“The most fascinating thing about the investment business today is that people will agree on the micro facts, but they hesitate to add it all up,” Mohamed El-Erian recently told a rapt audience of sovereign wealth fund officials. As CEO and co-CIO of $1 trillion asset management giant Pacific Investment Management Co., El-Erian urged the group to embrace new ways of approaching the markets. “Once people acknowledge that the facts are changing, then they have to be open to the notion that when it is all brought together, the world is going to look different,” the former International Monetary Fund deputy director and Harvard University endowment chief explained. “When markets are faced with all these new facts, it takes time and takes overwhelming evidence. That is why there is this amazing volatility in markets, not just weekly, but daily—because people are flip-flopping between old normal, new normal. The inclination as a market is to go back to the old normal, but the reality is leading people to the new normal.”
El-Erian wasn’t speaking at the World Bank in Washington. Nor was he at the World Economic Forum in Davos. He was in Juneau, Alaska — population 31,000 — on an unseasonably warm morning in late May, delivering a two-hour presentation on the state of the world economy to officials of the Alaska Permanent Fund Corp., which oversees the Alaska Permanent Fund, a $33.3 billion sovereign wealth fund set up more than 30 years ago to ensure the financial security of future generations of Alaskans against the time when the oil fields on the North Slope run dry. The APFC hired Pimco early this year to advise it on protecting those assets from the market’s unforgiving ways, but El-Erian wasn’t the only big-name money manager traveling to Alaska. Robert Prince, co-CIO of Bridgewater Associates, also was on hand to give his own three-hour presentation. Last year, APFC chief investment officer Jeffrey Scott persuaded the fund’s trustees to hire five of the highest-profile U.S. asset management firms to function as what he dubs “external CIOs,” giving them $500 million each to manage as they see fit, as part of a mandate that includes teaching and consulting. The others are AQR Capital Management, GMO and Goldman Sachs Asset Management.
“I’ve recruited a team,” says Scott, 45. “There’s not one voice anymore. There’s six of us now.”
Scott arrived in Alaska’s state capital in 2008, in the midst of the biggest economic downturn in 70 years, with a fierce determination to apply the latest and best thinking on investment management to the Permanent Fund. That would mean changing the way the fund’s assets had been allocated, invested and monitored for nearly three decades. Scott would have to create an industrial-strength risk management tool and redesign staff assignments. Most challenging of all, he would have to convince fund and state officials that this new path would lead the APF to a more secure future.
Scott is going to need all the help he can get. Selling the board, the state legislature and the Alaskan people on even the slightest change to the Permanent Fund portfolio will be a daunting challenge. “Unlike other state funds, the Permanent Fund, because of its dividend and history, is a much bigger part of the state identity,” explains Robert Maynard, CIO of the $10.5 billion Public Employee Retirement System of Idaho. “What you do is under a bigger microscope.” Maynard should know. A former deputy director of the APFC and Alaskan attorney, he lived in the state for 18 years.
Neither a pension fund nor an endowment, the Alaska Permanent Fund is one of the world’s oldest sovereign wealth funds, established in 1976 following a statewide vote. The idea was simple: Take the millions of dollars in royalties and revenue-sharing payments that Alaska receives from oil companies that had purchased land along Prudhoe Bay, and put it in a permanent fund that could be used to generate future income even after the oil revenue is gone. The fund, whose annual dividend payout is a key source of income for the poorest Alaskans and a bolster to the state economy, has been the subject of debate among its constituents for most of its existence. From the taxi driver who will use the fund for his child support payment to the pregnant mother of five who will soon be adding another beneficiary to her household to the indigenous people of the vast interior who depend on the fund for up to a quarter of their annual income, all Alaskans have a stake in its performance.
“This is a huge part of the economic future of the state,” confirms Michael Burns, APFC executive director since 2004. “Our mission is to turn nonrenewable natural resources into renewable financial resources.”
Unlike most public fund investment officers, Scott spent much of his career in corporate treasury, a place where risk management is king. As assistant treasurer at Microsoft Corp. in Redmond, Washington, Scott developed and managed a $56 billion absolute-return global asset portfolio that included investments ranging from cash to commodities. “Microsoft manages assets in a very unique way for a corporate,” explains George Zinn, Scott’s former boss and the company’s treasurer. “We manage for liquidity as well as longer-term risk-adjusted assets.” At Scott’s suggestion and the trustees’ invitation, Zinn sits on the three-member advisory board at the APF, along with Maynard and Jerrold Mitchell, a senior adviser at Boston-based family office Saltonstall & Co. and the former CIO of Massachusetts’ Pension Reserves Investment Management Board.
Scott’s decision to pursue the position in Juneau following a decadelong corporate career and short stints running both a hedge fund and a risk management consulting practice was a surprise to some members of the board. “Jeff was extraordinarily impressive in terms of résumé, background and ability to communicate with the board,” says Fairbanks native Stephen Frank, board chairman and a former state senator and representative. “I was impressed by his willingness to come to Juneau. He had been in the private sector. People have to want to come to Alaska — it’s not Wall Street.” Scott, a ten-year triathlete who could pass for a career military officer, sports a buzz cut and the lean build to go with it. On his way home from the office, he often skis down unmarked trails on one of the surrounding snowcapped mountains. He was looking for a challenge when he arrived in Juneau.
Scott needs to be more than an investment officer. He is a change agent who is sowing the seeds of a new investment management model far from the world’s financial capitals. He began by hiring a dedicated director of asset allocation and risk, former Microsoft colleague Max Giolitti, to create a risk dashboard that would continually monitor and assess the entire portfolio. Then he changed the fund’s traditional asset allocation structure to reflect risk factors such as inflation, deflation and liquidity. “He is one of the first movers in moving to a risk factor analysis, as opposed to an asset-class analysis,” says Pimco’s El-Erian. Scott’s third initiative was to unbundle the Barclays Capital aggregate fixed-income benchmark — a compilation of every major bond category and long the industry standard under its former owner, Lehman Brothers Holdings — then use only the bonds he deemed appropriate for Alaska. “Jeff is not just asking how things have been, but looking forward and asking how things should be, given that the world is changing,” El-Erian adds.
Scott’s investment philosophy is fundamentally different from that of the typical public fund. “Trying to manage to a return is a naive approach to investing,” he asserts. “You need to step back and think about what are the liabilities, how are you going to cover those liabilities, and how can you hedge and manage them.”
He continues: “At public funds there’s a tremendous focus on what they are doing relative to their peers. The biggest concern is relative performance, not absolute performance. There’s pressure from the politicians and pressure from the media.”
The new CIO had to convince the board of trustees and the state legislature that his changes would benefit both the fund and the Alaskan people. To make his case, Scott began by meeting with each trustee individually and holding all-day sessions with them as a group. “He’s done an effective job of making changes,” says Frank, speaking of Scott’s efforts. “He’s brought the board along. He made a pretty extraordinary effort to educate the trustees.”
The board education process has been crucial. But when state legislators learned of the changes, they called the whole enterprise into question. Scott, Burns and Frank had to fly to Anchorage to meet with state senators and representatives to explain the risk management initiative. Burns says he hired his CIO for his high energy level and communication abilities. “We hired him, not his approach,” he explains.
Selling the board of trustees and the state legislature on the new asset allocation and risk management concepts was only the beginning of the plans Scott is making to prepare the Alaskan fund to weather the volatile events of the new-normal investment scenario. “We’re not going to be able to replenish the oil on the North Slope,” he says. “The Permanent Fund is the second most important asset in the state of Alaska, next to that oil.” Oil production peaked at 2 million barrels a day in 1988; current daily production is 700,000 barrels.
On the first day of the May board meeting, the six Alaskan trustees assembled at the long dais at the front of the boardroom, alongside Scott, Zinn, Burns and Callan Associates investment consultant Michael O’Leary Jr. When El-Erian finished his two-hour presentation, the small audience, which included Gary Bader, CIO of the Alaska Retirement Management Board, thinned out. (Bader, whose office is located only a few blocks away from the Permanent Fund, had applied for Scott’s job when it became available in 2008.) Soon after El-Erian stepped down, the fund’s second co-CIO, Bridgewater Associates’ Robert Prince, took his turn working through a three-hour slide presentation and answering questions. Scott, focused and attentive, would have to wait a full day to find out if the trustees would vote in favor of the new, risk-based investment policy he had worked on for the past 18 months.
Jeff Scott spent his early years crisscrossing the U.S. Born in 1965 in Buffalo, New York, where his father’s family still resides, he moved to Florida with his mother and sister four years later when his parents divorced. After his mother remarried a few years later, Scott moved again, this time to northwestern Idaho, where the new family lived in a steel barn on a 40-acre ranch outside Coeur d’Alene. School was a two-hour, 52-mile round trip in a four-wheel-drive bus. “I spent a lot of time on my own, hiking in the woods or working,” recalls Scott.
He began his college education at North Idaho College, then moved to the University of Idaho, graduating in 1989. Scott struggled to declare a major until senior year, when he was bitten by the finance bug. “It was like a switch was turned on,” he says. “I became obsessed with finance and investing.” The nascent CIO got his first taste of investing real money during his senior year, when the Davis brothers of Winn-Dixie supermarkets fame, whose roots were in Idaho, established a $200,000 fund for students to run.
Scott was chosen as its co-head and wrote the first investment policy for the professor-supervised fund, still extant today. After graduation he took off for Midland, Michigan, with his classmate and bride-to-be, Carmen, a summa cum laude engineering major who had snagged her first job at Dow Chemical Co. Scott enrolled in graduate business school at nearby Central Michigan University and talked his way into an internship in the treasury department at Dow, which typically chose candidates from top-tier schools. Scott started out building models for leasing railcars but quickly advanced to a project on tax-exempt swaps to hedge interest rate risk.
In 1992, MBA in hand, Scott interviewed at Dow for a full-time position in the international treasury division. Once again he was told Dow hired graduates only from top-tier schools, but once again he talked his way into a job, working alongside Joel Wittenberg, current CIO of the W.K. Kellogg Foundation, and Christopher Li, now CIO at Lockheed Martin Corp.
But Scott missed the Pacific Northwest. In late 1995 he saw an opening in National Business Employment Weekly for an assistant portfolio manager of a $2.5 billion short-term fixed-income fund at Microsoft. Despite it being a lower-level, less sophisticated job than his Dow position, Scott quickly fired off a résumé. With 300 applicants, the job was a long shot, but he landed it in the spring of 1996 and headed west.After two years managing the cash portfolio, he spent eight months writing the software giant’s first derivatives policy. In 1998 he built a catastrophic-hedging program that ultimately won him and colleague Prashant Chandran, a former Microsoft derivatives manager, Risk magazine’s 2002 Corporate Risk Manager of the Year award.
“He pushed the Microsoft portfolio to limits I wouldn’t have expected,” recalls Chandran, now head of derivatives at Western Asset Management Co. in Pasadena, California. “That really put us on the map regarding treasury and risk.”
Next, Scott turned to leveraging Microsoft’s risk management group, applying techniques like a risk dashboard to his portfolio to better enable him to communicate with senior management. He teamed up with Giolitti, a transfer from Microsoft’s software side, using cutting-edge risk scenarios, some of which both men would later put in place in Alaska. By 2004, Scott was an assistant treasurer managing 30 people and all of the capital markets investing, from corporate finance to foreign exchange hedging. The total assets peaked at $80 billion, including the $56 billion absolute-return portfolio, and generated about 20 percent of the company’s annual earnings. That December, Microsoft plumbed the treasury to distribute the world’s largest dividend to shareholders: $32 billion. With the portfolio halved and a new CFO — Christopher Lidell from International Paper Co. (now CFO of General Motors Co.) — who didn’t want as much cash on the balance sheet, Scott and some of his colleagues reevaluated their roles and began exiting the company. “I didn’t know if I wanted to be a treasurer,” he explains. “My passion was running money.”
Before he had much time to ponder his future, Scott received a phone call in the spring of 2005 from Jonathan McCloskey, then an executive at the La Jolla, California–based family office of Ted Waitt, founder of Gateway computer. At first, McCloskey asked Scott to run some of Waitt’s money alongside Microsoft’s — an unrealistic request for a giant technology company with no interest in getting into the asset management business. A few weeks later McCloskey called Scott again and asked if he wanted to leave Microsoft and set up a multistrategy hedge fund. He offered Scott $200 million in start-up capital, with a five-year lockup and enough working capital to bring the treasury group back together.
That summer Scott brought his considerable powers of persuasion to the task of rounding up his team for the new hedge fund firm, Bellevue, Washington–based Tahoma Capital. The group included Bart Cocales, then Microsoft controller (now global head of operational due diligence at BlackRock), as CFO and COO and Michael Morrow, who ran Microsoft’s foreign exchange and commodities portfolio and had just gotten an offer from Peloton Partners, a London-based hedge fund that subsequently imploded.
“There was nothing new to build,” says Morrow, now at Nathan Myhrvold’s Intellectual Ventures Management, who signed on as CEO that August. “This was an opportunity to build something else.”
Microsoft treasurer Zinn counseled Scott to take a sabbatical. But Scott felt uncomfortable about developing a business plan on the company’s dime and exited Microsoft after nearly a decade. On March 1, 2006, Tahoma launched a six-strategy hedge fund with $245 million and 17 employees.
Despite the lineup of asset management talent, success was not in the cards for Tahoma. “We had no idea the financial world would collapse but thought the spreads on corporate bonds, high-yield bonds and the equity markets were overvalued,” Scott explains. But in 2006 the market had not yet come to that conclusion, and Tahoma tried to build short positions without losing too much money each month. Waitt’s Gateway stock plunged dramatically, however, and later that year he filed for divorce and became unwilling to wait out the stubborn markets. Scott realized that he’d made a mistake.
“It was gut-wrenching, the hardest thing I ever had to do,” says Scott about having to lay off 15 people. Most received severance packages and went on to work at places like BlackRock, Teacher Retirement System of Texas or private partnerships, while Scott and Cocales wound down the fund. “Once you face adversity, you’ve got to pick yourself up, dust yourself off and start over,” he continues. “I could have gone back to corporate America, but that would have been the easy way out.” Scott started a consulting practice, JCS Advisors, to provide risk management and investment management counseling from his home in Snoqualmie, Washington, a suburb of Seattle.
Scott spent a year working with several top U.S. technology companies, developing financial risk solutions and foreign exchange hedging programs, leading manager searches and providing fund oversight. Then one day he saw the Alaska Permanent Fund CIO job posting on the CFA Institute Web site. When he told his wife he would apply for the position, Carmen, who had sacrificed her engineering and consulting career to raise their two children, now eight and ten, was concerned that the compensation would be less than what Scott was earning in his consulting practice.
But Scott would have his way, despite having to put the APFC finalist interview off for two weeks while he went on a long-planned kayaking trip with 14 other men on the Charley and Yukon rivers in central Alaska. “I was probably the only one having trouble making the trip because I’d be in Alaska,” Scott jokes. At the end of the journey, in September 2008, Scott flew to Anchorage for the interview and was chosen from among three finalists. “It felt like he was a really good fit for our fund,” says board chairman Frank. “We feel fortunate to be able to hire him.”
Jeff Scott arrived in Juneau a few months into the dismal 2008–’09 fiscal year. Like many institutional portfolios, the Permanent Fund has a heavy equity allocation — 59 percent — which precipitated its fall from $40 billion in assets in 2007 to a low of $26.3 billion in March 2009. Although the steep market losses were not the impetus for Scott’s vision of a risk framework to steer the fund, they underscored the need for change.
“When I came in, my concern was, I wanted to improve our understanding of risk and the multidimensional aspects of risk,” Scott explains, sitting in a conference room in the APFC offices. The fund occupies the top floor of a three-story building whose atrium lobby is graced by twin totem poles in homage to Native Alaskans.
In late 2008, Scott began laying plans to reconstruct the asset allocation within a risk management framework. But after years of managing risk at Microsoft, he gauged he would have to move slowly. “You’re not going to go from Pension Fund 101 to Bridgewater in one fell swoop,” he says. Bridgewater has an all-weather fund, while the Permanent Fund Scott inherited was a fair-weather fund, he adds wryly.
In April he recruited former colleague Giolitti as director of asset allocation and risk, and Valeria Martinez moved from the APFC accounting department to become a research and operations analyst. Aided by Martinez, Giolitti set to work building a risk dashboard that would display risk levels as green, yellow and red zones for every asset class owned by the Permanent Fund.
“What Jeff has done at Alaska in terms of their risk management practice is like what we developed at Microsoft,” says Zinn.
The next step was to reconfigure the fund’s traditional asset allocation, accounting for five different risk-related scenarios. First, Scott created a new, 2 percent cash allocation to avoid having to sell assets like real estate and equities when the fund needed cash to pay the annual dividend. Next he set up a deflation portfolio, now 6 percent of the total, to house government bonds like Treasuries that would reduce risk if a market crisis reoccurred. To guard against the threat of rapidly rising prices, he put the fund’s 18 percent allocation to Treasury Inflation-Protected Securities, real estate and infrastructure investments into a separate inflation portfolio. He also created a new “special opportunities” portfolio to produce superior risk-adjusted returns relative to its company exposure — same risk, higher return — and to seek a different risk with an equal or better return than equities. At 21 percent of the total, special opportunities includes a 7 percent allocation to the five “real return” external CIO managers; 6 percent to hedge funds; and the rest to distressed debt, commercial-mortgage-backed securities and mezzanine debt.
The biggest portfolio change came with the creation of a “growth and prosperity” bucket — now 53 percent of the total fund — into which Scott placed all the fund’s public and private equity and corporate bonds. That done, the CIO was able to preach his gospel to the trustees and staff: An oversize equity allocation will follow the fortunes of the S&P 500 index, leaving the fund vulnerable during economic downturns. The growth and prosperity investments will rise in good times and fall in bad, he explains, and thinking that corporate bonds provide diversification for equities is folly. Both equities and bonds are exposed to the health of the companies that issued them.
Although the Permanent Fund assets had only been reorganized, not materially changed, the fallout from this restructuring reverberated both inside and outside Alaska. First, Scott had to sell these ideas to the trustees and APFC’s consultant, Callan’s O’Leary. “He’s very patient making sure the board understands what he wants to do,” O’Leary says. “To date, he’s been successful in creating this partnership with him and the board.”
The next phase was a little harder. For the new risk-based asset allocation to work, Scott had to pull apart the fund’s fixed-income investments, which historically had been benchmarked against the Barclays Capital aggregate bond index, and put them in the appropriate risk-related portfolios — or in some cases jettison them entirely. “Just because Wall Street sells it doesn’t mean we have to buy it,” Scott reasoned. But for director of fixed-income investments James Parise, it meant disconnecting his nearly ten-year track record from the index.
Scott acknowledges that tensions arose when staff perceived him as an outsider from Microsoft challenging the status quo. He took the educational approach he favors, donning a microphone at his second board meeting, in February 2009, and lecturing the trustees and staff on how he wanted to reshape the fixed-income portfolio, taking only the pieces he deemed appropriate — government securities that hedge for deflation or economic crises of confidence. The corporate bonds would be shifted to the growth and prosperity portfolio and mortgage-backed securities placed into special opportunities. (Most of the MBSs have subsequently been sold.) Drawing on his Microsoft experience, he explained that if the Permanent Fund bond managers could manage the portfolio on an absolute-return basis and understand the components, they would be much more valuable to their clients.
The CIO believes it will take a few years for his fixed-income team to feel comfortable using only sector indexes. For his part, Parise, who joined the APFC in 2001 as a bond manager from Chicago-based high-net-worth adviser Cedar Hill Associates and became director of fixed income in December 2004, says, “We’ve had a year to get used to it, and performance hasn’t suffered because of it.”
The fixed-income portfolio has shrunk to $5 billion from $9 billion when Parise arrived. “What’s kept me here are two guys — Josh Burger and Chris Cummins,” he says. “We love coming into work in the morning because of each other.” Burger, the credit portfolio manager and a 1997 Princeton University graduate, worked most recently as one of three investment officers at Bowdoin College’s endowment. Cummins joined the APFC in March 2007 from BlackRock, where he managed structured products like mortgage, credit and asset-backed securities. The three men, who serve as both analysts and traders, enjoy the freedom of expressing their views without a burdensome fixed-income investment committee, Parise adds. They are also avid skiers who, like Scott, often hit the slopes for a few runs on their way home from work.
After the May 2009 adoption of the new risk-based asset allocation, media reports of the changes reached the legislative budget and audit committee of the Alaskan legislature. Concerned that material changes had been made to the fund assets, the senators and representatives summoned Scott, Burns and Frank to Anchorage that September for questioning. At first, they grilled Scott about his domestic arrangements — how much time he was spending in Juneau and what flights he took to and from his home outside Seattle. APFC staff are supposed to live in Juneau, but Scott and his wife are waiting for their house to sell before moving their children. That’s not likely to happen anytime soon, as their neighborhood of high-end homes was built as the market peaked in 2006.
“I said, ‘This is my Bernanke moment,’” Scott quips about his grilling, but he had in fact prepared by studying the Federal Reserve Board chairman’s interview style. After both group and individual meetings, Scott was able to convince the legislators that the Permanent Fund assets had not been materially changed and that they now had greater transparency and risk controls.
Back in Juneau, Scott turned his attention to the equity portfolio, whose manager had left soon after his arrival. The CIO asked former APFC public equity manager Maria Tsu, then head of private equity and infrastructure, to add directorship of investments for equity strategies and infrastructure to her responsibilities. Tsu had worked closely with Scott’s predecessor, Richard Shafer, for four years, then left in 2007 to move back to Anchorage, where she has a family and a house. Earlier, as a naval engineer and with master’s degrees in chemical engineering and economics, Seattle native Tsu spent six years as a vice president in the equity derivatives research group in the equity division of Goldman, Sachs & Co. in New York before relocating to Alaska. “I’m not here to earn a big paycheck,” she says. “I gave up those things to come here.” Tsu’s annual salary, not including benefits, is roughly $178,000. (Scott makes $348,000 a year, which is significantly less than he was making in the private sector, he says.)
Scott judged that it was impossible for his new head of equities to successfully oversee 39 managers and 41 portfolios with limited resources. Tsu, who telecommutes from Anchorage, worked with him to pare down the roster. They cut the 17-manager small-cap pool that Callan had helped assemble down to just five managers (Eagle Asset Management, Jennison Associates, Pzena Investment Management, RBC Asset Management and T. Rowe Price Group). Scott also led the charge into a “high conviction, true alpha” process of evaluating managers and put Tsu and one senior analyst on the task. “It provided a level of rigor,” says Tsu. “Managers now have to pass the Jeff test.”
Although having fewer managers to track was liberating, for Tsu, the true innovation is the active risk budget adopted by Giolitti. Tsu now measures in basis points the active risk the portfolio has relative to the benchmark, giving her a clear idea, as she once had at Goldman Sachs, of how much risk she is taking if, for example, she moves $1 billion out of U.S. large-cap equity into international equity. An allowance of 300 basis points makes it easier to manage a portfolio of active and passive managers without using rigid style boxes. “Now I’m not managing to bands and percentages,” she says.
In late May, just a short walk from the APFC offices, bright sunlight was glinting off Juneau’s crystal blue Gastineau Channel. The temperature was an unusually balmy 70 degrees when Alaska Permanent Fund trustees, asset managers, consultants and advisers flew into the Juneau airport for the two-day quarterly board meeting. No roads lead into the small, frontier-style state capital, and seaplanes and cruise ships regularly come and go in the channel. Downtown streets are lined with souvenir, T-shirt and jewelry stores that cater to the five-month tourist trade, while snowcapped mountains provide a picture-perfect backdrop.
A critical component of Scott’s vision to build and preserve Alaska’s assets: his outsourced CIOs. “I needed to recruit players on my team who could speak eloquently about risk,” he explains. With help from Callan, five firms were selected from a field of 42. “A key motivation on Jeff’s part was making sure the board was exposed to best in class,” says O’Leary, the fund’s lead consultant since 1990. “To me, that’s a pretty innovative approach.”
The managers were each given a $500 million global mandate — an “incubator portfolio,” as Mark Evans, head of global portfolio solutions strategies for the Goldman team, terms it — to produce the same 5 percent real rate of return as the Permanent Fund’s objective. For this assignment, they receive a low base fee plus a performance fee after meeting the return objective of the consumer price index plus 5 percent. There is a cap on total fees and a high hurdle mark. The major constraint is that the managers can’t make investments with lockups longer than two years. The five are also tasked with providing education, consulting and other support services; Scott says this is of equal importance to their investment responsibilities.
During his May board presentation, El-Erian delivered the risk management lesson that the trustees signed him up for. The Pimco co-CIO explained that his firm has designed a customized, diversified global strategy across key risk factors in addition to asset classes. A small portion of the strategy is dedicated to tail-risk hedging, which attempts to mitigate volatility in the portfolio in the event of systemic market shocks or periods of severe market stress. El-Erian explained to the board that because different liquid asset classes can carry similar underlying risks, investing across asset classes may result in portfolios that appear diversified but have concentrated risk exposures.
With its $500 million mandate, Bridgewater Associates is demonstrating the firm’s approach to creating a “balanced beta” — a way of allocating risk evenly across an array of long-term stable assets. According to co-CIO Prince, this term was coopted by the asset management industry following his firm’s lead in 1996 and is now typically referred to as “risk parity.” The balanced beta represents 70 percent of Bridgewater’s Alaska portfolio, with the remaining 30 percent in alpha strategies that involve market-timing decisions. “It’s our representation of how we’d run the Permanent Fund if we were in their shoes,” Prince notes.
Bridgewater has let Scott analyze the Alaska portfolio using its proprietary risk budgeting tools and has consulted with APFC staff on assignments ranging from evaluating the risk of the hedge funds in their fund-of-funds portfolios to currency management, fee analysis and TIPs. Scott is looking to Bridgewater as a lead in formulating a beta strategy, says Prince, who believes that the APFC CIO is doing the right thing: “It may be different from what everybody else is doing, but that’s okay because it’s the right thing.” Prince points out that even though the company-risk-laden portfolios of most public pension plans are the reason most of them are underfunded, Scott faces a big challenge in making changes.
“Even though that’s an exposed, flawed, imprudent structure, the definition of prudence is what everyone else is doing,” Prince observes.
AQR’s co-founder and managing principal Clifford Asness says he has been having an active dialogue with APFC trustees: “I wouldn’t want to imply we’ve convinced the whole board to separate alpha and beta, but I think we’ll have influence over time.” Asness emphasizes that his first priority is beating the CPI-plus–5 percent benchmark that he and his fellow external CIOs have been given. But, he acknowledges, “it’s not just about having a strategic asset allocation, it’s about having a willingness and ability to share.” Asness, who is looking forward to his first board presentation at the end of this month, says this mandate is testing the skills of his firm across the board.
On the second day of the May meeting, after El-Erian and Prince had packed up and flown out of Juneau and APFC staff had given their reports, only the new investment policy still awaited trustee approval. Proposed soon after Scott’s arrival by trustee Nancy Blunck, an Anchorage-based financial planner, the new document is a compilation of a dozen different past resolutions, regulations, policies and statutes, in addition to Scott’s new risk guidelines.
As Scott waited tensely for the verdict, he dropped his copy on the floor, scattering the pages. With the upcoming November gubernatorial election, he was worried that, because the governor appoints two of the six trustees, if the document was not accepted, a reconfigured board would require him to restart the board approval process. To facilitate the vote, Scott reminded the trustees that the policy is a living document that can continually change and improve: “It’s not Shakespeare and we put it away and it’s perfect.” Patrick Galvin, Alaska’s commissioner of revenue, praised Scott’s comment.
The trustees debated some final points before Galvin, who is also the sole fiduciary of the $8 billion constitutional budget reserve and oversees the Permanent Fund dividend division, made a motion to accept the new policy. A vote was taken, and the decision was unanimous: The policy was approved. Scott’s call for bright lines to define what the staff can and cannot do, using the color-coded risk zones created by Giolitti, entered the APFC canon. Now, for example, when a portfolio’s risk level enters the yellow warning zone, the executive director will be alerted and staff given 90 days to move it back to the green zone. If there is a breach into the red zone, the CFO will notify the trustees.
The new investment policy is a milestone for the Alaskan fund, but there is much work still to be done, says Scott. Good news came recently in the form of improved returns for the 2009–’10 fiscal year, ended June 30. The fund increased 11.72 percent, setting it on the path to recovery from its previous losses. Although that result trailed the 13.28 percent average return for pension funds, endowments and foundations with greater than $1 billion for the same period, according to Wilshire Associates’ Trust Universe Comparison Service, Scott says that on a risk-adjusted basis his fund actually outperformed many of its peers. “Everyone wants to compare returns, but nobody wants to compare risk,” he adds. “The comparison really should be return per unit of risk.”
In the near term Scott wants to spend time making sure the board is comfortable with the new policy before he and Giolitti begin looking at how to construct the special-opportunities portfolio relative to the dominant equity risk. He also hopes to tackle the fund’s cost structure, a key area of inefficiency. “We spend a ton of money on gatekeepers,” he says. Possibilities include co-investment, strategic partnerships and consolidating to a few high-conviction managers, with resulting cost breaks for the fund. Limited resources remain a challenge. “That’s a difficult political situation,” Scott says. “The budget is set by the legislature. Compensation for professional asset managers with proven skill is higher than government scale.”
In the more distant future, Scott hopes to open a dialogue with the board about incorporating into the APFC’s investment model more differentiated risk factors, such as emerging-markets interest rates. Also in the future could be a look at whether the asset allocation should take Alaska’s own assets into account. Should the investment mix change over time based on the state’s amount of proven oil reserves? Should the fund allocate assets to alternative energy as a hedge?
“I’ve only been looking at the fund in isolation, not at its enterprise risk, like in a corporation,” he explains. “But that’s really long term. For now I want to tackle something that’s easier.” Maybe so, but given his predilection for tough challenges, Scott isn’t likely to wait long.
