low-volatility, unleveraged, absolute-return strategies where if the underlying beta blows up, you’re hoping that the skill level at least will provide you some alpha. We test them through time to make sure they’re market neutral. And if your underlying beta is your liabilities, then it works out great because you’re still hedging your liabilities and at the same time you have your alpha on top of it.
It seems like everybody is worried that something will go wrong. What is it that has investors so nervous?
Doane: It’s our job to worry.
McFate: Well put.
McLean: I think it’s two things. Valuations are clearly a lot higher than they were; that’s always a signpost. Second, we’ve had an artificial rise in asset classes from the easy-money policy that we’ve all benefited from. We’re not sure what it means or what the implications are, but it makes us nervous because there’s something about it that just doesn’t feel right. The economy is definitely better, but a lot of it has been driven by excess liquidity.
Diamonte: You can’t go to the textbook and read what happens next.
McFate: This is a new environment. We’re coming out of a deleveraging, but the leverage in the system really hasn’t come down. I hope the Fed’s successful in unwinding their huge balance sheet, but there could be some bumps along the way. You just look around the world in terms of China’s transition — the fear that they may have a little bit of a bubble in their financial services business and that they have a debt bubble. Europe still has a long way to go. And you’ve got all these geopolitical things that could happen at a moment’s notice. Things feel better than they did a couple years ago, but they still don’t feel great. And you’re right, we are professional worriers.
Shuman: We’ve always been worried. We were worried in 2007, and then we were terrified, as [GMO co-founder] Jeremy Grantham said, in 2008. We were terrified in 2009, when, looking back, we would have all just wished for that time to come back so that we could have poured money into the market when the S&P was at 600, but we were too scared. We had policy portfolios. Hopefully, that gave you the discipline to rebalance. Now we’re terrified even though we don’t really know what we’re scared of.
McFate: I think the genie’s out of the bottle and there’s no putting it back. I have meetings scheduled with my committee every month, and the understanding that I have with them is that if we don’t need a meeting, I promise I will cancel it. But it’s always on the calendar in case there’s something to discuss, and if there’s something urgent, we either get them on the phone or get them in the room or do what we have to do.
Diamonte: In the corporate world we are governed by ERISA. You need to document performance and strategy and different changes and decisions to be prepared if questions come up. You want to make sure that you’re governing and that you’re thinking about the right things and you’re bringing it to the committee. There is a lot of preparation, and some of the preparation is the tedious “Do I have the right format on the page or everything in the right font?” and that takes up some of the time.
Atwood: The tension that Paul and I have that’s a little bit different from everybody else here is the public fund environment — the need for a memorialized and transparent process. Given that I’m in Illinois, the value of and the necessity for transparency and memorialization — to stand up in front of God and everybody and make sure everybody knows exactly what and why we’re doing it — slows you down. But on a prudential basis, one can’t take 18 months to pick a private equity manager.
Hull: At the New York State Common Fund, unlike the corporate world, there’s a huge disconnect between the treasury function and the investment function. In New York, I worked for the comptroller, who’s the sole trustee. There was a disconnect between the comptroller and the budget division that works for the governor and sets fiscal policy. There was never a dialogue between our office and what I would say in the corporate world would be the CFO. Whereas in your world I assume there’s a pretty constant dialogue between you and the CFO.
Diamonte: I report to the CFO.
Hull: If you’re underfunded, they’re going to have to contribute. In a political environment, if they don’t want to fund, they don’t fund. And if they decide the actuarial assumption is going to be X, if that doesn’t fund the system — like in the state of Illinois, Chicago or Rhode Island — then the system remains underfunded.
Shuman: The good news is that to do our job effectively — whether you’re in a public plan, a private plan, an endowment, a foundation — getting a few basic things right, that’s the key to success. Fine-tuning the portfolio, sticking to your policy, adding a few uncorrelated managers over a reasonable time frame — those very fundamental, basic actions that are consistent with your long-term strategy will really take you a long way.
Tell us more about the basics of investing now.
Hull: We don’t like the bond market. We’ve combined bonds and cash into a single allocation, and we have shortened the duration of the fixed-income component. If we knew rates were going up, that would be brilliant. Of course, it has turned out to be anything but brilliant.
O’Connor: When I think about what you need to get it right, I think it’s unique for every organization. Our committee is nimble, with three members focused on long-term performance. But we also have made a very conscious effort to think about who we are as an organization and to focus more on grant making in terms of our staffing instead of staffing up to man a full-blown investment office.
We’ve wanted to focus on keeping the costs low and keeping it simple, avoiding complexity unless it really would add some diversification or higher returns. It’s a pretty unusual approach for an organization of this size, but it’s worked well. But it makes for very boring cocktail party talk. No raving about this private equity manager or that hedge fund manager.
Atwood: I’m a little concerned in the macro sense that people aren’t talking about risk anymore the way they were two years ago.
Doane: Yes, it’s quickly forgotten. Somebody threw something on my desk the other day: They’re relaxing mortgage lending practices now. How quickly we forget.
Atwood: And bank loans are being issued with no covenants.
Shuman: I think another outcome of 2008 is a lot of us realized we had too many managers in our portfolio. Post-2008 I’ve seen a trend to consolidate managers — to have fewer managers but have high conviction in them. It is easier to watch over fewer managers. And it also helps you have a better understanding of what you own.
Hull: I would say we talked a good game. We started out being very disciplined, and we weren’t going to add new managers. Now we’ll add one more here and one more there. Particularly outside the U.S. you don’t have many choices. If it’s private equity, you’re stuck in that marriage for a very, very long time.
McLean: Private equity fund extensions are turning ten-year funds into 12- or 14-year funds.
McFate: We had a consultant heavily involved in the beginning because there were just two of us. Now there are five of us in the front office. We talk to our managers every quarter, and if things aren’t going well, we do it much more frequently than that. We’ve turned over some managers, particularly on the 401(k) side, because some of the folks didn’t learn much from the crisis.
Diamonte: I don’t think our numbers have changed, but what’s different is the relationship we have with some of the managers. We developed more strategic partnership relationships. Because, let’s face it, they have the staff, you can use them to do a lot of analysis for you. So it’s deeper, stronger relationships with a handful. That’s what’s changed in my area.
Atwood: We’ve become much more thoughtful about where we choose to use active management and where we don’t. ISBI has increased our passive management. I’m highly skeptical in public markets how much value long-only active managers can add. On the other hand, we’ve been very cognizant of making allocations to the hedge fund space and long-short space — areas where smart people can add value.
McLean: We maintain a dialogue with the secondary market to try to see if there’s some private equity we can sell. It’s gotten pretty efficient, and the price is pretty rich now, unless it’s a really bad partnership, and then nobody wants it.
Do you think that more investors will be focusing their energies on finding managers, whether it’s outside the U.S. or emerging markets or very specialized strategies?
McFate: I think there’s a place for it, but I think you have to decide where you think active managers can outperform, net of fees. When we came out of the outsourced solution, there were certain asset classes where we intentionally went passive. We have to maintain a fairly high degree of liquidity because we pay out largely lump sums and there’s a feature in the plan where we have to strike a daily mark. We have sleeves of passive in some of our active equity strategies. I think that’s worked pretty well for us.
When we initially came out, we actually indexed — it was an enhanced index, our [liability-driven investing] strategy. It was a little daunting to try to select LDI managers in the first quarter of 2009 because could you really believe their track record? But after about a year and a half, two years, we decided we needed to get to an active implementation. We swapped that out and went active. We still have some passive on the equity side.
O’Connor: I agree. I think there’s an important role for passively managed parts of the portfolio. It’s a major source of cost savings too.
Gorrilla: I’ll advocate for the active management side because it has worked very well for us. We can go through the attribution analysis and see that in fact, net of fees, it is adding value to the portfolio. We do pick and choose those places. When we’re in traditional equities, we do tend to use more passive strategies, but we have that sizable allocation to active management.
McLean: You have to have a philosophy about where you’re going to be passive and where you’re going to be active. We think about the spectrum. Where the inefficiencies are and where they’re the greatest, we’re going to be the most active, and where they’re the least, we’re going to be passive.
Doane: I have a question about what is meant by “high-conviction managers.” Are there low-conviction managers? How does one know? Is it something that’s in their brochure? [laughter]
McLean: Given the strategy that the manager is executing, does the investor have the conviction that they can execute the inefficiency in the market, that they’ve set up the business to do that? And do you think they have a good chance of doing it because they have the edge and experience, strategy and operations? You have to have confidence in that.
I think we all have been guilty of having too many managers. There are a lot of private equity managers trying to raise new funds. You’re seeing a bifurcation; some managers are not able to raise a fund, while others are. The hurdle has to be higher. We push ourselves to make the hurdle higher, whether it’s qualitative evaluation or return expectation.
Gorrilla: I’d add that it’s a competitive edge and consistency of the strategy and that you had enough time to try to gauge it. It’s stability of the team, that they’re not going to get a better offer and walk away to go join another fund. If you do fall into a difficult period where returns are low, meaning they’re not going to get the compensation that they had hoped for, that they’re not going to leave you high and dry.
Doane: What about a situation where some partners leave to start their own firm? The old firm had a great track record. Could you have a high conviction in the new one?
Gorrilla: I wouldn’t put them on the high-conviction list. I would label them as having great potential. And we’d still be willing to go with them on that venture if we had a long enough relationship that we felt we could judge it.
Doane: I’ve always felt as though a person on their second or third fund is more aggressive. They want to establish a great track record. And I’m more inclined to go there than with the guy who’s on his 12th fund, because I’m figuring he’s just mailing it in.
What is the latest thinking on fees, particularly hedge fund fees?
McFate: When corporations close or freeze their pension plan, they want to fully fund and shed the risk. You see the hedge fund community marketing like crazy to get access to defined contribution plans, which I think could be a very steep hill to get up. I would think over time that you would benefit from this because with more capacity you’d be able to get lower fees. We are headed to a totally LDI bond hedge portfolio in the defined benefit plan.
Hull: I think the best funds are not going to cut their fees. The funds you want to be in, I think for the most part, the fee is the fee.
Gorrilla: A smaller manager has an easier time generating high returns because they need to find fewer opportunities that are winners. If they’re good at it, they’ll make money on their carried interest, and that’s what we’d prefer as an investor. But if they’re offered a large new account, there’s a trade-off of receiving a guaranteed management fee income stream versus having to find more attractive deals.
Atwood: So many of these funds are space-constrained. It’s like private equity. They’re effectively oversubscribed. There’s still enough money out there.
Diamonte: As long as you have people who are willing to pay the fees, those fees will stay that way.
Atwood: We are the funding of last resort for these guys. The last client a hedge fund wants is the Illinois State Board of Investment because we require reporting and transparency. We have a due diligence process they don’t want to deal with. And you see that in private equity. When we explain to them — just in the contracting process — they look at us like we’ve got three heads.
Hull: In New York you produce an annual report; you list every relationship and what the fees were.
Atwood: The interesting thing is that our Freedom of Information Act rules were written before there was such a thing as hedge funds, so the FOIA exemption for private equity doesn’t include hedge funds. We have to disclose if anybody asks.
Everyone is concerned about risk, perhaps now more than ever. What are you doing to address those concerns?
Atwood: There’s a big focus on risk mitigation. Just trying to figure out where’s the soft spot, what can possibly go wrong, and to do that in a methodical and an ongoing way, on a level we’ve never done in the past.
What are you finding?
Atwood: That our risks are pretty well managed. We could all look at these portfolios and pencil out what the risks are, and then when you do the deep dive, you find out the bets are pretty accurate.
Shuman: Valuation matters. On average, valuations are pretty robust, but there are lots of pockets of better risk-reward. I think that’s an area to continue to explore. It seems like the market is starting to differentiate more between different types of companies. Quality companies seem to hold up better. Not making a big bet because we don’t know where the world is headed and having the insurance policy of a lot of different strategies. To Adele’s point, having very-high-conviction managers in your portfolio can help. That’s about all you can do.
O’Connor: Because we don’t know where the next threat is going to come from, we focus on our long-term asset allocation. To combat our concerns about rising rates, I mentioned the bank loans and increased cash. We have an allocation to an inflation hedge portfolio. Because we know that returns are low in this environment, we focus on keeping costs low, so we have more passive investments — 43 percent — in certain areas where we don’t think there are inefficiencies. And we have active management in areas where we hope our managers will continue to outperform — in particular, small-cap equity and emerging markets.
Hull: By the end of the year, I hope we’ll have more exposure in what we call diversified strategies, which are multistrategy and credit hedge funds. I expect that we’ll slightly increase our exposure to emerging markets. I also expect we’ll have a slight increase in our exposure to Japan and Europe. The allocations will primarily come out of less exposure to long-only U.S. equities. My hope would be that long-short equity starts to work. It’s been a rough few years, and it’s been an awful four months for those firms.
McLean: We’ve been adding uncorrelated strategies to try to diversify away from our equity exposure. I think we need to raise the bar on the high-conviction managers. One of the principles that slipped for us and our peers around the crisis time was an alignment of interests. We will redouble our efforts to make sure that our managers are aligned across a number of fronts. That could be on a number of things, such as fees and benchmarks. We’re going back to basics there and making that bar really high.
Gorrilla: We’re firmly set on a course of maintaining our purchasing power, which is 5 percent plus inflation. We’re very happy with our investment policy, so we’re not likely to make sweeping changes in the near term. But we’ve been on the offense the past five years in trying to finance market dislocations and hire managers that are doing something different. We’re starting to switch to a bit more defensive posture. We already have a sizable allocation to long-short; hopefully, it kicks in, because it was painful in March and April.
Doane: We have an investment target of 8 percent set by the legislature that I’m sure is laughingly high for people in this room. That’s a challenge to begin with. We’re trying to develop greater nimbleness and reaction time, either through board governance or through managers being given less constrained mandates. We hope that the combination can allow us to remain current through changing times.
We had only 1 percent in alternatives when I got there, so we’re focusing on ratcheting that up. We’ll be continuing to put more into private equity, and we’ve just selected our first hedge fund manager, although we haven’t funded him yet.
Bill and I actually have the same hedge fund manager now. When I was checking on the references, I called him. He said, “My board voted four-to-three to initially put 5 percent into hedge funds, and when it came time to consider putting a larger allocation, the board was unanimous in its decision to go ahead with 10 percent.” And I anticipate that will be the same case here. My board has been very slow, but I think once they see the advantages, hopefully they’ll add to it.
McFate: We think of our portfolio in two parts. There’s the hedging piece, which is the long-duration fixed income, and the returns-seeking piece. We have a glide path that as we achieve higher and higher levels of funded status, I automatically have the authority to sell from the return-seeking bucket and invest in long-duration bonds.
We’re looking at the risk factors in the return-seeking bucket from the standpoint of diversification. When we’re looking at other ideas, can I be convinced that it’s going to outperform what we currently have on a net basis? If it doesn’t do that relative to how we’re funding it, I’m reluctant to move.
Diamonte: As far as investments go, our best strategy, which will increase over time, is probably the portable-alpha portfolio. That’s the portfolio of very diversified market-neutral strategies — low volatility, expecting to earn 3 or 4 percentage points over cash, with no underlying beta. And we put an underlying beta over that.
You have to stick to your strategy and believe in the equity risk premium for the long term. We have an endgame to deal with our underfunding. We look at a combination of interest rates, growth assets, the macroeconomic environment and our risk tolerance. Then you have a plan that takes you from current levels to where you want to be. • •