Institutional Allocator - July 2018 | Volume 1 | Issue 1 by Markets Group

JULY 25, 2018

Efficacy Test?

With markets threatening to “act up” this year, is riskparity investing ready for prime time?

Go Big or Go Home!

It’s War! ...Well Sorta

Illinois U. looks to drop $5bn on exchangetraded options.

E&Fs pipe up on concerns, or lack thereof, of a potential U.S. trade war with China.

Keeping it Close to Home

Key points for institutions to consider when building an internal asset management operation.

VOLUME 1 | ISSUE 1

High Fives at Colorado F&P

How the city’s fire & police pension fund developed an enviable (and cost-saving) in-house AM structure.

TABLE OF CONTENTS COVER STORY

ENDOWMENTS & FOUNDATIONS

4 FPPA’s Excellent Governance Evolution

29 E&Fs Eye Volatility as US/Sino Trade War Threat Looms

ASSET ALLOCATION 10 Is Risk Parity Ready For a Petulant Market? Risk parity investing, which ballooned in popularity in the aftermath of the financial crisis, may be entering the latest test of its efficacy.

15 Illinois U. Ops for $5B in Exchange – Listed Options The Champaign, Illinois-based University Retirement System is using an exchange-listed options strategy to hedge what some observers perceive as a U.S. equities market on the cusp of a painful tumble.

18 Why Some Investors Shy Away From Options Just 16% of the pension plans and endowments interviewed for a recent Greenwich Associates’ survey are considering investing in exchange-listed options or increasing their allocation to them.

20 Liquidity Benefits? Investors Target FixedIncome ETFs Institutional investors are moving in increasing numbers into fixed-income ETFs—their demand derived, in-part, from portfolios adjusting to an environment of rising interest rates.

22 Canada Leads the ETF Charge Canadian institutions are at the forefront of a growing move by institutions worldwide to integrate ETFs into their portfolios.

24 How to Build an All-Season Real Assets Portfolio Based on a Markets Group panel discussion conducted in the spring, Mark Fortune recaps a discussion among four investment specialists in the real assets class.

Many endowments and foundations are generally concerned about a trade war between China and the U.S. affect their investment strategies, but some remain unfazed.

INVESTMENT GOVERNANCE 32 Building the Business Case for Internal Asset Management Randy Miller and Rick Funston of Funston Advisory Services explain why more funds are exploring the feasibility of internal investment management.

36 Alaska’s Comp. Plan: A Fitting Model for Public Funds? The recent approval of new incentive compensation guidelines for investment staff by APFC’s board runs the risk of critical news headlines—a perennial risk faced by publicly funded investing institutions when they move to compensate staff competitively. But, so far, criticism of the initiative has been muted.

INVESTMENT CONSULTANTS 40 Developing a Private Debt Allocation Investment consultants address key concerns in developing a private debt allocation.

FUND FLOWS 43 Fin Searches’ Completed Institutional Mandates Chart Q1 & Q2 Manager search data on all completed mandates from U.S. public pension funds and foundations and endowments.

EDITORIAL TEAM Mark Fortune Editor Leslie Kramer Managing Editor Kaitlyn Mitchell Reporter

CREATIVE DIRECTOR Tony Patryn Senior Graphic Designer & IT Projects Manager

EXECUTIVE STAFF Adam Raleigh Chief Executive Officer Tim Raleigh Chief Financial Officer Shalini Sinha Head of People Operations Giseli Akaboci Head of Operations & Logistics Group Joyce Riley Operations Associate Paul Hamann Head of Private Wealth & Alternatives Group Paloma Lima-Mayland Head of Private Equity & Real Estate Group Kim Griffiths Head of US Institutional Sales

LETTER FROM THE EDITOR

Mark Fortune, Editor, Markets Group

It is my pleasure to introduce the inaugural edition of Institutional Allocator, Markets Group’s quarterly magazine. Let me summarize how it came to be:

Andres Ortiz Head of Production‚ EMEA Veronica M. Rodriguez Co-Head of US and RE Investor Relations Jason Peet Co-Head of US and RE Investor Relations Cassia Di Roberto Co-Head of Private Wealth Investor Relations Michelle Quilio Co-Head of Private Wealth Investor Relations John Zajas Marketing Manager & Data Protection Officer William Kazlauskas Office Manager

PROGRAM MANAGERS/INVESTOR RELATIONS Jane Popova Adena Baichan Amanda Jiang

Kari Walkley

Ann Lee

Kevin O’Connor

Audrey Kadenge

Kyle Becker

Brian Intemann

Logan Brodsky

Carolina Gomez-lacazette

Nada Radwan

Christopher Hoarty

Olga Gorlatova

Christopher Nelson

Patrick Murray

Cory Stavis

Peter Kempf

Domenick Pugliese

Rebecca Birch

Georgia Quinones

Samuel Siemons

Gerlim De La Cruz

Stephen Deiner

RELATIONSHIP MANAGERS Sam Ridley Brendan Davey Daniel Para Mata

Tom Hind

Max Tattersall

Tom Mallon

Nawshad Noorkhan

Tony McLean

Paola Segura

Will Hamilton-Hill

Patrick Egan

William McArdle

DELEGATE SALES Brett Windisch

Sean Walsh

PRODUCTION Institutional Allocator (Volume 1, Issue 1) is published 4 times a year by Markets Group. No part of this publication may be reproduced or transmitted in any form without the publisher’s permission. Authorization to photocopy items for internal or personal use, or the internal or persnal use of specific clients, is granted by Markets Group. © 2018 Markets Group. Entire contents copyrighted.

One afternoon in late January, I noticed that someone had taken a peek at my LinkedIn profile. As I was in the market for a new job at the time, I quickly clicked to see who it was. It was Adam Raleigh, ceo of Markets Group, an events company doing business in the institutional asset management sector. Curious, I immediately sent Adam an InMail, introducing myself, explaining my background and emphasizing that I was in the market for my next career opportunity. He thereupon invited me to his office “for a chat.” How much experience did I have as journalist covering institutional asset management? What did I know about the events business? How did I think a publication best fits with an events company? How did I think a publication might work at Markets Group? What kind of resources would an editorial operation require? Adam peppered me with questions like these. He concluded the meeting with a request that I send him a note summarizing some of my thoughts on the aforementioned questions. “Oh great,” I thought, “another job interview, only this time with homework!” I completed and submitted my homework—how could I not? And fast forward six weeks to March 1 and it’s my first day as Editor of two prospective publications from Markets Group—a weekly news email and a quarterly magazine both bearing the title Institutional Allocator. The first edition of the weekly news email was launched on May 1. You can find past issues here: www.institutional-allocator.com Our plan with our publications is quite simple—to deliver important news and analysis on the world’s institutional investment industry. Tailored to the information needs of asset owners, we want Institutional Allocator to deliver to its readers insight into the thinking of key decision makers at institutional funds, asset management firms and leading industry consultants and analysts. We believe Institutional Allocator’s probing features, proprietary surveys and insider’s perspective from the world’s institutional investment community will help its readers keep their fingers on the pulse of important industry themes, topics and innovations. I don’t mind telling you, I do not yet consider this magazine a finished product—it’s a workin-progress. I anticipate potentially making changes to its format and content going forward with the goal of making it more engaging and valuable to you, its readers. As such, I very much encourage you to contact me with any questions, observations or suggestions you may have for how I can improve the magazine. Before I sign off, I’d like to extend my profound thanks to managing editor Leslie Kramer, reporter Kaitlyn Mitchell, senior graphics designer Tony Patryn and marketing manager John Zajas for all their help and hard work in getting Institutional Allocator launched in an impressively quick time frame. And of course, thanks to Adam Raleigh for having the vision (and gumption) to pursue an opportunity to produce a publication of this caliber in the first place. Onward! Mark.Fortune@marketsgroup.org VOLUME 1, ISSUE 1

INSTITUTIONAL ALLOCATOR

FPPAâ&#x20AC;&#x2122;S EXCELLENT GOVERNANCE EVOLUTION BY MARK FORTUNE

Photo credit: Brian Walski, Colorado Visions

VOLUME 1, ISSUE 1

Photo credit: Brian Walski, Colorado Visions

INSTITUTIONAL ALLOCATOR

taff members of the approximately $4.5 billion Fire & Police Pension Association of Colorado (FPPA) are feeling pretty good about themselves currently.

process where there wasn’t really an investment staff to now where we have staff do manager research and make manager choices themselves without involvement from the board.”

Why? In 2009, an informal level of questioning, second-guessing and hypothesizing among staff members and the fund’s board regarding the fund’s longstanding, heavily-consultant-driven asset manager hiring process coalesced into formal action to change that process. In the pursuit of more efficient investment decision making and a reduction in service provider fees it would shift more of its assets to in-house management.

FPPA’s efforts in this area culminated in January 2017 when hire/fire decisions concerning investment managers were delegated to the investment staff by the fund’s ninemember board.

A decade later, the fund generated a 14.95% return for the year ending December 31, 2017, against a 13.64% internal benchmark, and spent some $1.2 – $1.5 million on staffing costs versus the estimated $4 – $5 million it would have paid in service providers fees last year, absent its governance changes, according to senior officials at the fund. FPPA recently made an investment in a spin-out strategy from an established hedge fund manager. It says that the ability to conduct due diligence and approve the recommendation in a timely manner, facilitated by its revamped investment governance structure, allowed it to take advantage of a unique opportunity and also pay lower fees. “We would unlikely have been able to move that quickly under our prior governance structure,” according to Dan Slack, executive director. He explained: “Overall, the board identified with the improved risk/return profile and with increasing exposure to alternatives (private markets and hedge funds). The board also recognized that manager approval at the board level and ultimately at the Board Investment Committee level was no longer appropriate given the time and expertise needed to evaluate these investments. While FPPA has historically utilized consultants and funds-of-funds for these strategies, additional fees and lack of customization led FPPA to an internal oversight model,” Slack explained, adding that at that time current board member Todd Bower was a strong advocate of the change. “Ten years ago, the board first wanted to move in a different direction from the investment-consultant-driven manager hiring process we had then—we’ve gone from basically a

It’s been very successful; it’s been driven by our fund’s desire to increase investment diversification,” CIO Scott Simon said. He added that “considering the complexity that came along with that, the fund could have outsourced. But we quickly saw the lack of flexibility and synergy that that approach created. So really, having an internal staff gave us more flexibility in our portfolio to create just what we wanted—and you also get that fee savings!”

FPPA’s governance evolution

Slack joined FPPA as executive director in 2008 from the Illinois State Universities Retirement System, where he held the same title. When he landed at FPPA, the fund had three investment officers—one chief investment officer and two investment analysts. It now boasts a 12-person investment staff. The fund’s current CIO, Simon, joined in August 2007 from the University of Colorado Foundation, where he held the same title. FPPA’s investment staff is now responsible for all investment classes, which currently include global equity, long/short equity, private market assets, fixed income, absolute return, managed futures and cash. According to Slack, one of the catalysts that initiated the fund’s move on investment governance was that, “Scott [Simon] and I felt it was an appropriate way to manage the portfolio. And we were fortunate that we had on our board a few investment professionals that shared that view. So there was a meeting of the minds that this made sense, and we took it slow.” The fund’s board was very conscious of large increases in staff cost that can pose headline risks, he said. “The board understood that, but felt like it was the right thing to do.”

“Having an internal staff gave us more flexibility in our portfolio to create just what we wanted–and you also get that fee savings!” VOLUME 1, ISSUE 1

Prior to 2009, FPPA maintained a roster of three consultants: general investment consultant Pension Consulting Alliance (PCA), private equity consultant Hamilton Lane and real estate consultant Townsend; it also worked with various fundsof-hedge funds. The fund now has one retainer consultant on its roster, Cambridge Associates. “[PCA] was supportive of the changes and provided support throughout the process,” Slack said, but noted that though PCA was the fund’s general investment consultant during the entire transition, it did not directly analyze or recommend its new governance structure. In May 2010, the fund’s board authorized the creation of a Board Investment Committee to comprise at least three board members (it currently seats five members, namely Bower, Dave Bomberger (Chair), Karen Frame; Guy Torres and Tyson Worrell. The committee assists the board in monitoring the implementation of the investment program and ensuring compliance with the investment policies and objectives of the fund, Slack explained. The committee reviews the appropriateness of portfolio construction recommendations made by investment staff. “David Bomberger, who has been chair of the board’s investment committee for the last three years, worked with staff and the system’s consultants to facilitate the governance changes that have taken place,” Slack emphasized. Bomberger is CIO of Denver-based Pinnacol Assurance, prior to which he served as deputy chief investment officer for the Colorado Public Employees Retirement Association (PERA), where he oversaw more than $40 billion in assets.

General Counsel Kevin Lindahl, Risk Officer Scott Bryant, Director of Private Markets Dale Martin, Director of Liquid Strategies Ben Bronson and Director of Asset Allocation and Research Austin Cooley. “The IIC must concur in all investment manager hires and terminations. In addition, the IIC will generally review staff investment-related recommendations to the Board or its Investment Committee,” according to Slack. The “whole adventure” began in 2009, Slack said. He credits its success to a good collaborative working relationship with Simon and to a supportive and pragmatic board. “It was a very evolutionary process. Working together [with Scott] was important in implementing these changes. Further credit needs to go to leadership on the board and support from a quality investment staff Slack summed up one obvious benefit of FPPA’s governance changes thus: “Our board investment committee used to meet 25-30 times per year (usually by phone) to approve investment recommendations. As a result of these changes, the board investment committee now meets quarterly (mostly) and can focus on more strategic matters, such as portfolio construction and asset allocation.”

Next steps

The fund is now setting its sights on an expansion of its coinvestment capabilities in its private markets portfolio. The expansion, which the fund anticipates will commence in 2019, will require continued evolution of its governance structure to analyze and approve those investments.

Most recently, last year, FPPA’s board authorized the formation of an Internal Investment Committee (IIC), composed of seven members of staff, namely Slack, the committee’s chair, Simon, FPPA’S INTERNAL INVESTMENT COMMITTEE

(Top to bottom, left to right) David Bomberger, chairman, board investment committee; Ben Bronson, director of liquid strategies; Dale Martin, director of private markets; Austin Cooley, director of asset allocation & research; Scott Bryant, risk officer; Kevin Lindahl, general counsel Todd Bower, board member

INSTITUTIONAL ALLOCATOR

2019 US & CANADA INSTITUTIONAL EVENTS www.marketsgroup.org

6TH ANNUAL

Central States Institutional Forum February | St. Louis 7TH ANNUAL

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For speaking opportunities, please contact: Kim Griffiths Head of US and Canada Institutional Sales Phone: +1 646.416.6214 Email: kim.griffiths@marketsgroup.org

California Institutional Forum December | Napa INAGURAL

Michigan Institional Forum TBA | Lansing *Dates may be subject to change

VOLUME 1, ISSUE 1

ASSET ALLOCATION

IS RISK PARITY READY FOR A PETULANT MARKET? BY MARK FORTUNE

INSTITUTIONAL ALLOCATOR

ASSET ALLOCATION

isk-parity investing, which ballooned in popularity in the aftermath of the financial crisis, may be entering the latest test of its efficacy. According to some investment market practitioners, peculiar market dynamics have raised questions about the performance potential of the strategy, for the short-term at least. “Risk parity has enjoyed an unusually good environment for the last 18 years because correlations have been unusually low (see Aon chart on historic correlations below; return correlations between the Barclays Capital U.S. Aggregate Bond Index and the S&P 500 have averaged –0.1 since Jan 2000). But I don’t see why we would expect that to remain the same going forward,” said Chris Walvoord, partner and global head of hedge fund research at Aon. He added that “for some clients, risk parity can make sense depending on what the rest of their portfolio looks like, but tactically we don’t think now is good time to be adding to the strategy.” “I think that expecting the returns we saw from the strategy in 2016 or 2017 is unrealistic. The reason for that is that there are a number of factors at play that were not at play two years ago,” according to Banjamin Patzik, who heads liquid alternative, hedge fund, and opportunistic research efforts at consulting firm Segal Marco. “So, is risk parity primed to benefit from market conditions today? Not necessarily,” he observed.

What is risk parity? Risk parity is a multi-asset tactical allocation investment approach designed to balance the risks from various asset classes evenly in a portfolio based on the inherent risk profile of individual asset classes. The strategy’s objective is to deliver a constant stream of risk/adjusted returns over the long term. “So, the manager’s goal is not to knock the ball out of the park in any given year. At the end of the day, the goal is to generate consistently strong risk-adjusted performance and a consistently high Sharpe ratio,” Patzik explained. He noted that most risk parity managers will generate a Sharp ratio of between 0.7 and 1. The Sharpe ratio measures an investment’s returns per unit of risk. It is calculated by subtracting the risk free rate

(the rate of return of an investment with no risk, i.e. Treasury bonds) from the portfolio’s expected return and dividing that by the portfolio’s standard deviation of return. Generally, the greater the value of the Sharpe ratio the more attractive the riskadjusted return. The strategy tries to accommodate economic conditions across and throughout entire economic cycles such that the overall portfolio can withstand declines in any specific asset class at any time without fear of an overall portfolio rout. “These solutions are meant to serve as diversifiers, first and foremost. When one combines different asset classes into a single fund wrapper, one should expect the portfolio to generate a differentiated return stream relative to traditional asset class allocations,” Patzik explained. “The environment into which we are entering is not particularly good for risk parity,” Patzik said in May. The conditions to which he referred include a rising interest rate environment and a period of potentially heightened inflation. “Inflation and fixed-income don’t really go well together. How that has influenced central banks’ thinking and actions could have implications for risk parity. We are in a weird environment in which global central banks are trying to toe the line in allowing economic growth while tempering economic growth. They are actively raising rates and hoping for inflation to pick up. How that impacts the broader market dynamic is very uncertain,” Patzik said.

(Top to bottom) Benjamin Patzik, head of liquid alternative, hedge fund & opportunistic research efforts, Segal Marco; Chris Walvoord, partner & global head of hedge fund research, Aon; and Robert Croce, managing director, Salient Pa

“The whole point of risk parity is that you don’t want to allow any single asset class to kill you when it performs poorly,” stated Robert Croce, managing director, quantitative strategies, at Salient. “A risk parity investor applies this principle to bonds and everything else in their portfolio. Over time we will make money in every asset class, and we don’t care so much where it will come from this year; that’s unknowable ahead of time.” Salient boasts $14 billion in total assets under management, $500 million of which is in risk parity strategies. Global risk parity assets currently stand at approximately $250 billion.

1A. WILL BONDS BE A GOOD DIVERSIFIER GOING FORWARD: TRAILING 3-YEAR CORRELATION S&P 500 VS. BARCAP AGG (1/75 TO 12/17)? 0.8%

0.6%

0.4%

0.2%

0.0%

Nov ‘75

Apr ‘81

Oct ‘86

Apr ‘92

Sep ‘97

Mar ‘03

Sep ‘08

Mar ‘14

-0.2%

-0.4%

Jan ‘00 -0.6% Source: Standard and Poors, BarCap | Aon | Retirement & Investment | Proprietary & Confidential

VOLUME 1, ISSUE 1

ASSET ALLOCATION

Performance history

The performance of global risk parity strategies has seesawed over the last handful of years. In 2015, for example, a wide swath of asset classes generated negative returns, with U.S. equities representing one of the best performing assets with a 1.4% return; risk parity strategies returned across a range of 8% to -12% approximately, one consultant said. “So when risk parity investors asked ‘how can this strategy give me such negative returns?’ the answer was that’s because in 2015 correlations between asset classes were so high,” Patzik said. He added that 2016 represented the opposite situation. “Global equities did well. Commodities—a major component of risk parity investing—rebounded to some degree, and fixed income was as steady as she goes. The slight rise in interest rates was insignificant enough that fixed-income managers could still capitalize in certain sectors. So, overall, risk parity performed well.” The wide disparity in risk parity strategy returns in 2015 and 2016 was partly the result of overall market performance and partly a function of the assets in which portfolio managers were investing.

Strategy’s downside?

“There is really only one downside to the strategy: headline risk,” Croce said. “The next time stocks are up 30%, reporters and/or board members will point out that the plan down the road made more money with a less complex portfolio over some arbitrary, short period of time,” he said, adding that investors considering a risk parity allocation (or anything that increases their differentiation from peers) need to have a keen sense of how much shortfall they can withstand politically during periods of underperformance, then allocate accordingly.

“We see many of the big public plans moving toward a 10% static allocation to risk parity. That should deliver substantial portfolio benefit and maximum underperformance versus peers of something like 3% in a year when stocks are up 30% and risk parity returns zero, like 2013.” In the absence of other constraints, he continued, investors should run their entire liquid portfolio in a risk parity framework, he advised. “But there are other constraints; the maverick risk of running a pure risk parity portfolio would be massive. Fortunately, even a 5%-10% allocation can have a big impact on returns and risk. A 10% allocation to risk parity, funded by selling stocks, increased returns by 70bps versus the 60/40 portfolio, and reduced risk as well. (See chart 1B).

How about concerns regarding strategy’s use of leverage?

The correct answer here is “it depends,” Croce said. The most powerful thing about Salient’s strategy is the speed with which it adapts to new risk environments, he claimed. “In very lowrisk environments, we will have a little bit more leverage in the portfolio and in very high risk environments leverage will be low or even completely absent. We think this makes sense because low-risk environments can be very rewarding, especially on a risk-adjusted basis. 2017 is a great example. The S&P was up over 20% and had a realized volatility of well under 10%, yielding a Sharpe ratio well over 2!” Croce said that this year, through the close of April, his risk parity funds have basically been flat, while bonds were down 5.5% for that period. “Clearly, risk parity isn’t just levered exposure to bonds, or we would be down 11%,” he noted

1B. HYPOTHETICAL ANNUAL PERFORMANCE WITH AND WITHOUT RISK PARITY 30.0%

60/40

50/40/10 with Salient Risk Parity

40/40/20 with Salient Risk Parity

20.0%

10.0%

0.0%

-10.0%

-20.0% 1990

1991

1992

1993 1994 1995

1996

1997

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2011

2012

60/40

50/40/10 with Salient Risk Parity

40/40/20 with Salient Risk Parity

Return

8.5%

9.2%

9.9%

Volatility

8.9%

8.5%

8.4%

Ratio

0.73%

0.84%

0.94%

2013 2014 2015 2016 2017

Source: Salient Advisors L.P. June 2016. For illustrative purposes only. Returns for partial years (i.e. 2017) are not annualized. Salient Risk Parity is a backtested model that begins in 1990. See disclosures for full methodology. All backtested return figures are hypothetical. Returns over other time periods may have differed from those shown here. Please see Slide 3 for important disclosures regarding the limitations of model performance.

INSTITUTIONAL ALLOCATOR

2018 MARKETS GROUP FORUMS ASSET ALLOCATION

FEB

7 | Ohio Institutional Forum | Columbus

SEP

8 | Texas Institutional Real Estate Investor Forum | Austin

6 | Private Wealth DC Metro Forum | Washington, DC 10 | Benelux Institutional Forum | Amsterdam

13 | Private Wealth Texas Forum | Dallas

12 | Great Plains Institutional Forum | Minneapolis

20 | Private Wealth UK Spring Forum | London

12 | Private Wealth France Forum | Paris

28 | Switzerland Institutional Forum | Zurich

13 | Private Wealth Great Plains Forum | Minneapolis 18 | AltsSV | Silicon Valley

MAR

14 | France Institutional Forum | Paris

13 | Canada Institutional Real Estate Investor Forum | Toronto

14 | Private Wealth Northern California | San Francisco

18-19 | Private Equity Europe Forum | London

15 | Private Wealth Switzerland | Geneva

19 | Private Wealth Benelux Forum | Amsterdam

20 | Central States Institutional Forum | St. Louis

20 | Southwest Institutional Forum | Santa Fe

21 | AltsLA | Lost Angeles

OCT APR

5 | Tri-State Institutional Forum | New York

2 | Private Wealth Mid-Atlantic Forum | Philadelphia 9 | AltsTX | Dallas

11 | Mountain States Institutional Forum | Denver

10 | New England Institutional Forum | Boston

17 | Private Wealth Europe Forum | Paris

11 | UK & Ireland Institutional Forum | London

18 | Nordics Institutional Forum | Copenhagen

16-17 | Private Wealth Latin Americ & the Caribbean Forum | Miami

24 | Private Wealth New England Forum | Boston

17 | Private Wealth Germany Forum | Munich

24 | Northwest Institutional Forum | Seattle

17 | Midwest Institutional Real Estate Investor Forum | Chicago

26 | California Real Estate Investor Forum | San Francisco

18 | Private Wealth Mountain States Forum | Denver 23 | Southeast Institutional Forum | Atlanta

MAY

1 | New England Real Estate Investor Forum | Boston

30 | Pennsylvania Institutional Forum | Philadelphia

3 | Canada Institutional Forum | Toronto 8 | Private Wealth Canada West Forum | Vancouver

NOV

9 | Private Wealth Spain Forum | Madrid

6 | AltsMIA | Miami 7 | Private Wealth Ohio Forum | Columbus

9-10 | Private Equity US Forum | New York

8 | Private Wealth Canada Forum | Toronto

15 | Mid-Atlantic Institutional Forum | Washington, DC

12 | Switzerland Institutional Real Estate Investor Forum | Zurich

17 | Europe Institutional Forum | London

13 | Texas Institutional Forum | Austin

29 | Private Wealth Nordics Forum | Stockholm

15 | UK Institutional Real Estate Investor Forum | London 15 | Private Wealth Tri-State Forum | New York

JUN

6 | Tri-State Real Estate Investor Forum | New York

15-16 | Greenwich Economic Forum | Greenwich

12 | Midwest Institutional Forum | Chicago

27 | Private Wealth UK Autumn Forum | London

JUL AUG

DEC

18 | Private Wealth West Forum | Seattle

14 | Private Wealth Midwest Forum | Chicago

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VOLUME 1, ISSUE 1

“There are many possible outcomes, but use of derivatives markets make it more likely the balance sheet is larger than it would have been without their use.”

Photo credit: Jake Barlow

INSTITUTIONAL ALLOCATOR

ASSET ALLOCATION

ILLINOIS U. OPS FOR $5 B IN EXCHANGELISTED OPTIONS BY LESLIE KRAMER

he Champaign, Illinois–based State Universities Retirement System of Illinois (SURS), with approximately $20 billion in assets under management (AUM), is using an exchange-listed options strategy to hedge what some observers perceive as a U.S. equities market on the cusp of a painful tumble, in order to beat the market. “Some option strategies can trail. But popular strategies like covered calls, ATM [at the money] and OTM [out-of-the-money] and put writing should beat a bear market in equities,” according to SURS Trustee Paul R.T. Johnson Jr. The system is looking to transition up to 50% of its equities—or about $5 billion—over the next year into primarily exchange-traded options, due to the products’ “high liquidity, ability to immediately enter or exit positions, transparent pricing and AA+ counterparty risk of a clearing corporation,” he said.

executing the equity/options rebalancing in 2017, under NEPC’s guidance. But, due to internal turmoil and staff shakeups at the fund and at NEPC, the program did not launch fully.

Johnson, who has been a proponent of the strategy even prior to joining the fund’s board in 2012, claimed options strategies will help the Illinois system “keep up with the market in a fastmoving bull market and outperform in a declining and slowmoving market.” He added that “any good options manager will beat the options benchmark, while active S&P 500 managers can’t say the same. Which is why many have moved to passive investment—especially in large cap stocks.”

Cash overlay/rebalancing strategy

In February, SURS hired investment consultant Pension Consulting Alliance (PCA), replacing NEPC, to help the system move forward with asset allocation recommendations that included the use of options. The Illinois system began

Chief Investment Officer Douglas Wesley, who has been serving as interim CIO since SURS former CIO Dan Allen’s retirement in August of 2016, is also an advocate of the new strategy. “Because Doug has a strong understanding of options use, and what the lack of use may have cost it—SURS is no longer held back,” Johnson asserted. Wesley has been with SURS for just over 20 years. “PCA has been a leading advocate of the use of options overlay strategies, having recommended approximately $10 billion of various options mandates since 2010,” according to a spokesperson at the firm. NEPC declined to comment on clients or strategies it employs with them. SURS began its cash overlay/rebalancing strategy using futures in 2014 to immediately deploy state funding of $1.5 billion to $2 billion that had originally sat for up to 90 days in a cash account, Johnson recounted. “Sitting in a cash account meant that precious money that was part of Illinois’ annual required contribution went unused, thereby returning a fraction of what it could earn in the equity markets,” he said. “Using S&P futures and similar global indices gave SURS immediate equity market exposure and has added millions to the bottom line,” Johnson claimed. SURS also uses about $400 million in a combination options strategy that replicates rebalancing its portfolio. “This strategy VOLUME 1, ISSUE 1

ASSET ALLOCATION

takes advantage of price movement in equity value that is otherwise left to the professional traders to harvest. Simply put, it sells OTM puts and calls to…replicate [the] buy or sell orders it would make if [its] equity portfolio were to be out of balance by 5%,” Johnson explained. “Doing this means that SURS gets paid and takes no extra risk than if it were selling or buying at a price 5% out of the money.” Johnson noted that other systems have also used this strategy to harvest in excess of hundreds of millions in extra income. “Had SURS been using this strategy over the decades it could have possibly produced an average 0.27% extra income annually, or about $43 million on a $16 billion portfolio plus reinvestment returns,” he speculated.

HAWAII ERS cuts loss in down market

Johnson cites the approximately $17 billion Honolulu-based Employees’ Retirement System of the State of Hawaii’s (HIERS) put selling strategy initiated under its former CIO Vijoy Chattergy, who left the fund in February, as an example of how this strategy could work. “He offers a good example of derivatives Vijoy Chattergy, former chief investment officer, use,” Johnson said. From Jan 25 to Feb 8, Employees’ Retirement of the State of Hawaii Hawaii was down 6%, while U.S. equities System (HIERS) were down 11-12%. For calendar year 2018 through Feb 8 HIERS was down 1% while equities were down around 2%. “You never want to lose money, but if you must lose, lose less,” Johnson said. “The Hawaii options selling program performed well within expectations from 2011 through February 2018, and appears to continue to be doing so,” said Chattergy. “The long-term investment horizon, total portfolio context, and using zero leverage has resulted in equity comparable returns with much less risk. The addition of option selling strategies have dramatically improved Hawaii’s risk-adjusted return profile, making the pension fund’s investment portfolio more stable and less risky, despite the moment in time losses from February 2018,” he said. PCA, also the consultant for the Hawaii ERS, was crucial in implementing the strategy there, Chattergy noted. In February, SURS voted to replace $400 million in funds of hedge funds with hedged strategies using equity-listed options. “The [$200 million] FoHF replacement will be put writing, using S&P, while the [$200 million] global combination strategy will use stock indices around the world,” Johnson said. Going forward, “SURS will be adjusting its asset allocation under PCA guidance. So, these recently deployed strategies may just

be moved into our equity replacement silo or elsewhere, as we proceed into the fall,” he said. For now, “it is still in the works with PCA, staff and board collaboration helping us to move conservatively and pragmatically,” Johnson said.

HOOPP hitches hopes to derivatives

Johnson also pointed to performance of the $77.8 billion Healthcare of Ontario Pension Plan (HOOPP), last year, as an example of the success this type of equity-replacement strategy can yield. “The fund’s 10-year annualized return is 9.55% and its 20-year annualized return is 9.01%,” according to a spokesperson for the plan. “A good U.S. fund like SURS had a 5.4% return average over the last decade,” Johnson noted. “Everyone should be asking why they aren’t doing as well, what have they missed, and what has HOOPP gotten right?” he emphasized. “The answer is using highly liquid exchangetraded tools and the private equity world more prudently,” he advised. HOOPP often uses derivatives and option strategies to gain broad exposure to equity markets, according to a spokesperson at the plan. Exposure to individual stocks is achieved through a combination of cash equity holdings and derivative instruments, she said. Given his druthers, Johnson would move all of SURS’ domestic equity positions into equity-listed options or derivatives that may include passive ETFs or futures products. He asserted that by doing so, the system could potentially become solvent over the next decade, assuming similar bull and bear markets that have been seen over recent decades. “Simple math says that if we could get most of the 368 basis points better return [like the HOOPP did] in the first year and on average for a decade, Illinois becomes 90% to 100% funded,” Johnson calculated. “That’s decades faster than what is now hoped for,” he lamented. The strategy “also saves an almost quasi-bankrupt state (Illinois) from imploding or raising taxes, which is chasing away taxpaying citizens,” he said. According to the HOOPP’s 2017 annual report, the plan’s objectives in using derivatives are to enhance returns by facilitating changes in the investment asset mix, to enhance equity and fixed-income portfolio returns, and to manage financial risk. “Derivatives may be used in all of the HOOPP’s permitted asset classes,” the reports states. The plan utilizes foreign exchange forward contracts, futures contracts, options and swaps. “These types of strategies are always good, though, like most assets, they may at times have negative returns,” according to Johnson. “They will have times of outperforming in most markets and will protect and possibly make money in equity bear markets. If everything goes wrong, you may lose a little less, and if it all goes right you will be way ahead of everyone

“Had SURS been using this strategy over the decades it could have possibly produced an average 0.27% extra income annually, or about $43 million on a $16 billion portfolio plus reinvestment returns.” 16

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else,” he said. “There are many possible outcomes, but the use of derivatives markets makes it more likely the balance sheet is larger than it would have been without their use,” he added. Derivatives can be easily used in a sideways to slightly up or down market, according to Johnson. “OTM call selling adds revenue as does OTM put selling—all while your equities go nowhere. A hundred million [in revenue] here and a hundred million there, and you have billions down the road,” he said. And if markets go up? “Many strategies will still make money. Derivatives such as long S&P ETFs will keep up with

“You never want to lose money, but if you must lose, lose less.”

stockholders. January 2018 was an example of an extremely fast upward moving market. All it did was prompt me to add At the Money covered calls to my portfolio in late January 2018. Put sellers still made money, but less than an outright long stockholder,” Johnson said. “Stocks have caught up during the “Trump” rally into January, and in the short time since, options are coming back,” he added. Johnson also observed that many pension systems simply look at lowering investment manager fees as a way to increase portfolio revenue. “It’s important, but that’s like getting new windshield wipers for your convertible that has to go up a mountain during a snowstorm. Does it help? Absolutely—to the tune of millions. However, using these options strategies are like new windshield wipers for a four-wheel drive SUV with snow tires. You must navigate the markets better in bad times, so that you can accelerate during the good,” he said. Johnson believes that many other pension plans are losing out by not embracing an options strategy. Their reason for not doing so, he says, is a lack of education and experience with the products, as well as a lack of initiative on the part of investment officers who fear a backlash—and scathing headlines—if the strategy under performs in the short term. Johnson’s comfort level in dealing with derivatives comes from his experience in trading and executing these products for decades at the Chicago Board of Trade (CBOT), where, on the exchange’s board of directors, he was also responsible for the writing and maintenance of futures and options contracts. Before joining the SURS-IL Johnson was CIO at LSU Trading, a Chicago-based company Johnson founded to trade equity options, equities, futures and interest-rate products.

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WHY SOME INVESTORS SHY AWAY FROM OPTIONS BY LESLIE KRAMER

ust 16% of the pension plans and endowments that were interviewed for a recent Greenwich Associates’ survey, How Institutional Investors Use and Think About Exchange-Listed Options, are considering investing in exchangelisted options or increasing their Tim Barron, senior vice chief investment allocation to them, compared with 48% president, officer, Segal Marco Advisors of money managers. “It appears that the use of listed options has come in and out of favor over time,” said Tim Barron, senior vice president, chief investment officer, Segal Marco Advisors, an investment consultancy. Just 3% of pension funds are considering using or increasing their allocation to overthe-counter (OTC) options versus 38% of money managers, the survey found. Interest in option strategies typically increase in post-crisis periods, “as fear takes over from greed and investors seek protection post a melt-down,” Barron said. “Interest also increases from some investors as bull markets get long in the teeth as investors seek to protect from a possible melt down. In both cases, the question of when you act is a pretty important determinant of effectiveness, and therein lies the reason that there has not been widespread adoption: A highly variable experience that is investor and timing dependent,” he said. The risks often associated with options are dependent on how they are being implemented in a portfolio, according to the report’s author, Richard Johnson, v.p., market structure and technology, at Greenwich. “Some investors think it doesn’t fit with their primary investment strategy, but there are many different Richard Johnson, VP, market and technology, types out there; you can have options structure Greenwich Associates on T–bills or on Indexes, you just have to find one that sticks with your overall investment strategy,” Johnson said. In fact, some of the risk factors typically associated with these tools may simply be

perceived risk, he said. “It depends how you use them. They can be risk producing or risk reducing.” They can also be revenue producing. Barron concurs. “Derivatives of any sort, even listed, give pause to many investors, particularly due to somewhat of a reputation for being a form of leverage associated with risk. In fact, many options-based strategies can be applied as risk reducers or as ways to enhance return, particularly by moderating tail risk,” he said.

Outdated mandates

The seemingly tepid investor interest may also be due to a combination of a lack of familiarity with the products along with outdated mandates that bar some pension funds from investing in these instruments, which are still perceived in some quarters as risky, Johnson said. The Greenwich study did not provide data on how many public pension plans overall invest in options, but Johnson suggests that it’s a minority of funds, due to individual plan’s investment policy statements (IPS) or stated guidelines and restrictions. Johnson also suggests that compliance departments should take a hard look at the value these products could provide to a plan’s portfolio, and possibly rescind or reverse mandates against investing in them. “Legacy mandates can be 10 or 20 years old and not a reflection on the latest news,” he said. In the meantime, many investment officers’ hands are tied when it comes to giving options a try. Joseph Cusick, director of institutional investor education at the Options Industry Council (OIC), which commissioned the report, also criticizes outdated IPS’s. “The guides for establishing pension investment decisions have not been reviewed and updated. These outdated policies are a roadblock,” he said. The OIC does not have hard data on how many pension funds have mandates that bar them from investing in OTC options or exchange-listed options but “what we do know, from the 80 entities that were surveyed, once a group started the process of looking into and implementing option strategies [the] time to market for 73% of the respondents was less than one year,” Cusick said.

“If you use them and make lots of money you won’t get a raise, and if something bad happens, you could lose your job.” 18

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“Some investors think it doesn’t fit with their primary investment strategy, but there are many Trustee Johnson also cites fear on the part of some investment different types out officers as a reason for the lack of options being used at public pension plans. “If you use them and make lots of money you there; you can have won’t get a raise, and if something bad happens, you could lose your job,” he noted. “So, what’s the incentive?” options on T–bills But change may be afoot. “With the advent of so many strategies that utilize some form of derivatives, this is changing. Time and or on Indexes, you education have created greater comfort as well,” Barron said. just have to find one Missed opportunity? Many of the pension plans that continue that sticks with your to be underfunded today could be using exchange-listed options as a way to help reduce risk and provide protections overall investment and risk-adjusted returns, according to Cusick. “Since 2008, pension funds strategy.” have been trying to claw back from the Lack of education

The other speed bump that may be stalling use of options strategies “is a lack of education and lack of real-world quantitative research, in terms pensions can understand,” said Cusick. Paul R. T. Johnson Jr., a trustee of The State Universities Retirement System of Illinois (SURS), finds this notion particularly unnerving. “The people (trustees) who approve these strategies have little or no knowledge of how these investments work,” he said. SURS of Illinois does use options in its portfolio to both hedge risk and produce revenue and is looking to increase its usage.

fall we had, when they were all down on average 22%. But since then we have seen an unprecedented bull market, so they should be looking at different offerings,” Cusick stated.

Joe Cusick, director of institutional investor education, Options Industry Council (OIC)

He adds that while many pension funds are looking to add alternatives to their investment portfolios, they are still mostly tapping illiquid credit and private equity, compared to private asset managers who have a much broader reach when it comes to alternative investments. Thirty six percent of the respondents to the Greenwich survey are public pension plans, 27% are corporate pension plans, 23% are asset managers and 14% are endowments. Measured by assets under management (AUM), 30% percent of respondents have over $50 billion, 30% have $2-10 billion, 26% have less than $2 billion, 9% have $26 to $50 billion and 5% have $11 to 25 billion. Eighty U.S. investors were interviewed for the Greenwich report. Total AUM for the funds captured in the survey was more than $1 trillion.

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INVESTORS SEE LIQUIDITY BENEFIT IN FIXED-INCOME ETFS BY LESLIE KRAMER

nstitutional investors are moving in increasing numbers into fixed-income exchange-traded funds (ETFs). The heightened demand for these products is derived from insufficient liquidity in the fixed-income market as well as institutional portfolios adjusting to an environment of rising interest rates. For the past two to three years, there has been a demand for fixed-income ETFs as a source of liquidity, given the poor liquidity in the global bond markets, according to Andrew McCollum, managing director at Greenwich Associates. “With the roll-out of increasingly granular and sophisticated fund structures, fixed income may be emerging as the next great growth frontier for ETFs,” he speculated. McCollum said, “We’ve seen big ETF trades—trades of $50 million or more—which shows that investors feel comfortable that they will find the liquidity they are looking for using ETFs.” These recent moves into fixed-income ETFs represent a change in vehicles, as opposed to a change in portfolio allocation by investors, he noted.

(Top to bottom) Bobby Eng, head of SPDR ETF business development, State Street Global Advisors; Zev Frishman, chief investment officer, Morneau Shepell Asset and Risk Management and Jack Bensimon, chairman, Technion Canada Endowment Fund.

The Juneau-based Alaska Permanent Fund Corporation (APFC) is an example of one fund that has increased its position in fixed-income ETFs in recent years. The approximately $65 billion fund uses the class “to gain temporary exposure to less liquid asset classes, where buying the individual constituents can take longer than we would like,” according to Jim Parise, APFC’s director of fixed income. “Currently, we are using highyield ETFs to gain exposure to the sector, while we build an internally managed high yield portfolio,” he said. “ETF’s do allow us flexibility to put cash to work and are easily liquidated when the cash is needed. We had explored buying high-yield ETFs and taking delivery of the underlying securities, but found that strategy to be expensive and required us to give up too much control of our final portfolio,” Parise added.

Increased use to continue Close to 20% of participants in a study ETFs: Valuable Versatility in a Newly Volatile Market, recently released by Greenwich Associates, who are not currently investing in fixed income ETFs, said that they are somewhat likely to start using them in the next 12 months. Among current fixed income ETF investors, one quarter plan to boost bond ETF allocations by more than 10%, and more than two-thirds are targeting increases of 5% or more. Fixed-income ETFs are becoming increasingly prevalent in institutional portfolios, according to Bobby Eng, head of SPDR

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ETF business development-Canada, at State Street Global Advisors. “Approximately eighty percent of our conversations gravitate toward fixed-income ETFs, and we expect that is where the majority of the growth will come from over the next three to five years,” he said. “Fixed-income ETFs provide a liquid, transparent and tradeable way to manage yield, credit and duration, and as an alternative to cash bonds and derivatives vehicles like CDX (credit default swap index), TRS (total return swap) and futures,” Eng said. “A rising rate environment makes it even more challenging to manage fixed income, so ETFs provide another tool that fixed income portfolio managers can use.” Observers who have seen the growth in use of ETF over the past few years say there is no sign of it abating going forward. “Since the inception of the first fixed-income ETF, the growth rate has been 42% per year. There is now over $600 billion in fixed-income ETFs assets globally, with approximately half of those assets coming in during the last three years,” Eng noted. He expects that growth trajectory to continue for the next three to five years.

Emerging market exposure APFC also uses ETFs to gain exposure to emerging market debt, in both local and hard currencies. “They allow us to express our bias toward both currencies, while staying relatively liquid versus our active managers,” Parise said. “They suffer the same tracking error and high fee problem as high yield, but the liquidity advantage serves our immediate needs,” he said. The Ontario-based Technion Canada endowment fund, which takes a global approach to investing, also gains exposure to emerging markets through ETFs, in addition to direct equities. “ETFs are a low-cost and liquid vehicle to gain exposure to a broad group of securities while controlling for risk,” said Jack Bensimon, Chair of the Technion Canada endowment fund. “Our interest in investing in less developed countries reflects the growing global market cap of these countries and regions. Investing in emerging market ETFs provides direct exposure to these markets with less volatility and enhanced relative returns, while allowing for reasonable liquidity levels,” he said. “The key is to be top-down selective in emerging markets as risk profiles can differ dramatically from one emerging market to the next.”

Ease of access and trading Pension plans’ keen interest in ETFs has also grown as these institutions have become more knowledgeable about and comfortable with the product, according to Eng. “Since the global financial crisis, regulation and policy changes have led to

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higher capital charges and restrictions on proprietary trading. Dealer inventory has decreased, making it more challenging for institutional investors to source cash bonds,” he said. “As they look for alternative sources of liquidity, ETFs have become a go-to solution.” Many investors have also commented on the operational ease of trading in the class along with speedy execution, facilitating access to fixed-income markets otherwise unavailable to them through individual securities, said McCullom, author of the Greenwich report. “That’s one of the key points around the bond story: liquidly, ease-of-use, and the quick access they provide. That’s what jumped up as key take-a-way around the bond ETF story,” he said. The ability to trade ETFs on the secondary market is another appealing factor, Eng noted.

Smart-beta ETF investing on the rise

Institutional investors are also increasing their allocation to smartbeta ETFs as a direct response to the volatility in the markets, according to the Greenwich report. The study showed that of the 180 investors surveyed, the share of participants investing in non-market-cap-weighted/smart-beta ETFs increased to 44% in 2017, up from 37% in 2016. “Many people talked about how they used nimble smart-beta ETFs over the course of the past year, and volatility was part of the drive,” said McCollum. Eighty percent of institutional funds that participated in the study and that currently invest in smart beta ETFs said they expect to increase their allocations to these products this year.

“We’ve seen real growth in more niche areas in equity ETFs--in smart beta, or factor-based ETFs, rather than in broad market indices, said Zev Frishman, chief investment officer at Toronto, Canada-based Morneau Shepell Asset and Risk Management. “In the past, there was immense growth in ETFs based on broad market indices; over the last decade and particularly in the last few years, there is more and more interest in algorithm driven ETFs,” he said.

The study’s participants

The Greenwich study’s participants included institutional asset managers, endowments, foundations, corporate definedbenefit plans, public pension funds, insurance companies and insurance asset managers, along with representation from family offices, investment consultants, and other segments. Approximately 45% of the institutions in the study have assets under management of $5 billion or more, and more than 1 in 5 have AUM topping $50 billion. Most of the participants in the study are large institutions. Forty-five percent have AUM of more than $20 billion (up from 33% in 2016) and approximately 1 in 5 have AUM in excess of $100 billion (up from 14%). Together, the study participants represent a sizable slice of the U.S. institutional market, with a combined AUM of $11.16 trillion, up from $6.67 trillion in 2016.

“These figures are aligned with a broader industry trend of an increased focus on factor-based investing,” McCollum said. “That’s the place that we saw the biggest jump this year, on a year-over-year basis. The focus has bled over into the ETF market, as people are looking at new ways of investing, beyond just market-cap weighted,” he said. “Driving that growth in demand has been institutions’ concerns about the prospects of a spike in volatility—a fear that became all too real in February 2018,” the report stated. Sixty two percent of institutions that participated in the study and are investing in smart-beta ETFs are using minimum-volatility ETFs, making these funds by far the most popular in the category.

“Investing in emerging market ETFs provides direct exposure to these markets with less volatility and enhanced relative returns, while allowing for reasonable liquidity levels.” VOLUME 1, ISSUE 1

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CANADA LEADS THE ETF CHARGE BY LESLIE KRAMER

anadian institutions are at the forefront of a growing move by institutions worldwide to integrate exchange-traded funds (ETFs) into their portfolios, according to the 2017 Canadian Exchange-Traded Funds Study, recently released by Greenwich Associates. In fact, the 52 Canadian institutions that participated in the study currently allocate an average 18.8% of their total assets to ETFs—the highest average allocation found in any of the five regional markets covered in Greenwich’s studies. That’s an increase of 3.5 percentage points from 2016. By comparison, Asian institutional participants in the Greenwich Associates 2017 Asian Exchange-Traded Funds Study said their allocation to ETFs actually declined slightly, to 14% in 2017 from 17% in 2016. Average ETF portfolio allocation among the institutions participating in Greenwich Associates European Exchange-Traded Funds Study increased to 10.3 % of total assets in 2017, from just 7.7% in 2016. Across Latin America, institutions increased their allocations to ETFs to 13.1% of total assets in 2017, from 7.6% in 2016, according to the Greenwich LATAM study.

Bobby Eng, head of SPDR ETF business development, State Street Global Advisors

Canadian institutional investors have been growing their use of ETFs by “leaps and bounds,” said Bobby Eng, head of SPDR ETF business development-Canada at State Street Global Advisors. One of the reasons is the level of knowledge and expertise that Canada’s pension plans have around these products. “Canadian

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pension plans tend to be more sophisticated with internal investment management and trading capabilities,” Eng said. They also do most of the strategizing and investing in-house. “Most of the largest pension plans have their own trading desks, portfolio managers, and analytics and research teams compared to others who may outsource to third-party external managers,” he said. “This enables them to use ETFs more.”

Andrew McCollum, managing director, Greenwich

Zev Frishman, chief investment officer, Morneau Shepell Asset and Risk Management

The widespread use of ETFs in Canada may also be due to the fact that the first ETF was created there. Its widespread adoption as a strategic tool, rather than just for tactical purposes, took hold in the U.S. and Canada well before European and Asian investors caught on to its variety of uses, posited Andrew McCollum, managing director at Greenwich and author of the report. Zev Frishman, chief investment officer at Toronto-based consultant Morneau Shepell Asset and Risk Management has also seen a rise in investment in fixed income ETFs in Canada. “In fixed income, we’ve seen growth in the passive or broad universe tracking fixed income ETFs” he said. “Canadian funds commonly use variations of the Canada universe bond indices (total universe or short term only; federal, provincial or corporates) or global indices (investment

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grade, high yield or emerging markets debt – unhedged or hedged to the $) because you can tailor them to your needs. If you believe rates will rise, you can buy a short term index, if you want to bet on rates declining you can go to the long end. You can do maturity or duration management with passive ETF indices as well,” he said.

Fragmentation in the ETF market

The sheer number of ETFs being offered in Canada has caused fragmentation in the marketplace, however, according to Jack Bensimon, Chair of the Ontario-based, Technion Canada endowment fund. “Although Canada was the pioneer of very first ETF, the market has become highly commoditized and fragmented, with far too many funds for the marketplace to absorb. There are over 28 ETF providers with over 80% of the market dominated by two providers. This is acute in a small market such as Canada,” he explained. For that reason the endowment doesn’t use ETFs alone for risk-reduction purposes. “It’s too competitive a landscape to look at just that particular instrument to control volatility and risk,” he said.

Strategic use of ETFs

A growing number of Canadian institutions are using both fixed-income and equity ETFs for the first time in both domestic and international markets, according to the Greenwich report. The consultant credits the versatility of ETF products as the primary driver of their increased institutional uptake. “At the strategic level, Canadian institutions are increasingly using ETFs to obtain “core” investment exposures and diversification benefits,” the report said. Technion Canada increased its fixed-income ETF allocation in the last two years in order to pick up more yield in the current, low-interest-rate environment and to reduce equity price volatility and risk. “We have a fixed spend-ratio and a fixed target rate-of-return, so it’s been very challenging trying to hit those target rates-of- return,” Bensimon said. “We have opted to go for more fixed income and are scaling back on the equity allocation, because of more volatility and a few other factors,” he said. The fund has a 60% / 40% fixed income/equities mix,

currently. “We are using indexes to manage risk, including fixed-income ETFs, and over the last 12-to-15 months have increased our fixed-income ETFs by a small margin, mainly tactical allocations,” he said. Use of ETFs by Canadian institutions increased overall last year in each of 10 primary portfolio functions covered in the study. Study participants said they liked the product’s: §§ Ease of use, the fast execution of trades §§ Liquidity §§ Simplicity §§ The ability to trade them relatively cheaply “These features make ETFs flexible enough to be applied to a fast-expanding list of portfolio applications,” the report said. Bensimon concurs, noting that the Technion Canada fund likes the lower management expense ratio and liquidity ETFs provide, and how they facilitate relatively easy replication of a given index. “ETFs provide for a fairly easy and efficient way to diversify a portfolio in a given sector,” Bensimon said. “It makes sense to get exposure to that sector in a cost efficient way with liquidity.”

Study participants

Between October 2017 and January 2018, Greenwich Associates interviewed 52 Canadian institutional investors for its annual study. The 2017 research sample includes a wide variety of institutional respondent types. More than half the participants (48%) are asset managers. The remainder of the research universe includes endowments, foundations, corporate definedbenefit plans, public pension funds, insurance companies and insurance asset managers, along with representation from family offices, investment consultants and other segments. Most study participants are large institutions. Approximately 45% of the institutions in the study have assets under management of $5 billion or more, and more than 1 in 5 have AUM topping $50 billion.

“Canadian pension plans tend to be more sophisticated with internal investment management and trading capabilities.” VOLUME 1, ISSUE 1

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HOW TO BUILD AN ALLSEASON, REAL-ASSETS PORTFOLIO BY MARK FORTUNE

olatile equity markets and inadequate bond yields have driven a spike in investor interest in real assets this year. Investors are building larger and more diversified real-assets allocations, or considering doing so, by adding global and sector exposure, including infrastructure, maritime and international real estate to their real asset mainstay, domestic core real estate. IA spoke recently with four specialists in real assets investing and asked them to share some of their thoughts on the strategy and on what new and prospective entrants to the class should consider when structuring their exposure. According to data research firm eVestment, total liquid real assets under management for U.S.-domiciled investors at the close of Q1 2018 stood at $20.7 billion, $19.4 billion at the close of Q1 2017 and $14.3 billion at close of Q1 2015. Total AUM in U.S. real estate investment trusts (REITs) for

the same periods were $79.5 billion, $98.1 billion and $80.6 billion, and for global REITs $49.3 billion, $51.1 billion and $50.4 billion, respectively. According to Pulkit Sharma, head of portfolio construction, real assets and other alternatives, J.P. Morgan Alternatives Solutions Group, “We define an all-season real assets portfolio as a collection of real assets that form the ‘core foundation’. These are real assets that exhibit enhanced resiliency across economic regimes. The core foundation can be viewed as an anchor allocation to real assets, given the similar attributes these investments exhibit: diversification from public stocks and bonds, inflation-protection, steady income and lower volatility of returns.” The primary component of the core foundation is core real estate, which typically comprises domestic exposure and, increasingly, international investments in developed markets, he said. “In the past five to 10 years, we have seen VOLUME 1, ISSUE 1

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many investors add core infrastructure to further strengthen and diversify their core foundation,” he said. The firm manages some $100 billion in global real estate and other real assets such as infrastructure and transport. Infrastructure is additive because it enhances the defining characteristics of the core foundation: additional diversification, stable income and often more explicit inflation protection and greater downside resilience in difficult economic times, according to Sharma. He added that the third component of the core foundation, core transport, also exhibits foundational characteristics—most importantly, diversification, due to its global nature, plus enhanced income potential through longterm charters or leases with high-credit-quality counterparties. “Over the long-term, a well-diversified portfolio of core real assets has the ability to generate attractive investment outcomes versus a 60/40 stock/bond portfolio: two to three times more income, a 200–300 basis-point-return premium, up to 2030% lower volatility, low equity beta, low duration risk, better downside resilience and greater inflation sensitivity,” he claimed. He declined to share returns in the class generated specifically by JPMorgan. “The way we look at things when it comes to real assets, the starting point is what is the role within the portfolio?” said Gabriel Nelson, associate director, liquid alternatives, at Pavilion Advisory Group, which has offices in Montreal, Minneapolis and Chicago. The firm manages approximately $249 billion in total assets, of which $2.8 billion is in real assets. For Pavilion, the role of real assets in a client portfolio is twofold: primarily, it provides diversifying earnings streams, as well as an unexpected-inflation hedge, Nelson said. He added that Pavilion has seen increased interest from client groups asking the firm to assess if they are properly positioned for increasing inflation. Pavilion implements its strategy using liquid real asset classes or, where appropriate or clients have the ability to build in some illiquidity, through illiquid real assets, Nelson said.

Ideally, an investment portfolio should have a hedge against inflation, he said. “You don’t want every part of your portfolio to be negatively impacted by inflation. You want assets that react positively when there is a threat of inflation or actual inflation.” In its May 2018 Real Assets Outlook, Verus placed a “positive view” on only three of nine real assets classes, namely: private real estate, private natural resources and midstream energy/ Master Limited Partnerships (MLPs). It was neutral on REITs, commodities, infrastructure, neutral/negative on timberland, and negative on Treasury Inflation Protected Securities (TIPS) and farmland. Regarding its neutral/negative call on timberland, the report said that “despite several years of disappointing returns within timber, we don’t see returns reaching beyond single‐digits on a go-forward basis. Competitive timber from South America has driven prices for certain softwood products lower and favorable hardwood markets in the Pacific Northwest remain difficult to access.”

Where to start?

Because of the relatively wide range of assets to use in a real assets portfolio, it can be difficult for a new entrant to the strategy to know where to start, Orr noted, adding that if he were entering into real assets for the first time he would seek out a real-assets diversified fund. “You want real assets but you don’t know the variance between different asset types. There are a number of competing funds in the marketplace that enable you to get started.” He suggested that “if you come from a fixedincome background, you may lean toward TIPs, for instance, or if from an equity background you may lean toward REITs. Take your background and start from there, and then use your hard-knocks education,” he advised. The ability to hedge short term versus long term, liquidity needs, and the availability of the product is important. REITs are readily available, but timberland is not always readily

He explained that Pavilion’s starting point is to achieve an equal weight for four liquid real assets using the equal-weighted, blended, real assets benchmark it has created. “So, thinking holistically, one has 25% allocated to commodities and the other 75% allocated to diversified earnings streams. That would be how we think about a diversified real asset pool,” he said. “Having a diversified real-asset portfolio is very important over a market cycle,” asserted A.B. Orr, executive director, alternative investments, Providence St. Joseph Health, a Reston, Virginia -based not-for-profit health care provider—one of the largest in the U.S. with 50 hospitals in seven states. The fund has in excess of $20 billion in investable assets, managed via nine separate investment pools, each with its own asset allocation. Some have real assets, some do not, Orr said. “It’s important for the simple fact that when you’re formulating asset allocations you are looking first at public equity and fixed income. Alternative investments, inclusive of real assets, diversify your portfolio—giving you enhanced risk diversification, risk mitigation and downside protection via low correlation with traditional assets. With a portfolio of 100% equity and fixed income, that won’t occur.”

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(Top to bottom, left to right) Ada M. Healey, vice president, real estate, Vulcam, Inc.; Gabriel Nelson, associate director, liquid alternatives, Pavlovian Advisory Group; A. B. Orr, executive director, alternative investments, Providence St. Joseph Health; Pulkit Sharma, head of portfolio construction and other alternatives, J. P. Morgan Alternative Solutions Group

ASSET ALLOCATION

available to all, he said. Fees, too, are important—not all asset classes cost the same to gain the desired exposure. “These are the things that you must discover on your own and that you gain with experience,” he said.

correlated from an industry (tech concentration) standpoint. “While diversification always reduces risk, this is less important in our real estate portfolio because Vulcan gets diversification from other non-physical assets.”

Between 2012 and 2016, Seattle-based Vulcan Real Estate monetized some $3 billion in real estate, and is now in the process of rebuilding its portfolio, according to Ada M. Healey, vice president for real estate at Vulcan Inc.

She posited that in the current environment of volatile equity markets, rising interest rates and the specter of rising inflation, the role of real assets/real estate in an investment portfolio is threefold:

The firm manages approximately $1.5 billion of real estate assets, which comprises land, operating assets and projects under construction. Its real assets portfolio includes holdings such as inflation-linked bonds. “Our owner also has an extensive art collection, which I would categorize as real assets,” Healey said. “In terms of real estate specifically, our development portfolio includes both commercial office and multi-family residential (rental) product types.”

1. Return generator

She said the firm’s current allocation is about 50% commercial and 50% residential real estate. “We like the fixed-income stream from long-term leases at our commercial projects combined with residential income characteristics—residential can be marked-to-market more often due to the short-term nature of residential leases, she said, declining to disclose the performance of the firm’s real-assets investments.

Real assets are well-positioned versus traditional asset classes in today’s uncertain economic environment. According to JPMorgan’s Sharma, “One of the defining attributes of real assets is the diversification they provide to volatile and often correlated public equities. The performance of real assets is largely tied to the local markets in which they are located or operate, and they are subject to local supply and demand dynamics. Their connection to local markets is a key contributing factor to their low correlation to both fixed income and equities. From an interest-rate perspective, historically there has been very low correlation between interest-rate movements and the returns of real assets, in particular core real assets. And that is because rising rates are generally consistent with an improving economic environment, which we are currently in, with healthy job growth and low unemployment. Again, in such a scenario, vacancies can be filled and rents raise—which is particularly true in periods of low new supply, like today.”

Healey characterized a real assets portfolio as “investments that provide a material return above inflation. But, in terms of an “all season real assets portfolio,” she said, “you want to have geographic diversity—not just within the U.S. but also globally to manage risk more broadly. Also, it is important to include ‘economic’ diversification, not just geographic diversification.” For instance, she said, a large position in Seattle and Silicon Valley/San Francisco, while geographically apart, would not meet diversification goals since the two geographies are highly

2. Hedge against inflation 3. Combination of asset appreciation and income return “Therefore real assets are a key component of any diversified investment strategy,” she said.

The bottom line

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VOLUME 1, ISSUE 1

ENDOWMENTS & FOUNDATIONS

“The biggest risk factor, today, is not really trade or international geopolitical issues, but the speed of interest rate hikes.”

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ENDOWMENTS & FOUNDATIONS

E&FS EYE VOLATILITY AS US/SINO TRADE WAR THREAT LOOMS BY LESLIE KRAMER

ndowments and foundations are addressing concerns about how a looming trade war between China and the U.S. could affect their investment strategies. Volatility in the markets, created by tit-for-tat tariff pronouncements from President Donald Trump and Chinese president Xi Jinping, has many investors on edge, with no clear end to the disputes in sight, as this article went to press in mid July. That said, many are taking a long-term approach rather than reacting to daily market gyrations, and some are looking at the volatility as an opportunity to grab deals. “Our view is the current trade dispute with China is likely to be a prolonged issue, and investors should expect ongoing tariff discussions with China to be the “new normal.” With that, we expect market volatility for both U.S. and Chinese equities to be elevated relative to Phillip Nelson, partner and director of asset allocation, recent years, but the trade disputes do NEPC not materially alter our long-term views,” said Phillip Nelson, partner and director of asset allocation at consulting firm NEPC. According to NEPC’s recent Endowment and Foundation Survey, a whopping 78% of the 47 endowments and foundations surveyed said that they are “moderately concerned” about the prospect of a full-on trade war between the two countries, with 11% indicating their level of concern is “very high.” Another 11% say that they are not concerned.

Long-term Approach “Of the 89% of survey participants who said they had some level of concerns about a trade war, most have allocations to China and most of them have it through a broad emerging market strategy,” said Cathy Konicki, partner and head of NEPC’s E&F Cathy Konicki, partner practice group. The potential trade war and head of NEPC’s E&F plays into their overall concerns about practice group the increased volatility in the market, she said. “In fact, their number one concern is volatility, driven by these types of geopolitical events happening, Konicki emphasized. That said, “They have not made any changes to their portfolios in response to the volatility and are instead choosing to take more of long-term approach,” she said. One North American endowment with $1.7 billion in assets under management (AUM), that preferred not to be named, said that on the equity side, all of its strategies are active except its passively managed ETFs. Rather than seeing the volatility as a problem, this endowment sees it as an opportunity. “We think more volatility allows for more opportunity. We have good managers, and believe that they can do what they say they can do, so they should be able to outperform in those environments,” said the endowment’s portfolio manager. The endowment also does not let the daily news cycle dictate portfolio moves. “We follow the news flow daily, but it does not impact our decision making,” the portfolio manager VOLUME 1, ISSUE 1

ENDOWMENTS & FOUNDATIONS

explained. “We have a long time horizon, and do not do tactical investing, so we take a more forward-looking approach, looking at longer-term trends, and are not overly concerned with the daily news. We try to decipher the noise from the action, stick to fundamentals, and stay focused on the long run,” he said. Hideaki Mizuno, executive director of the San Francisco-based BCA Endowment Foundation, also tries not to let talk of trade wars affect him. “The trade issue is only one of many risk factors, but I do not anticipate it becoming a major risk for healthy Hideaki Mizuno, executive economic growth, he said. For Mizuno, director, BCA Endowment interest rate hikes are where more of Foundation his attention is focused. “The biggest risk factor, today, is not really trade or international geopolitical issues, but the speed of interest-rate hikes,” he said. “Higher interest rates are always negative for equities.” he said. “Higher interest rates increase borrowing costs for companies, reduces market liquidity for investors, and slow down consumer spending,” Mizuno said. “If rates continue to rise, BCA will take a defensive approach and move into shorter duration bonds.”

Taking a wait-and-see approach Andy Rothman, investment strategist at San Francisco-based asset manager Matthews Asia, which has $35.2 billion in assets under management, said, “I’ve not seen any evidence of a change in strategy and allocation, and that is wise because the odds are

that we are not going to see a trade war between Washington and Beijing,” he said. Instead, “Trump has been indicating that he wants to resolve the problem, and if you look at way he is behaving it’s clear that Chinese president Xi Jinping wants to avoid it as well,” Andy Rothman, investment he said. Xi has already made several strategist, Matthews Asia concessions to Trump. For example, China has canceled tariffs on U.S. sorghum and announced reductions in tariffs for autos and a number of other consumer goods, as well as plans to better protect intellectual property rights.

Volatility a long-term trend According to the NEPC survey, 81% of respondents said they believe the recent uptick in market volatility will prove to be a longer-term trend, lasting more than a year. But, 75% of those respondents said that they have made no changes to their portfolio in response to that volatility. The U.S. equity market has, indeed, exhibited petulance this past year, especially when compared to the past 10 years, when it was on a mostly upward climb. Konicki attributes the recent volatility to a range of geopolitical concerns, including the rise of populism in Europe and the impact of Brexit. “Those have been a big cause for concern in terms of the move in many countries toward insularism versus a more open global trade,” she said. “Lots of countries are tired of globalism and want to do what’s best internally, which plays into the volatility in the

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ENDOWMENTS & FOUNDATIONS

markets. The ever-fluid atmosphere has made it difficult to make quick reactions,” she added. The North American endowment portfolio manager that spoke on background said he does not execute investments in-house, so does not worry about watching the market on a daily basis. “We delegate it to our partners, our investment managers, and we speak with them on a quarterly basis, so we are not stock picking,” he said. “We watch daily volatility, but don’t act on it. We are focused on the next decade more so than the next week, not shifting daily or monthly market moves.”

Investment in China through broad EM strategy

The NEPC survey also looked at endowments’ and foundations’ overall exposure to China. Of those surveyed, 72% said they are investing in China via a broad emerging markets strategy, while 4.25% are investing in China via both a broad emerging markets strategy and a dedicated China-only investment strategy (e.g. China A-Shares). Exactly 8.51% of respondents said that a China-focused private equity or private debt strategy represents their portfolio’s exposure to China, while another 8.51% said that they have no direct exposure to China. Just 6.4% of respondents said their exposure to China was in another form or asset class. “We have a dedicated allocation of 10% to emerging markets, including a China portion aggregated through three managers, with each fairly close to the benchmark with not much deviation,” said the North American endowment’s portfolio manager. “We don’t have a China strategy, it’s at the discretion of the managers,” he said. Mizuno said that BCA Endowment Foundation’s direct China exposure is through an international and an emerging equity fund and neutral exposure, via an index fund. “We still believe emerging markets offer good investment opportunities, so we overweight the sector by a small percentage point,” he said. “We are also aware of earnings disappointment risk caused by the trade issues among the U.S. blue ship companies from their business exposure in China. However, the valuation and economic fundamentals also support our overweight position in U.S. equities, as current valuations are at a historical average and fundamentals are in good shape,” he said.

because China’s economy is no longer export-led. “Ten years ago, China’s net exports—the value of exports minus imports—were equal to almost 10 percent of GDP. Today, the figure is only 2 percent,” Rothman said. “The largest part of the economy is the domestic demand part, which now accounts for the majority of economic growth in China. It’s not an exportled economy. The listed universe is also not export-focused. Less than 10 percent of A-share companies, and less than 1 percent of the Chinese companies Matthews holds shares in, are exportfocused,” he noted. “Across all of our strategies, less than 5% of our China holdings have significant exposure to the U.S. market, Rothman added. Rothman remains very bullish on the country. He calls China “the world’s best consumer story,” with 7% real retail sales growth, supported by 6% real-income growth, low household debt and a high savings rate. “This consumption-driven economy should be fairly well insulated from any trade conflict. So, even if there were a trade war and that results in shortterm panic and lower valuations, that would create a buying opportunity for long-term investors,” he predicted. Going forward, Nelson sees three possible trade war scenarios playing out. “The first is a broad negotiated solution akin to a trade agreement that addresses a multitude of disputes for the U.S. and China. This conceivably would need to include agreement on tariffs, market access in both China and the U.S., intellectual property rights, and availability of U.S. technology. The second is a full-blown trade war between the U.S. and China that severely limits economic access to the other’s markets. We view this as a less likely scenario, as the leaders of both the U.S. and China know the outcome is severe and likely results in a global recession. With that in mind, we think both the U.S. and China are motivated to avoid the trade disputes from escalating dramatically. The third scenario assumes the trade disputes will be a prolonged irritant, but have a minor impact long-term,” he said.

Emerging markets can stand the heat

“We would expect portfolios that have an overweight to emerging market equities to experience a heightened level of volatility during periods when the U.S. and China trade disputes become featured headlines,” said Nelson. “These bouts of volatility represent an opportunity for investors to rebalance and/ or increase their exposure to emerging market equities.” Mizuno agreed, noting that “higher return justifies higher volatility.” “Emerging market exposure is still the highest growth sector globally, notwithstanding the volatility, due to growing populations and a rising middle class that is buying more goods and services,” Konicki observed. “It’s the unknown factors about those markets, such as political risk and currency risk, that still bring volatility to those investments,” she said. Rothman too concurs. “Even if there is a trade war with China— Trump putting tariffs in place and a response from China—the impact on Chinese companies will not be significant.” That’s

VOLUME 1, ISSUE 1

ENDOWMENTS INVESTMENT GOVERNANCE & FOUNDATIONS

BUILDING THE BUSINESS CASE FOR INTERNAL ASSET MANAGEMENT BY R A N DY M I L L E R A N D R I C K F U N S TO N

ccess to investment performance information has been democratized. In the past, Institutional investors had to use investment managers for their access to information. Technological advances now allow investment organizations to better understand and evaluate their portfolios and manager performance, identify sector, credit, geographic tilts and the quality and context of their returns. With rising concerns about the amount of fees being paid to external managers, more funds are exploring the feasibility of internal investment management. As shown in Figure 1 below, there are currently 70 U.S. public pension funds with more than $10 billion in assets. Just under half manage a portion of their non-cash assets internally, with larger funds more likely to have internal management.

3A. AUM AND INTERNAL MANAGEMENT

FUND SIZE (AUM) SOURCE: P&I 2/6/17

# OF FUNDS

# WITH INTERNAL MANAGEMENT

% OF FUNDS

> $50 Billion

90%

$25–50 Billion

35%

$10–24 Billion

33%

All > $10 Billion

51%

Source: Funston Advisory Services LLC Research

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While there is no clear threshold for how large a fund must be to have sufficient scale to undertake internal management, Figure 1 suggests that $10-24 billion in assets is a reasonable starting point. In 2015, John Simmonds of CEM Benchmarking stated, “the actual ‘crossover’ point, when it makes economic sense to build an internal team is therefore around £0.5 billion ($0.65 billion) for public equities. For fixed income, the minimum size is closer to £1 billion ($1.3 billion).”

Potential benefits There is one primary driver for internal management, i.e., to improve net risk-adjusted performance of the fund through lower costs. Funds also report other benefits of internal management including, for example, enhancing staff recruiting, workplace culture, and overall fund image; and, acting as a catalyst for building the overall capability of the organization. The State of Wisconsin Investment Board (SWIB) recently stated: “SWIB keeps costs low because it hires the best people— based on their ability to meet aggressive investment targets and add value to the trust funds—to manage funds in house at a much lower cost. SWIB staff manages almost two-thirds of the assets of the WRS for one-fifth of what it would cost to pay external managers for the same work. SWIB’s greater reliance on internal management saves $75 million per year compared to what similar funds would pay to manage the same assets. This is more than SWIB’s $53 million total annual operating budget including all staff compensation.”

INVESTMENT INVESTMENT CONSULTANTS GOVERNANCE

In April 2017, the Investment Committee of the Teachers’ Retirement System of Texas (the team which manages its Internal Active Management portfolio) stated that it manages “$24 billion actively; has a well-developed investment processes (18% of TRS’ Portfolio) with effective risk management; has experienced investment and trading teams; and produces an annual cost savings of approximately $100 million.” The Ontario Teacher’s Pension Plan (OTPP) – like most Canadian funds – also provides an excellent business case. “Since its inception in 1990, (OTPP) the $175.6 billion ($138 billion) fund for more than 300,000 of Ontario’s teachers, has achieved an average, annualized return of 10.15; fully funded four years on the trot, it now boasts an $9 billion surplus. It’s a track record achieved by a revolutionary investment approach that prioritizes active, internal management and buying chunky direct stakes in companies, infrastructure and property, and has made OTPP the benchmark for endowments and pension funds the world over.” If internal management has a strong financial business case, why don’t all public funds with sufficient scale manage at least some assets internally? Obviously, because it’s not easy.

Internal asset management challenges 1. The board lacks the needed autonomy.

2. Managing investments internally successfully requires that the board has the authority to: §§ create staff positions and a staff compensation structure they deem prudent; §§ approve internal investments and operating budgets (whether directly or through delegation); and, §§ acquire necessary technology and operational support. If staff compensation cannot be brought to competitive levels, then internal management may not be feasible. Even though the cost savings from internal management can be a large multiple of internal staff costs, in some environments this hurdle cannot be overcome. Hiring and retaining staff capable of successfully managing internal investments cannot be achieved unless experienced staff can be hired. In most cases, this also includes implementing an incentive compensation plan. If a board does not have the requisite authority (and many do not), then it needs to engage its governing body and key stakeholders to demonstrate the benefits of increased autonomy and resources. Stakeholder engagement is critical. It takes time and requires a long-term plan based on a convincing business case. 3. The board’s willingness to seek autonomy and adapt its governance and oversight. Success demands that the board has the will to overcome the inevitable challenges. If it does not, then it must be willing to engage in a long-term plan to seek needed autonomy. Even when they have it, some boards may be unwilling to exercise their authority and remain closely tied to the compensation schemes of their sponsors. The board needs to authorize the Executive Director to pay staff at competitive rates, and also to approve adequate incentive compensation pools commensurate with the longterm performance of the staff. Media reports complaining of “overpaid” public servants should be expected and

communications must effectively anticipate and explain the business case. The long-term move to internal management also requires a commitment by the board to adapt its powers and prudently delegate to a staff investment committee. This is not without risk. Although fiduciary responsibilities do not change, sub-par performance or failed internal processes with internal portfolios can subject a fund to more “headline risk”. The board must be confident that internal management can outperform external management on a risk adjusted net of fees basis. The board needs to trust, but they also need to verify the reports and insights they receive are timely and reliable. Independent reviews of investment operations can also build confidence in staff capabilities and identify priorities for improvement. Internal asset managers must be held accountable to the same degree as external managers. A board needs to carefully consider compensation, performance management and disciplinary policies in this context.

Low hanging fruit typically doesn’t yield big returns

Most funds approach internal asset management incrementally and typically begin with the “easy” and more efficient public market asset classes, e.g., domestic fixed income and passive equities. However, these strategies don’t save much money and don’t make for a compelling business case. Today’s typical large U.S. public pension fund has about 30 percent of its portfolio in “alternative investments,” i.e., real assets (including real estate), hedge funds, and private equity. While comprising less than one-third of the assets, these alternative investments can easily exceed 70 percent of the management fees paid. It is much more when carried interest (profit-sharing) and performance fees are included. Those funds who already are doing some internal management are now looking to bring in at least some portions of the more challenging public markets (e.g., emerging market equities, high-yield credit) and private markets (real estate and other real assets, private equity, hedge funds). Although this is a more difficult and long-term undertaking, it is also where internal management can make the biggest difference. Some funds use existing private asset co-investments or opportunistic investments as stepping stones to gain appropriate experience. As shown in Figure 3B (next page), externally managed fixed income is available very cheaply (in a passive and efficient market) and is easy to implement. Implementation difficulty and the required investment in people and infrastructure increases with more active management and inefficient markets. As potential savings increase, so does the difficulty of accessing the skill sets and resources needed to match the returns offered by expert external managers. In building a business case for internal management, it is important to look beyond the “easy” investments and plan for some of the more challenging asset classes and investment styles. A compelling business case requires that internal management exceed the net risk adjusted performance of external managers for similar portfolios. Although the internal team doesn’t necessarily have to match the gross performance of their external managers, the difference in performance cannot exceed the cost of the manager’s fees less the cost of internal VOLUME 1, ISSUE 1

INVESTMENT GOVERNANCE CONSULTANTS

management for comparable portfolios. 4. Difficulties in building long-term capabilities (people and systems). Most externally-managed funds will need to make significant investments to ready themselves for internal management. The fund will need investment professionals with portfolio management experience. This, in turn, will require more attractive compensation levels. It is possible, but for many funds, this is a leap of faith as to whether it can be done. Leadership stability and low staff turnover are also important factors for building internal management capabilities. At many funds, relatively high investment staff turnover has become a fact of life. However, internal management can provide opportunities for staff growth and development and ultimately greater retention of valued resources. Internal management also requires increased staffing for investment operations, for tactical execution of post-trade processes as well as ensuring that adequate controls are in place to mitigate operational risks. Internal management also places more demands on resources for information technology, vendor management, contracting, and program/project management.

Moving forward with internal management Despite these challenges, more public funds are considering long-term plans for the internal management of a range of assets to optimize long-term performance. Here are several lessons learned to help pave the way. 1. One size fits one! While public funds face many common challenges, every system is at a different stage of capability development. As a result, each system must develop an approach to internal investment management that matches its unique situation.

Build a business plan with a long-term horizon and short-term milestones A business plan with a long-term perspective (10+ years) needs to be developed and communicated to key stakeholders, including the board, legislators, and members. The business plan should articulate the reasons for increasing internal staffing and budgets and how this will benefit the performance of the fund and the stakeholders. 2. Plan to leverage external service providers The investment process can be viewed as a supply chain where outsourcing can occur at various points. Funds generally approach internal asset management as an evolution from bringing decision-making in-house, then execution, and finally some of the support functions, although there are no strict dependencies. Different asset classes may be at different points on the continuum. Most funds which have moved into internal management in recent years have relied heavily upon outsourcing for many execution and support activities. Outsourcing has several key advantages in areas such as trade execution, risk reporting, and custody.

Get started and build autonomy and capability as you go Many funds wrestle with limitations on their authority to set compensation and increase headcount. Start small and build confidence in your systemâ&#x20AC;&#x2122;s capabilities. If you can obtain adequate resources and compensation to begin the journey, get started and demonstrate that the investment team has the capabilities to be successful, even if it is more modest than desired. Some very successful funds, such as the State of Wisconsin Investment Board (SWIB), have gained increasing autonomy in this manner as part of a long-term migration plan. Resources and autonomy increase as trust in performance increases.

3B. IMPLEMENTATION DIFFICULTY AND RETURN EXPECTATIONS DIFFICULT

External Model

HIGH PrivateMarkets 30% of Assets/70% of Fees More Difficult to Implement.

FEES

IMPLEMENTATION

Internal Model

Public Markets 70% of Assets/30% of Fees Easier to Implement.

EASY PASSIVE/ EFFICIENT

INSTITUTIONAL ALLOCATOR

LOW

Management Style/Markets Efficiency Asset Classes

ACTIVE/ INEFFICIENT

INVESTMENT ASSETGOVERNANCE ALLOCATION

Conclusions

Interest in internal investment management is growing and for good reasons. Funds will typically need a higher degree of autonomy to insource investment management. Greater opportunities for reductions in external fees are to be found in more active and inefficient markets which require greater expertise. Funds will need to convince governing bodies of the benefits of the business case to gain needed autonomy, and system members can be helpful in gaining such support. Once boards have the requisite authority, they will need to prudently delegate to their investment staff. Investment staff must have the requisite expertise and tools to execute internal management. Compliance and control systems must be robust. Independent reassurance and reporting protocols are essential monitoring tools to ensure things stay on track. The journey is certainly challenging, but the benefits can justify the effort.

(Left to right) Randy Miller, principal, Bloomfield Hills and Rick Funston, managing partner, Bloomfield Hills

About the authors

Randy Miller is a principal and Rick Funston is a managing partner of Bloomfield Hills, Michigan-based Funston Advisory Services LLC, which specializes in advice, capability assessments, independent reviews, and educational services to public retirement systems in the areas of governance, operations and risk intelligence. 3C. DEGREE OF INSOURCING Strategic Asset Allocation

Research/ Analysis

DECISION MAKING

Order Generation

Trade Execution

Post-Trade Operations

EXECUTION

Compliance

Performance & Attribution

Risk Reporting

Investment Accounting

Custody

SUPPORT

VOLUME 1, ISSUE 1

INVESTMENT GOVERNANCE

ALASKA’S COMP. PLAN: A FITTING MODEL FOR PUBLIC FUNDS? BY MARK FORTUNE

he recent approval of new incentive compensation guidelines for investment and other staff by the board of the Alaska Permanent Fund Corporation (APFC) runs the risk of critical news headlines—a perennial risk faced by publicly funded investing institutions when they move to compensate financial-market professionals on staff competitively. But so far criticism of the initiative has been muted. Some observes point to the process the fund used to formulate the compensation scales as one reason for the silence of potential detractors. This, they say, may be an indicator that the fund’s compensation formulation process was the correct one for it and other similar public funds. The new compensation guidelines must now await approval by the Alaska State legislature. Also, APFC planned in July to begin recruiting for 10 new staff positions: four investment positions and six middle- and backoffice support positions. “Moving more investments in house requires an increased investment in both the investment staff and those that offer investment support, such as IT, accounting, trade operations and administration. The investment positions are two investment officers and two investment associates,” according to a spokeswoman for the fund. Pension funds’ primary driver for bringing on internal management is to increase net returns by reducing the cost of investment management, particularly as return expectations in today’s markets are lower than in the past. Most public pension plan sponsors understand, however, that there are headline risks with internal management, and seek to take steps to have strong governance in place and communicate to stakeholders that they

INSTITUTIONAL ALLOCATOR

are taking on the challenge to improve returns, according to Randall Miller, a principal at Funston Advisory Services, an advisor to public retirement systems in the areas of governance, operations and risk intelligence. He continued: “Many funds that do not adopt internal management choose that path because they see too many governance hurdles; for example, an inability to hire the right staff or make appropriate investments, or insufficient autonomy in other areas.” “As we move towards implementing an incentive compensation policy, it will be subject to governor and legislative approval,” the APFC spokeswoman explained. The fund plans to propose the new compensation guidelines to the state’s governor and legislature for passage during the FY20 budget process. “APFC strives for a compensation program that competes well in the market and motivates all employees to bring their best efforts to the scope of their job responsibilities. The program provides a systematic means of tracking, measuring, and compensating employees and allows flexibility for APFC to act quickly,” she said. The spokeswoman referred to APFC’s five-year strategic plan for 2017-2021 as illustrative of the fund’s staffing objectives. Under the plan, the fund has prioritized two elements: developing best-in-class investment management capabilities, partnerships, and geographic reach to maximize investment returns; and enhancing talent and staff across APFC. “One of our goals in support of those priorities is to implement a competitive incentive compensation program by October 2019,” she said. With its May 24 approval of the compensation guidelines, the board of the Juneau-based $65 billion sovereign wealth fund observed in internal documents that “…It is imperative that

INVESTMENT GOVERNANCE

APFC is in a position to attract, incent, and retain staff at all levels and in all positions.” It added that “because the level and complexity of internal investment management at APFC and the value-added and savings achieved by this internal management have grown significantly in the last five years, the Board feels strongly that fair and competitive compensation for APFC staff needs to evolve and grow to acknowledge and foster this successful result.”

Varying compensation levels

“We see a very wide variety of compensation levels among investment staff at public funds,” according to Keith Brainard, research director at the National Association of State Retirement Administrators (NASRA). “Often, that disparity is based on state compensation Keith Brainard, research rules for public employees. Some states director, National Association allow funds to have their own comp of State Retirement Administrators structures, others do not. The thing is, though investment specialization is now often part of a public fund’s staffing needs, in some states some funds find it is very difficult to compensate their staff competitively, while others are able to do it,” he said. He added that “sometimes, we see managers of public funds that have to deal with legislators who don’t like the fact that some public employees are making a lot more in salaries than others—they resent it. But at the same time, they wouldn’t think twice about a fund writing big checks to external asset managers.” When asked if the APFC board has any concerns about possible criticism in the press or a backlash or rejection from Alaska legislators based on the heightened compensation levels it is proposing for its investment staff, the fund responded by email only that “The APFC looks forward to working with the Governor and Legislature on forwarding this priority during the upcoming session.”

APFC’s new comp guidelines

In March of 2017, APFC hired Stamford, CT-based compensation consultant McLagan to execute a review and develop an incentive compensation plan for the fund. At the December 2017 board meeting, the board adopted updated base salary pay bands for each position as a result of that review. The adjustments warranted by the new base salary bands were incorporated into the FY19 budget request for APFC, according to fund documents. The new comp guidelines are part of a strategic five-year plan embarked upon by APFC beginning in late 2016. The plan comprises five priorities, according to fund documents: §§ Gain greater control of resource allocations; §§ Optimize APFC’s operational processes and use of financial networks and resources; §§ Develop best-in-class investment management capabilities, partnerships, and geographic reach to maximize investment returns; §§ Enhance talent and staff across APFC; §§ Implement a competitive incentive compensation program for FY19 by Oct 2019. Recognizing that APFC competes with a broad range of firms for investment talent, McLagan assembled pay data from three peer groups: 1. U.S. and Canadian public funds with internal/direct asset management capability; 2. Private sector investment organizations with AUM less than $100 billion, including advisory firms, banks, insurance companies, endowments, foundations, and corporate plan sponsors with; 3. A blended peer group: 75% public funds and 25% privatesector firms.

4A. APFC’S PAY VS. MULTIPLE PEER GROUPS AGGREGATE PAY SPEND ($000S) 25th Percentile

Median

75th Percentile

% APFC

$ vs. Mkt

Quartile Positioning

#of APFC Employees

APFC

Private Sector Firms

$6,514

$6,537

$7,706

-15%

$9,252

-30%

Public Funds

$6,514

$4,912

33%

$5,858

11%

$6,949

-6%

75%/25% Public/Private Sector

$6,514

$5,318

22%

$6,320

$7,525

-13%

Private Sector Firms

$6,514

$10,280

-37%

13,807

-53%

$19,734

-67%

Public Funds

$6,514

$5,769

13%

$7,994

-19%

$11,135

-41%

75%/25% Public/Private Sector

$6,514

$6,897

-6%

$9,447

-31%

$13,285

-15%

BASE SALARY

TOTAL CASH COMPENSATION

Top quartile / Q1 pay positioning (75th to 100th percentile)

50th to 75th / Q2 percentile pay positioning

25th to 50th percentile / Q3 pay positioning

Bottom quartile / Q4 pay positioning (0 to 25th percentile)

VOLUME 1, ISSUE 1

INVESTMENT GOVERNANCE 4B. INTERNAL MANAGEMENT: PUBLIC FUNDS OVERVIEW # OF FUNDS

# OF FUNDS WITH INTERNAL MANGEMENT†

% OF FUNDS

AUM $50 B+

81%

AUM $25–50 B

35%

AUM $10–24 B

33%

All with AUM >$10 B

40%

PUBLIC FUND SIZE

§§ 70 U.S. public pension funds with over $10 billion assets §§ Just under half manage a portion of their non-cash assets internally §§ Larger funds are more likely to have internal asset management † Internal management of non-cash assets Source: Foundation Advisory Services LLC reserach

Among the resolutions made by the board at the May 24 meeting are that compensation for APFC staff should be commensurate with its peer equivalent. (see table 4A, previous page).

analyst. Brown and Chang have since moved on to pursue other opportunities, according to the spokeswoman, adding that the fund is currently recruiting for a private equity associate.

The board also resolved that APFC staff responsible for administration and operations, including the Director of IT, Administrative Services Director and the Human Resources Manager should be compensated at competitive regional salaries, eligible for annual merit increases, targeted at median total cash compensation at APFC’s peer equivalent, and that APFC staff responsible for the investment, including the Chief Investment Officer Russell Read, should be compensated through a base salary plus annual incentive compensation targeted at median total cash compensation at APFC’s peer equivalent. APFC executive management, including the Executive Director Angela Rodell, Chief Financial Officer Valerie Mertz, Chief Operating Officer Robin Mason and General Counsel Chris Poag may be subject to incentive compensation at the discretion of the board.

APFC’s investments gained 8.86% through the third quarter of fiscal year 2018. The fund ended March 31, 2018 with assets under management totaling $64.6 billion, and returned 8.35% over the last five years and 6.52% over the last 20 years.

APFC’s investment operations

“For larger public pension funds, for example those over $25 billion in assets under management, we would call adoption of internal investment management, as well as increasing the level of internal management where it already exists, a trend,” Miller said.

In September 2016, APFC announced it would seek more investment staff, promoting and hiring externally. At the time, internally managed assets accounted for 24% of overall assets; the goal was to increase it up to 50% over the next five to 10 years. As of June 30, 2017, 38% of APFC’s assets were managed internally and 62% were managed externally. In the prior year, 34% of its assets were managed in-house and 66% managed externally, according to a presentation the fund delivered to the Alaska State Legislature in February 2018. Early last year, AFPC hired three investment professionals to expand its internal management to half of its total assets. Travis Brown joined the fund’s private equity and special opportunities team from Goldman Sachs as an investment officer. Ben Chang was hired as a senior associate covering private income and hedge funds. Prior to joining the fund, Chang spent four years working in private equity and private equity consulting with Boathouse Capital, based out of Philadelphia, and Stax Inc., based out of Boston. And Tom O’Day joined as a fixed-income investment analyst. He previously worked for the insurance and reinsurance firm Endurance for six years as an investment

INSTITUTIONAL ALLOCATOR

Fiduciary responsibility Largely as a result of ever-increasing pressure on public funds to operate more cost-effectively and to maximize investment returns, several large public funds have taken up the mantle of in-house asset management in recent years. According to Funston Advisory Services, 70 U.S. public pension funds, with $10 billion or more in assets, have in-house investment management. Just under half manage a portion of their noncash assets internally, and larger funds are more likely to have internal asset management. (see table 4b).

The approximately $117 billion State of Wisconsin Investment Board (SWIB) and the approximately $147 billion Teacher Retirement System of Texas (TRS) are two recent examples of large pension funds that have increased their internal investment operations. In an April 2017 press release, SWIB stated: “SWIB keeps costs low because it hires the best people—based on their ability to meet aggressive investment targets and add value to the trust funds—to manage funds in house at a much lower cost. SWIB staff manages almost two-thirds of the assets of the [Wisconsin Retirement System] for one-fifth of what it would cost to pay external managers for the same work. SWIB’s greater reliance on internal management saves $75 million per year compared to what similar funds would pay to manage the same assets. This is more than SWIB’s $53 million total annual operating budget including all staff compensation.”

INVESTMENT GOVERNANCE

In March TRS, proposed a plan to almost double the size of its in-house investment team in an effort to lower costs. The fund’s CIO, Jerry Albright, made a case to the pension’s board for hiring 120 people over the next five years. That would increase the size of the in-house investment team to almost 270. According to a spokeswoman for the fund, “TRS Investment Division is considering a plan to maintain current competitive advantages and total returns as well as enable us to manage cost structures that increase net alpha generated by TRS Investment programs. In order to do so, we are considering increasing internal asset management capabilities in the public markets and increasing principal investment activities in private markets (Private Equity, Real Assets, and Energy, Natural Resources and Infrastructure). Currently, TRS is targeting to increase the investment team by 63 and to realize a potential fee savings of approximately $600 million over the next 3 years.” New hires are planned for September this year, but the details and timing of those hires are still under discussion at the fund.

§§ Enhanced staff recruiting, workplace culture and overall Fund image; §§ Improved “closeness to the markets”; §§ Catalyst for building overall capability of the organization; §§ Can facilitate unique investment approaches, such as ability to take advantage of temporary market dislocations in an opportunistic manner; and §§ Fees that would otherwise go to out-of-state investment firms instead support the local economy, enhancing longterm plan stability. According to NASRA’s Brainard, boards have fiduciary and moral responsibility to act in the best interest of their funds and their fund’s beneficiaries. So, sometimes these funds embark on building internal investment resources even in the face of potential headline risk, Brainard said. “But if you’re going to do that, then you must perform,” he emphasized. “Many public

“Many public retirement systems manage assets internally and many do it quite effectively. But funds are not likely to get kudos for doing so because, much like a goalie in hockey, if you do well, you’re simply doing your job!” There is one primary driver for internal management, i.e., improve risk-adjusted net performance of the fund through lower costs, according to Funston Advisory Services. The firm points to other potential benefits, which include:

retirement systems manage assets internally and many do it quite effectively. But funds are not likely to get kudos for doing so because, much like a goalie in hockey, if you do well, you’re simply doing your job!”

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INVESTMENT CONSULTANTS

Risk Return

DEVELOPING A PRIVATE DEBT ALLOCATION BY LESLIE KRAMER

hen its clients are considering investment in private debt, investment consultant Mercer suggests to them broad diversification, both globally and within the type of private debt they are seeking, according to Bill Muysken, the firm’s global chief investment officer for alternatives. Consultants at Aon recommend using private debt to diversify a portfolio heavily weighted in stocks and bonds: “There are a lot of different types of private debt; it could be a replacement for return-seeking fixed income or high-yield bank loans or emerging market debt,” said Eric Denneny, senior consultant, global private equity research at Aon. Neils Bodenheim, senior director, private markets at the London-based consultancy bfinance is experiencing a greater client demand for direct lending opportunities ahead of real estate and infrastructure private debt.

Muysken. “So, we encourage clients to have allocations to those as well,” he said. “After analyzing portfolios and realizing that the bulk of clients’ risk is in the equity markets, we are looking for higher-risk strategies and equity substitutes that can provide growth in portfolios. Clients are not making tactical calls, but they also don’t want to have all their eggs in one basket—they want to spread it around a bit,” he said.

Risk factors Mercer’s clients approach private debt in two different ways: They are either looking for low-risk, low-return vehicles in order to match liabilities or high-risk, high-return products. “For high-risk, high-returns, we have been talking to clients about putting it in their portfolio as a replacement in place of equity allocations, in the riskier part of their portfolio,” Muysken said.

In interviews with IA in June, one important requirement of a private debt investment strategy all three consultants agreed on was “diversify, diversify, diversify,” both within the asset class and in a portfolio. The consultants shared their succinct thoughts on risk factors investors in the class should consider, along with the types of investors that are comfortable with the class, the way they should think about structuring an allocation, and where pension funds’ view the class differently from F&Es’.

On the lower-risk, lower-return end, we are talking to clients about putting private debt in their portfolio in place of cash, in the defensive part of their portfolio,” he said. “Either way, we think you don’t get paid to take concentration-risk in private debt, because if things go well your upside is contractually capped, and if they don’t go well, the downside is potentially quite bad,” he said. Mercer generally recommends clients invest 5% to 15% of their portfolio in the asset class, noting that it varies by clients and circumstance.

They also highlighted the differences between the various segments within the asset class. “Most investors think about private debt as corporate private debt, which is the main area, but there is also real estate debt and infrastructure debt,” said

Bfinance touts direct lending opportunities within the space because the sub-category offers enhanced yield, perceived better security positions, and a natural hedge against inflation with floating-rate debt, said Bodenheim. “Senior debt in direct

INSTITUTIONAL ALLOCATOR

INVESTMENT CONSULTANTS

lending generates a higher return vs real assets senior private debt, given that the underlying security position is different. Real assets are not able to generate similar levels of returns with the same security position, and so an investor needs to go to subordinated products in real assets to generate the same levels of return,” he said. The consultancy’s first-time allocators are allocating as little as 1% of their portfolio to the asset class with the more seasoned investors, who are more comfortable with direct lending, going up to 3% to 5 % percent of their portfolio. Private debt “managers have been able to show better default rates and loss recoveries versus the more liquid corporate loan space and, with the enhanced yield, it makes sense to have reasonable allocations, even though it’s a relatively new asset class, historically,” Bodenheim said. In fact, “the biggest issue is under-allocation, because typically these private debt products don’t provide immediate exposure on day one,” he noted. “It takes time for general partners to make investments, and so there is a delay on drawing down the investor commitments over time, often two to three years,” he said. “After that, they have a capital repayment back to investors, so the delayed drawdown and swift re-payment requires a lot of cash management from the investors in order to maintain their percentage exposure,” Bodenheim explained.

Who should invest in it? The same types of investors that are more comfortable with other alternative investments are typically comfortable with private debt, said Eric Friedman, partner, retirement and investment at Aon.“That’s because those investors typically have a tolerance for illiquid investments, understand the complexity, and have a governance structure that is comfortable with complex investments. They also have the in-house expertise or access to expertise, and are willing to do things that are different,” he said. “We have clients that are comfortable with all parts of it,” Aon’s Denneny said. “We find strategies within private debt that institutional investors, in many instances, have been investing in for years: distressed debt, mezzanine, private real estate lending strategies, and opportunistic credit type strategies that may have been within a hedge fund strategy,” he said. Private debt is more illiquid, so there are many different underlying strategies that fall within it, so that you find investors that range across all strategies, he said.

Real estate bucket vs fixed-income bucket Because most private debt being offered today is corporate direct lending, followed by real estate and infrastructure debt “for some institutional investors, those assets sit in different allocations, because those sectors have different levels of return,” Bodenheim said. For instance, “some clients see private realestate debt as part of the real-estate buckets in their portfolios. Globally, they probably have 10 % of their allocation invested in real estate, with private real-estate debt being part of that allocation, he noted. Canadian investors typically have a larger portion allocated to real estate (10-15%) and infrastructure (510%), given their comfort around real assets, he added. Overall, however, “allocations from clients that we work with globally mostly come from a fixed-income perspective, and they tend to be looking at more senior-debt related products,” said Bodenheim. “They look for first priority interests and security positions that tend to yield roughly 6-8% net IRR (internal rate of return) range,” he said. “When we look at traditional fixed-income products, by comparison, there is a significant yield enhancer by making these re-allocations,” Bodenheim said. “For investors that are seeking the equivalent level of return they need to go to the subordinate level or 2nd ranking debt in the real asset categories of private debt. We are seeing activity there, but the most popular is still direct lending with the complement of real assets behind it, like real estate or infrastructure,” Bodenheim said. Institutional investors are very aware of the potential for an upcoming downturn, given the bull market run, Denneny offered. “So when we talk with our clients about direct lending as an opportunity, part of the discussion has been how are you viewing a direct-lending strategy within the portfolio, and in many cases, because it’s senior secured debt lending there is more of an aspect of a fixed-income lending alternative approach, he said. “If you are approaching it from that perspective, it changes the discussion. If you have the view that fixed income would be negatively impacted with a credit downturn defense than private debt would also be negatively impacted, but not as much as with public fixed income, so it’s still attractive, as a strategy,” he said.

Different strokes for different investors: Pension vs F&Es Investment officers at pension funds look at private debt differently than foundations and endowments do. “For defined

“For high-risk, high-returns, we have been talking to clients about putting it in their portfolio as a replacement in place of equity allocations, in the riskier part of their portfolio” VOLUME 1, ISSUE 1

INVESTMENT CONSULTANTS

benefit pension schemes, those clients seem to divide assets into two pieces; one piece is the liability matching component, the other piece is the growth component, for which investors are seeking to take risk and to add value,” said Muysken.

“For investors that are seeking the equivalent level of return they need to go to the subordinate level or 2nd ranking debt in the real asset categories of private debt.” For the liability-matching component, investors are typically using futures overlays as a way to match the duration profile of their liabilities, Muysken said. “But many find that they are sitting on lots of free cash in their portfolio that is not earning them very much. So, what they are looking to do is to replace part of the free cash in their portfolio with senior private debt to earn a healthy margin above a cash-like return,” he said.

(Top to bottom, left to right) Niels Bodenheim, senior director of private markets, bfinance; Bill Muysken, global chief investment officer alternatives, Mercer; Eric Denneny, senior consultant, global private equity research, Aon; Eric Friedman, partner, retirement and investment, Aon

In the growth part of portfolios, most clients find the risk part is dominated by equity risk, so they are looking to take some equity down and substitute it with high-risk higher-return private debt. For foundations and endowments, the same broad principle applies, but there is no liability component. “So, most of it is just return seeking for the growth part. They want higher risk and higher returns,” he said.

NOVEMBER 15-16, 2018

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INSTITUTIONAL ALLOCATOR

FIN SEARCHES ASSET ALLOCATION CHART Q1

COMPLETED SEARCHES Active Equity

8,070

12,055

US Equity

1,919

4,240

International

3,226

1,401

Emerging Markets

860

1,268

Global

2,055

5,146

Passive Equity

4,270

1,140

Active Fixed-Income

4,285

8,508

US Fixed-Income

4,193

7,551

Emerging Markets

132

Global

825

Passive Fixed-Income Alternative

1,441

27,793

239

28,042

250

27,991

Hedge Funds

2,873

5,265

Private Equity

135

16,809

163

16,647 4,346

Credit/Distressed Debt

4,552

Other

3,808

1733

8,922

8,085

Consultant

Asset Study

Real Estate

Record Keeper

Commodites/Real Assets

4,610

3,891

The quarterly search data includes all completed mandates from U.S. public pension funds and foundations and endowments as reported by FIN|Searches. The accuracy of the data, which is compiled from comprehensive reporting, institutional board meeting minutes and investment reports, is deemed reliable but cannot be guaranteed. All amounts are in US$ millions unless otherwise stated. fin|searches is a powerful sales and marketing tool that aggregates manager search leads from its U.S. defined benefit product, fin|daily, as well as its Foundation & Endowment product, Nonprofit News. For further information on U.S. institutional manager search leads, please contact: Gene Dolinsky, director of business development, on (646) 810 1072 or gdolinsky@finsearches.com

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