The Exchanges

Q So what are those four strategies you came upon?

A The biggest chunk of them actually is 30 year U.S. Treasury bonds, because that is the flight to quality. The next largest chunk is also of equal size is CTAs, which are trend following managers. So it's a trading strategy. They've got the whole world to trade in, but they're going to be looking at movements and momentum and shifting, therefore, away from U.S. equities or global equities at different sequences. We put a little bit of global macro in there, which obviously is really you're trusting on people's talents, but what we found is while they tend to react a little bit late to declines like that in the market, They actually give you some upside, so they reduce the cost of the insurance, and then the smallest slice of it is risk premium strategies, and we're just starting to deploy that.

AI assessment note: “The biggest chunk of them actually is 30 year U.S. Treasury bonds”

Q Is there something specific about the US system that prevents the US government from evolving the way that these other types of institutions or the non-US governments have?

A Well, I wouldn't say it's US specific, but you recognize in USA we don't react to something until it absolutely breaks. We won't repair something until there's a crisis and then we wake up. And I've often said that at some point someone's going to look at this and say, hey, this is crazy, a flawed model. We need to move it external and operate it. Oddly enough, Delaware is the only place that you've seen that that happened in the eighties and nobody followed suit. There have been a few places, Missouri, Oregon, that talked about it, but then didn't go full throttle with it. So I think at some point there will be a recognition and just kind of a wake-up moment that, well, yeah, that absolutely makes sense. You privatize it, but we're not there yet, and I think the reason the USA model is different is simply because we're first. It evolved into this structure in the seventies and eighties in a government entity, and nobody thought to make it different. It's the entities around the world, the groups that have started from scratch that have had a chance to look at the best models and move them into Public-private partnerships.

AI assessment note: “the reason the USA model is different is simply because we're first.”

Q Yeah, that's a happy thought. Let's dive in a little bit. You mentioned that despite the flawed business model of managing these assets that you're still fighting the fight. What have you learned about governance that keeps you in it and keeps you trying?

A I think the key with governance is a clear definition of roles and responsibilities. All the funds I've worked at, which have been three, been very policy-driven and very clear and concise policies, not notebooks full. I'll take it back to what most people can relate to, a financial planner. You come into a financial planner and you want to write a plan and be clear with them so that they understand your risk tolerance and your risk appetite. And what I find too often in governmental plans is that they actually haven't defined that well, and the risk appetite and tolerance shifts board to board as elections happen and things turn over. But for us within governance, it really has to be clear about what role the pension board should play, what decisions they should make, what decisions should they delegate to their professional staff, What's the oversight? What's the reporting back? When we get those roles clear, and everybody's on the same page, it can work fairly efficiently within that model, but I have seen the average tenure of a state pension CIO is only four years, and that has been true since the 19 eighties, and I think the reason for the constant turnover is, often time, the governance is unclear, and They run into problems about what decisions the board should make. What should they delegate to the CIO? What should the staff be doing? And if you look at what we do, it'…

AI assessment note: “the key with governance is a clear definition of roles and responsibilities.”

Q Let's turn to this risk mitigating bucket, which is among the more interesting things you're doing. How did you start thinking about where you wanted to implement in the markets in that bucket?

A You know, it actually started all the way back in 2012. The board had one of the goals that we did for the investment committee was to look at alternative strategies, and it was a recognition back then that interest rates were gliding towards zero. Who knew they would go through zero? But interest rates were in a constant decline. We were consistently lowering our exposure to fixed income. We had gone from 20%, 25% to 20%, down to 15, and then now the new target of only 12. And we knew we needed diversification in the plan, especially after oh eight. So we spent a lot of time really studying 2008. We thought it was a one, 1.5% likely occurrence, and realized that, you know what, in this day and age, it's probably closer to a four percent occurrence. And for the listeners, that's in essence, instead of a hundred year flood, we realized it's a 60 or 70 year flood. So you don't run out and slap a bunch of insurance or move away, but you do pay attention to that risk and try and find ways to balance it. So we spent a lot of time studying different strategies, realized there, of course, isn't one silver bullet to take for a pension plan that will solve that problem. But when you look at our fixed income at about 12 and then risk mitigating at about nine, we're back to about a 20% level of What I would call diversifying assets. And when we looked into that bucket, we really looked at…

AI assessment note: “we really looked at, it comes down to trading strategies”

Q So a lot of that comes down to communication. You have a lot of constituents. So you have the board, you have a portfolio and a team, and you have all of the teachers in the state of California. How do you go about communicating with the various constituents?

A Well, almost a million constituents. We do a lot of communication with the board, and what I've realized is we've had to expand the communication channels. In the past, it was all just written materials, but now we actually shoot videos for the board. We shoot videos for the membership and put those out there. One of the reasons I'm here, as you and I have talked earlier, is because I want to learn about how to do podcasts, because that's going to be our next medium, and we've realized, I have said to the staff, Particularly to the younger Gen X people, they need to figure out how to write an agenda item that can go on Instagram, because we have some members that will only look at that, and we need to be agnostic as to the median, but just get the communication out there constantly. And you're right, a big part of governance is communicating and making sure everybody understands, but you have to have their attention. So it's easy to get the board's attention because they want to be up to date and get a quick summary of what's going on. The membership is an interesting challenge. So almost a million members. I can tell you firsthand, because my daughter is a public school teacher in California, that for the teachers that are about 35 and under, they know our name, but they're not quite sure what the initials stand for. They've seen the word CalSTRS because it shows up on their p…

AI assessment note: “what I've realized is we've had to expand the communication channels.”

Q How many different private equity relationships do you have with external managers?

A In our case, it's actually fairly narrow. I have studied that for a number of years and been a strong believer that really you want to be a large bite size with a few people. Some funds, particularly near us and then here on the East Coast, have decided to take the index method and invested with hundreds of partnerships. And what you find is you get the average return out of private equity, which is actually below public Equity. So with us, it's actually a fairly concentrated portfolio. We have 70 core relationships. We probably have about 200 in total, but many of those are not growing or, or fairly static, but I would often say we have about 70 core, and that's why it's difficult. We really aren't trying to add to that number, so when we see a new opportunity, it's a question of where are we going to clean up the portfolio and not re-up in some of the funds, and which ones do we want to re-up with?

AI assessment note: “We have 70 core relationships. We probably have about 200 in total”

Q So that leads itself to talking about these overlay strategies. How have you done it?

A Overlay really is an outshoot of that, as I described, that asset allocation process. The board picks the long-term asset allocation. We've got interim targets, but we've realized that we really need to have a team that can look more intermediate, near-term, and make decisions about within the ranges of the asset allocation, where do we want to tilt the portfolio? Should we be risk-on? Should we be risk-off? Back to my analogy of an ocean liner. As I said, should it be full-sale Full speed ahead and party on the decks, or should it be batten down the hatches and tie down the luggage? And that is our tactical asset allocation team, our TAC team that meets at least monthly, but as needed. We get external advice from a number of our different managers. One of the blessing at CalSTRS, because of our size, we do business with some of the smartest people in the world, and we tap into that to get their ideas and their thoughts about where they feel about risk on, risk off, different markets. And so what we'll do is particularly a good example you would think of is Brexit, where we have a natural constant exposure to the British pound and to the euro. We have a currency team, but within that, should we hedge the overall plan at the plan level to protect against that? Do we want to be at a plan level, overweight equity, overweight US, or overweight non-US, or underweight a particular re…

AI assessment note: “And that is our tactical asset allocation team, our TAC team that meets at least monthly”

Q So you've also done something to gather a lot of allocators in something called the 300 Club. Can you talk a little bit about what that is?

A One of my mandates from my board, it's in my duty statement, is to be a industry figure, to be a global CIO. And I'm involved in a couple of groups, one called Triple C and another, which had been around for a while, called the 300 Club, which was really founded by Hermes as a way because they felt that in the O eight crisis, we heard a lot from Wall Street. We heard a lot from the banks and the brokers, but we didn't hear from investors. And so they wanted to create a voice where institutional investors could, in essence, be sort of the canary in the coal mine. We could speak up when we thought there might be a danger or risk out there in the market. They came up with a clever name of the 300 Club, the 300 Spartans. I joined, but I made it clear I wasn't just, like, going to risk my life for the markets. I certainly don't have the abs to be part of the Spartans. So, ambitious name, and we're only about 40 strong, so it's not that we're up to 300. But it has really been one of the few global groups that has come together, where you have a European chapter, a North American chapter, CIOs from public funds, from corporates, universities, from money managers, who get together and just talk about markets and things that are important to them, and then write white papers, and we publish them out there, so that it's not necessarily a firm taking a position, but an individual saying, …

AI assessment note: “wanted to create a voice where institutional investors could, in essence, be sort of the canary”

Q and wealth management firms moving to Ridgeline gain a decided advantage. That's why customers call it miraculous, game-changing, and an awakening. If that's not how you would describe your investment management tech, request a demo at ridgeline.ai. And now back to the show. When you do the pieces of that externally, how do you balance this goal for low cost when some of these strategies have kind of higher cost?

A Oh lord, they're expensive. One is obviously we can use our size to negotiate very aggressively. I have said for probably over five years that two and 20 is gone, and that's been broken. Unfortunately, small plans still have to pay that, but larger plans have gone through that. And We, I think, were coming into the market at a very good time when everybody else was getting out of the market. So many people had rushed into, quote, hedge funds as an asset class, and then been immensely disappointed while they were moving out of these. And I always like to point out to teachers, we're not going into hedge funds. I don't consider that an asset class. It's just a business model structure. It's 22 odd strategies. We're using two specific strategies. So I think our size was an advantage. We've also looked at some of these, particularly things like trend following. Can we build some of those formulas in-house? Can we do some of those things in-house? There aren't pure passive strategies that replicate those, but we want to look at different ways that we can potentially do those things at a lower cost structure.

AI assessment note: “obviously we can use our size to negotiate very aggressively.”

Q What are some of the examples of those?

A Well, I would point out microfinance, which has ebbed and flowed, but it was all the rage at one point. And then it became that some of the microfinance firms were really causing social stress, and that maybe it wasn't the panacea that people thought it would be. And we knew that at our size, it was going to be incredibly inefficient. But it's an area, now we have a decade-long research file on it, so as it comes back, we'll take a hard look at it. Another area is life settlements. That has ebbed and flowed. Very interesting business. That's good, but no thank you. We don't really want to be investing in it, but we've done the research. We took a deep dive, look at gold. Is it a commodity? Is it an inflation hedge? Is it a currency hedge? What the heck is it? And came back with a lot. And unfortunately the answer is for us, it wasn't any of those, but some of our peers have bought it. So a number of things that they've delved into that I don't want to discuss on the air because we'll get phone calls from people, but that has actually been pretty helpful. But literally we actually did a presentation once Well, they came up to the board with their lab coats and safety goggles, because it really drove home the point. They're out there test driving all kinds of ideas, and in many cases, the goal is, one, does it reduce the risk of the plan? Two, does it increase the return of the p…

AI assessment note: “Well, I would point out microfinance... Another area is life settlements... look at gold.”

Q How did you originally get started in the business?

A Boy, that's a long story. I was in college in the eighties. Before there were computers, Wall Street was hardly known on the West Coast. I was going to be a financial accountant, interested in management information and that stuff, and my mom inherited an account at Dean Witter, a name that has disappeared, and we had a blast Going in a meeting, and I thought, this is really interesting to manage money, to follow stocks and trade. Took a couple investment classes at my university, where we actually did real hard financial analysis of opening a prospectus and dissecting a company. And sadly, that is a very lost art most of the time. But actually started on the sell side. So started back with Dean Witter, got into financial planning, got into small corporations and their retirement plans. And I decided to go into government just for five years to kind of build some stability. I was tired of being in the roller coaster of the banking side. So I went on the buy side, and I found I actually liked it, and it surprised me. I enjoyed it, and I have shocked to say that I've stayed in government for over 30 years because, boy, it's a flawed business model when you look at it as a way to run a money management firm, but I've enjoyed the challenge.

AI assessment note: “started back with Dean Witter, got into financial planning”

Q So let's work backwards through these inflation sensitive, internal or external?

A Mixture. Because you recognize we've studied it for a number of years. There's not any constant driver of what creates an inflation boom. And we've looked back, it could be cost, push, or wage pull. But it could also come from other areas in the commodity space, particularly. So it's a basket of tips, which are internally managed, makes sense, fixed income instrument, we've got a desk, But we look at anything that has some correlation to inflation. So we've done some commodities. There we've done some commodity swaps, so we internally manage the other side of the swap, the collateral side. But externally, we've got timber. We have some infrastructure, which we recognize isn't totally correlated, but should over time, if we had a prolonged inflation turf, have some correlation. We've looked at farmland as an option of adding that in. Things that just aren't as correlated to typical stocks, but have some inflation. We know at the beginning of an inflation regime, it's actually good for global equity, and it will do well, but what we're worried about is that value erosion over a long, broad time period.

AI assessment note: “Mixture. Because you recognize we've studied it for a number of years.”

Q Yeah. Eight percent's not nothing. Have you invested in that area?

A The challenge within private equity is that it is such a long time to build up that portfolio. There is a secondary market, but it's not that deep, and it's not of significant size. So within private equity, you actually, I think, have to be a stable investor over time. You can't time the market. You can't pick your EBITDA multiples because you're investing in partnerships, which then have their own five-year investment period. And so I've worked at two funds that have had fairly large private equity portfolios, and it's not so much the percentage of the fund. I think it's literally a dollar amount you can put to work efficiently in private equity. If you've got a billion dollar private equity portfolio, you can be really nimble. You can be very focused on venture. You could do middle market buyouts. When you get into the 20 and 30 and forty billion dollar private equity portfolios, you're just going to be exposed to mega buyouts. A good friend, Bon French, always said it's the hierarchy of size, and it's a challenge when it gets bigger, not efficiency, because you're suddenly just exposed to the mega buyouts, dominate your portfolio, you can invest in venture, but you can't really get enough of it to really move the needle very much. So for us, it's a consistent budget of investing over time. How did we get there? We started at about two and four percent Built that portfolio c…

AI assessment note: “We started at about two and four percent Built that portfolio consistently over time.”

Q What are the other social hot button issues you've tackled?

A It's a constant challenge, I would say. When you look at E, S, and G, the governance issues have been around a long, long time, and they still remain. They seem to reoccur executive comp, board diversification. And you look at the environmental issues, those are right in front of us. Climate change is a current near-term issue. The social issues really do ebb and flow, and it is often difficult to figure out where they're going to come from. I did not have construction firms and a border wall on my agenda four years ago. It wasn't even on my mind as something to worry about, and yet now we have people asking us, well, why do you own those construction companies? Well, they weren't involved in this before that, and they had been around a hundred years, so those issues very much tend to be issue-specific pop-up. We end up having to really drop a lot of things and focus in on those, so it's a balance of When you think about climate change or governance, those are critical things that are long-term in nature versus important issues that arise from time to time. So most recently, we've been in the press, the discussion about private prisons. It's no surprise that most of the people in America were absolutely up in arms with the immigration policy, and now the current immigration crisis in San Diego and Tijuana. So those kind of issues just really get people's attention. And that's w…

AI assessment note: “I did not have construction firms and a border wall on my agenda”