How Michigan’s muni pension is reviewing its portfolio

The $11.6 billion fund’s CIO explains how his organisation is responding to the prevailing environment, how it employs passive strategies and why he is wary of property assets now.
How Michigan’s muni pension is reviewing its portfolio

The Municipal Employees’ Retirement System of Michigan has this year launched a new portfolio management approach with a view to enhancing returns for the 800-odd different member schemes for which it invests.

The $11.6 billion state retirement fund is not alone in moving to update its investment strategy with an eye on boosting performance, greater tactical flexibility and, in many cases, cost savings. It is true of North American public peers such as the teachers' retirement funds of California and Texas and the UK's Coal Pension Trustees (CPT).

Similarly, a trend among Asian asset owners, including pension funds and insurance firms, looking for higher returns has been to build up their alternatives and foreign-asset exposure. 

Jeb Burns

But Mers of Michigan, like CPT and others, has already hit its limit on illiquid assets and can't simply invest more into private markets; it must find other solutions.

Jeb Burns, the US fund's chief investment officer, spoke to AsianInvestor about the changes his organisation is making, how it is developing its use of passive strategies and why it is wary of property assets right now.

Q. What’s been your general response to the prevailing low-yield environment in the past decade or so?

We’ve generally gone up the risk spectrum by reducing our traditional fixed income exposure and starting to invest in diversifying strategies, higher up the risk spectrum. But we have reached the limit of what we can do of that kind of work. We have about a quarter of our portfolio in private markets and can’t add more illiquid assets. Given the maturity of our plan, at a certain point it’s not prudent to take on additional risk.

Q. What is your current asset allocation?

Our asset allocation as of the second quarter of this year was 48.56% in equities, 27.35% in fixed income, and 24.09% in private markets.

Q. So what can you do to boost performance?

What we’re doing to raise returns is to tactically shift the portfolio. Right now we’re holding a lower equity allocation because we think markets are stretched. That’s how we think we can add value over a market cycle – we’ve moved away from a static allocation.

Similar to the approach taken by endowments, we have asset-class bands, which have been in place for 15 years.

But starting this year we’ve started using an internal valuation-based allocation model. We now track market valuations internally and tilt the [public market] portfolio based on those inputs. It’s more of a quantitative approach than in the past.

It gives us more flexibility and means we can react quicker to what happens in the market. We rebalance the portfolio quarterly, but if there is a major shift to the downside or upside those adjustments can be made in real time.

Q. Presumably the new model spans asset classes?

The portfolio is split into two sections – the public market and private market portfolios – with nine sub asset classes.

[As mentioned,] we tactically tilt the public market portfolio, which is around 75% of total AUM.

Private markets account for 25%, although that could drift down much lower. For that section, we’ll look at certain segments of the market. For example, core real estate is not an area we’re looking at right now; it doesn’t seem a good idea to lock up money at this point [because of market uncertainties and wider geopolitical developments]. And a lot of private market assets are expensive.

So we are looking more opportunistically – for example, at distressed sellers or value-add opportunities that need enhancing, both in private equity and private debt.

For example, private debt offers shorter-term opportunities, such as one or two years or even shorter.

Q. What’s the breakdown of your private assets?

The private market portfolio contains private equity, private debt and real assets such as real estate, farmland and infrastructure.

For private markets, most of the agricultural assets we have invested in directly, while the rest is mostly done through funds, with some secondaries and co-investment.

We use both funds of funds and direct fund holdings but have been going more direct, particularly in the real asset space. We’ve been on a steady trend to do more co-investment and more direct deals.

Q. To what extent do you use passive strategies?

We’ve historically believed in having a mix of passive and active managers. But we have shifted more  towards the passive side over the past decade.

For instance, we moved away from active management of large-cap US equities 10 years  ago. We no longer have any active exposure at all to US small- or mid-caps [because it’s very difficult to obtain alpha in that area so managers generally underperform]. We mainly use index mandates for that, along with exchange-traded funds to tilt our allocation.

Q. How about on the fixed income side?

Our fixed income exposure is mostly active and will probably stay that way. But over time we’ve started to use passive instruments to supplement our exposure.

Q. Do you make use of factor or smart beta strategies?

We don’t use factor or smart beta strategies for fixed income. But for equities, we have created some internal factor-based portfolios; we’ve been using these for about five years. They are managed in-house.

But we’re kind of in a pause mode on this – our factor allocation is static. It’s because the performance of our factor-based portfolios has been mixed. Historically, we’ve sought to use a quality or value bias, which has not been rewarded.

Mers of Michigan is also spending more time on considering how it accesses Asian assets, as Jeb Burns explained to AsianInvestor recently. 

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