Difficult times often call for decisive action. That may explain why the US’s second biggest public pension fund is embarking on an overhaul of how it manages its assets, with a view to reducing costs and keeping closer control of its risks.
California State Teachers’ Retirement System plans to insource more of its investing capabilities to cut investing costs amid a volatile global backdrop – thanks in part to the US-China trade war.
Asian institutional investors will be interested in how it goes about this: the move reflects a growing trend among large public asset owners worldwide as they look to adapt to the stubbornly prevailing low-return environment.
Like many of its US state pension peers (and indeed many in other countries), Calstrs is well short of the capital it needs to cover its payout obligations. The $234 billion fund’s ratio of assets to liabilities stood at 65.6% on June 30 last year, well below the 80% that the federal government views as a healthy funding ratio.
Reducing that deficit will not be easy, especially in today’s uncertain and ultra-low-return environment.
Yet Calstrs feels its new ‘collaborative model’, which will entail managing a bigger chunk of its portfolio in-house and investing more directly, could be a game-changer. Other US state pensions, such as the Teacher Retirement System of Texas, are taking a similar view.
And, like the Texan fund, Calstrs sees its focus on Asia growing (as detailed in an AsianInvestor article recently), deputy chief investment officer Scott Chan said during an interview in mid-May.
Calstrs officially proposed the collaborative model at a very productive investment committee meeting on May 8, and expects to hire a specialist consultant to help implement it.
At the same gathering it also launched an asset-liability study with the expectation of adopting a new allocation strategy as early as November and an implementation plan by February 2020.
Chan said the benefits of deeper collaboration and more direct investing were amply demonstrated by its investment cost report for 2017, which was presented in January 2019.
The report revealed that in 2017 Calstrs managed 44% of its portfolio net asset value internally, for a total cost of just $30 million (excluding carried interest). However, the 56% of its assets that were externally managed cost it $1.8 billion (including incentive fees).
Chan said Calstrs’ aim in implementing the new model was threefold: to save costs, increase its control over risks, and to develop a stronger pipeline of investment opportunities through its partners.
As part of these plans, the fund plans to increase its share of internally managed assets to at least 60% over the next five years. That will also mean a big staff expansion over that period: from 182 to most likely a little over 300, Chan said.
Most of the fund’s in-house investments are listed equities and bonds (85% of its fixed income assets are managed internally), and the goal is to insource even more of them.
But the biggest change in Calstrs’ approach and setup – and perhaps the toughest to implement – will be to internally manage more private assets. This is the area that will necessitate the largest increase in headcount.
Still, the fund doesn’t expect to be leading deals or going totally direct for some time. Its goal for the next few years is to co-invest more alongside asset managers, corporates and other institutional investors.
One likely area for more co-investment is property. “Our real estate division is looking to create more joint ventures and to buy partial or majority interest in more real estate operating companies,” noted Chan.
For instance, in May the fund bought a controlling stake in multifamily property developer and manager Fairfield Residential from Canada’s Brookfield Asset Management. The San Diego-based developer has some 1,200 employees in 19 US states across acquisitions, sales, property management, asset management and fund management.
It makes more sense to acquire such capabilities than to try to build them, Chan said.
Similarly, Calstrs currently co-invests just 7.5% of its $20.4 billion allocation to private equity. It wants to double that to 15% over the next three to five years, he added. It is also eyeing more partnerships with asset owners, like the one it has with Dutch pension fund manager APG for infrastructure investing.
However, achieving all this is will be no mean feat.
A major challenge will be sourcing strong investment talent. Doing so is tricky for US state pensions, as their boards can be reluctant to approve the outlay required to attract high-quality staff, said Rich Nuzum, president of Mercer's global wealth business. This is a hot-button political issue these days that has been playing out publicly in the media.
Indeed, it has been raised as an issue in during Calstrs’ investment committee meetings, with proposals being made that pay levels for private equity staff should be higher.
Chan acknowledged that major challenges lie ahead: “We have to face very difficult competition: folks who are sometimes larger than us, folks who can be more nimble than us and folks that don't face necessarily the regulatory environment that we do as a California state pension organisation.”