Tuesday, October 9, 2012

CalSTRS Considers Asset Risk Factors?

Amanda White of Top 1000 Funds reports, CalSTRS considers asset risk factors (h/t Mr. "Z"):
The $152.5-billion Californian State Teachers Retirement System (CalSTRS) is undertaking an asset-allocation review that will consider the underlying risk factors of assets for the first time.

Chris Ailman, chief investment officer of CalSTRS, says the fund is in the middle of an asset-allocation study, which would likely take six months, and would take a different tack.

In the past the fund has only considered capital-market mean optimisation in making asset-allocation decisions, but now it will look at allocations according to risk factors as well.

“We will look at the drivers of risk – including inflation, interest rates and GDP – and what the fund is willing to include and exclude. We will optimise our allocations from a capital and risk perspective,” he says.

“If it reaffirms that we’re taking the right level of risk and return, then that is enriching the decision-making,” he says.

Watching its weight

Ailman says the fund is adding points of view to the asset-allocation study and, at a recent board meeting, had an “interesting debate” on whether the goal of the portfolio was to make money or not to lose money.

“Capital-market theory and mean optimisation calculates risk by only one-term standard deviation, but it is much more complex than that. We apply so much math to investments because we want it to be a science, but it’s an art, and requires judgement.”

CalSTRS also makes tactical asset-allocation decisions and this week was due to hold a TAA meeting with one decision on the table: whether to go overweight the US.

At the moment the fund is neutral US, underweight Europe and underweight fixed income.

It has an automatic rebalancing process when allocations exceed the ranges, and Ailman says the question becomes when to rebalance and by how much.

“We are trying to build out an overlay portfolio with focus on left-tail risk,” he says.


Acknowledging inflation as a risk

Ailman’s view is that the biggest bubble in investments is fixed income, and acknowledging inflation as a risk is missing in most portfolios.

CalSTRS will look to expand its inflation-hedging portfolio among a basket of investments, including treasury inflation-protected securities and infrastructure.

The fund currently has a lot of growth assets, with 50.7 per cent in global equities and 14.5 per cent in private equity.

It also allocates 18.4 per cent to fixed income, 14.2 per cent to real estate, 1.6 per cent to cash, 0.2 per cent to inflation and 0.4 per cent to an overlay.
There is a lot to cover here. First, it has been argued that in a world of zero-bound interest rates and quantitative easing, inflation is the key risk factor. Francois Trahan of Wolfe Trahan & Co. insists that "inflation is the new fed funds rate," and he's right. In a world of highly levered consumers, every time inflation goes up, financial and economic conditions contract.

But as I stated in my last comment, far too many investors are more focused on career risk than investment risk, and this is creating a huge misallocation of capital. You see this in the way fund flows are still entering the fixed income space but also in the way investors are all investing in large, brand-name hedge funds and PE funds, typically getting raped on fees with little return to show for it.

Paradoxically, this herd mentality is creating new investment opportunities, especially in risk assets that suffered the most as everyone hunkered down, preparing for the end of the world. I'm not just talking about distressed debt, but also many high-beta cyclical stocks (Romney was bang on touting US coal companies, they're grossly oversold).

In my comment last Friday on replicating Ontario's success in Alberta, I discussed how AIMCo is bringing assets internally and looking at opportunities that others are shunning. AIMCo's CEO, Leo de Bever, calls this "investing between the cracks," and in order to do this properly, AIMCo is investing heavily in risk and attribution systems and attracting the right people to Edmonton (no easy feat).

Of course, what I didn't mention on Friday is that Leo de Bever will never be able to replicate Ontario Teachers' success for the simple reason that he cannot take the directional leverage that the Oracle of Ontario is allowed to take. Alberta's provincial laws bar AIMCo from taking such directional leverage (OTPP follows the prudent person rule, giving senior managers discretion to take such leverage).

CalSTRS, is also looking to replicate Ontario Teachers' success, by bringing assets internally but they first need to get the governance right. In order to attract the right people to manage private market assets internally, they need to compensate staff properly and make sure they understand the risks they're taking.

And while inflation is a key risk, I wouldn't bet the farm on it. While some are convinced the 'titanic battle' over deflation will sink bonds, the reality is that we live in a world where an aging population, high unemployment and massive private and public debt are placing enormous downward pressure on prices. Deleveraging, sluggish job growth and an aging demographics are with us for another decade, if not more, and the risks of deflation remain high.

I mention this because as I see pension funds shifting more assets into alternative assets like infrastructure and real estate, taking on more illiquidity risk, they could be in for a nasty surprise if a protracted period of debt deflation engulfs the global economy.

When it comes to the inflation-deflation debate, funds better get it right or else they're screwed. All the asset allocation studies in the world won't mean a damn thing if the forces of deflation win out, wreaking havoc on public and private market investments.

I'm still in the deflation camp but realize that global banksters and central banks will be fighting deflation tooth and nail. The financial oligarchs and power elite don't want deflation, it's bad for profits. This means they will be pumping massive liquidity into the financial system for as long as it takes to create inflation. Will they be successful? I don't think so but it creates huge trading opportunities for investors (even in a deleveraging cycle, you can make a lot of money).

As far as CalSTRS trying to build out an overlay portfolio with focus on left-tail risk, they need to be careful here too. Tail-risk funds have been the latest fad to disappoint investors. I laugh at blogs like Zero Hedge (I call it 'Zero Edge') which have been publishing daily drivel on how the end of the world is near.

In the last two years, the stock market has continued to climb the wall of worry, just like I predicted, and is now closing in on new highs. This despite endless summits in Europe as the continent falls deeper into a recession and despite a significant slowdown in China (not a hard landing as most bears warned of).

More importantly, Chris Ailman should talk to Neil Petroff, CIO at Ontario Teachers', on his thoughts about hedging against tail risk. In our conversations, Neil told me "it doesn't make sense to hedge against tail risk when you have long-term liabilities."

It certainly doesn't make sense to pay 2 & 20 to some hedge fund "hedging" against tail risk. These funds have gathered huge assets since the financial crisis erupted but their performance has been just awful (all too predictable!). What makes more sense is to adopt certain tail risk strategies internally, especially if a fund is expanding its private market investments, taking on more illiquidity risk (contact Catalin Zimbresteanu, former VP Risk at PSP Investments, directly at catalin_zimbresteanu@hotmail.com for an expanded discussion on this topic).

Finally, factor-based investing is nothing new. ATP and APG, two of the best global funds, have been engaging in it as they get back to basics. Most large Canadian pension funds have teams looking at risk factors across public and private markets. My biggest concern is that these teams are overpopulated by "quants" and not enough experienced senior analysts who understand qualitative risks, easily sniffing out collateral damage long before the quants get a whiff of the bigger picture (speak from experience, quants are over-glorified and overpaid in the investment management industry).

Below, a CNBC interview conducted in late April with Chris Ailman, CIO at CalSTRS, regarding the impact of the eurozone crisis on the global economy and where his fund is investing. Also watch a more recent interview with Michael Gayed, CIO at Pension Partners, discussing how the expected weak earnings season could be the excuse for markets to correct a little bit in October.

Perhaps but I think markets will continue to rally as most of the earnings disappointment and negativity is already priced in. Stay long financials, tech, energy and load up on US coal shares and other basic material industries that got slaughtered over the past two years.