The Exchanges

Q All right. So you mentioned the separation of alpha and beta. As you think about the portfolio, how do you first go about approaching that challenge?

A So the first thing that we really think about is, all right, we have these funding objectives in the total plan. And so based on those funding objectives, what's the amount of risk we need to take in the portfolio to meet our return hurdles? And so first is setting the appropriate amount of total risk. And then second is saying, okay, and then I'll just use it as an example. Let's say the total risk that we want to take over a long period of time, call it 10 plus years, is about 11% volatility. So what we do is we take that 11% volatility and we say, well, we're going to break it into two pieces, and we call this our risk budget. So the first piece is going to be our beta, or our asset allocation, and this will drive most of our volatility And what we say is, okay, we're going to build an allocation on our betas, but we're going to be very mindful of the risk it generates to three macro factors. And one is growth, inflation, and rates. We're going to allocate that beta so that we can meet that risk objective and more importantly, that return objective, but we're going to ensure that we have diversification so that we're being as diversified to those three macro factors as possible. So that's beta. And then, so in alpha space, we'll say, you know what, in addition to the risk we're taking in asset allocation space or beta, we want to take up to another two percent tracking error…

AI assessment note: “we literally separate those two things into risk budgets”

Q So let's turn to this alpha piece. Easy word to say, a little bit harder to execute in the market. So you mentioned 26 different strategies. Where do you like to play in that space?

A So the first thing is, We view private assets as not asset classes. We view the private assets as another way to access active management or alpha. So at a very high level, we're building three big books, three alpha lines or business lines. We're building a long biased alpha line. So in non-US equities, emerging market equities, small cap equities, long only based strategies. But what we're doing is we're making sure that those strategies have High concentration, high active share. We're not buying benchmark huggers. We're buying things that zig, and that we expect two to three percent alpha out of them over time. The same is true as in fixed income. We're doing similar things in fixed income, alternative credit, and then on to REITs and listed infrastructure and real estate. So we have a book. We have 32 different individual strategies that we're invested in in just long only Long biased alpha management. And then in addition to that, what we're doing is we're buying hedge funds. We're buying market neutral hedge funds because on a risk adjusted basis, hedge funds are still pound for pound the best alpha generators. And so what we're doing is we're building a market neutral hedge fund portfolio. We think can generate something around a three percent excess return or alpha over cash, and then we're porting it over our bonds. So we're making it a portable alpha structure. And t…

AI assessment note: “we're building three big books, three alpha lines or business lines.”

Q So why don't you take me back before you joined SWIB, and we'll obviously circle back to this as you return, but what did the portfolio look like? You're still young and learning the business.

A So the work I did as the deputy at Para back in those days is we lived on a legal list of investments. So what that was, was in statute, it basically said thou shall invest in this and thou shall not invest in that. And really what it meant was you can buy government bonds, you can buy U S equities, and you can only buy up to 25, 30% of non U S equities. And so it was very restrictive and it was only publics. And so this was back in 2004, 2005. And so at that time, the big push that we had was moving from this, what we called the legal list of investing to the Prudent Investor Act, which would allow us to go into alternatives in effect. And so since I just built up some goodwill at the legislature here in New Mexico and moved over at the time, that was really the big push that I had kind of helped out on. And so back in 2004, 2005, all the New Mexico pensions and the sovereign wealth fund, we all moved off the legal list and onto the Prudent Investor Act. And so all three of us, all three of the funds, and particularly the pension, that started our race to ramp up to alternatives. And so being a deputy at the time, it was really about building the foundation for ramping up to alternatives. And, and as I left, I think I allocated maybe some of the first dollars into private equity and real estate and hedge funds at the time.

AI assessment note: “you can buy government bonds, you can buy U S equities”

Q Okay, so given market conditions where they are now, how do you come close to getting to that seven and a quarter?

A Great question. So a couple of things is, as you know, if you were a sixty-forty investor for the last 30 years, you generated eight to nine percent. But the thing is that eight to nine percent, half of that over the last 30 years was just from cash. And so your cash return now is probably zero. And so how do you generate enough with a cash rate of zero? And for us, just beta alone and the allocations that we have, I think is going to get you five to six percent. And so what we're looking into right now is what if you incorporate appropriate leverage on your assets in the beta book? Can you get an extra 50 to a hundred basis points out of that? And so I think that's a key challenge and a key issue for folks going forward. And so for us, What we're looking at is in our beta book, we're looking to incorporate embedded leverage in the asset classes and then about in a very modest amount, which is about 10% at the total asset allocation level. So we think we can get somewhere around a six percent ish, six to six and a quarter percent in just the beta book with that. And then the alpha. We still think we can generate about a one percent alpha going forward. Obviously that's a much more difficult thing to achieve and et cetera. But, but I think when you put those two together, you can get to about a seven and a quarter percent return.

AI assessment note: “when you put those two together, you can get to about a seven and a quarter”

Q On top of that, I know the plan is currently underfunded or is underfunded when you got into it. How do you think about sort of catching up in addition to what you need to make?

A Yeah, so this is probably one of the best things that happened for us in 2020. Again, taking a playbook from SWIB and other plans that have done really well on a funding sustainability perspective. In 2020, we were able to get a pension reform pass and it did two big things for us. The first is it increased our contribution rates near our arc or the actuarial required contribution. And the second thing is it created a variable Cola for us. And this is a very big deal. So prior to this change, our benefit structure, the day somebody retired, they had a base benefit, the promise guaranteed benefit that we're going to provide. But a year later, they had a fixed guaranteed cola that they were going to receive. And so what we did in 2020 was we decoupled those two things. We said, you're still going to get this promise benefit forever. But going forward, Whatever COLA you receive, it's going to be now be a profit share. It's going to be based off of the funding level and the returns that we generate. So what that means is our actual base benefit, the cost to pay that base benefit is actually more like five and a half to six percent investment cost. And so going forward, if we can exceed that base cost of five and a half to six percent, then we will share those gains in a profit share COLA. So going forward, We are on a much more sustainable path and we project over the next 25 plus …

AI assessment note: “we project over the next 25 plus years that we'll be close to being a fully funded plan”

Q on one side, and in this alpha book, like two of these three buckets have a lot of embedded beta when you put it together, right? The market neutral hedge funds don't, but the rest of them, you're owning assets, and somehow that's tied to the economy and growth and inflation and rates. How do you port that back so that you just have that alpha stream with low correlations?

A So it really gets back to our risk budgeting process. So I'll take an example. Let's say our private equity portfolio. So private equity in a very simplistic way has maybe two return streams relative to our beta book, private equity, we're benchmarking to the MSCI world. So if our private equity book is going to have X amount of exposure to MSCI world, and then it's going to have a Y amount of exposure That's idiosyncratic tracking error relative to MSCI world. And so private equity in general is going to have something around 10% tracking error to MSCI world over time. So we take that tracking error and we put that into our alpha book. But the exposures that are MSCI world, that is in the beta book. And so we have to use our technology process to ensure that that tracking error is well evaluated and well measured. And so we're doing that with Anything that has any beta attached to it. We're making sure that the right amount of risk is measured and accounted for in the beta book. And then the residual idiosyncratic risk or tracking errors is in the alpha book. But in addition to that, we also have two overlays. And so what we do is, for instance, let's say we like active management in non-US equities or in small cap equities. But non-US equities relative to the MSCI world will generate two risks. It'll have a geographic risk and then the stock picking risk or the idiosyncratic …

AI assessment note: “we'll have an overlay that hedges that geographic risk or that cap risk back”

Q Great. Well, let's just dive in. I mean, I know you're a New Mexican native, so why don't you walk me through that early part of your career and how you got involved in this business?

A Yeah, sure. So yes, I am a native New Mexican. Both my wife and I are from New Mexico, grew up here. Families have a long history here, generations. When I was young, I actually went to graduate school up in Chicago. This was back in 2001, around there. And I went to public policy school, and while I was up there at University of Chicago, I kind of fell in love with public finance and finance, doing a lot of study between the policy school and the business school, which wasn't Booth at the time, it was just GSB. And then after graduation, my wife and I, it was my girlfriend at the time, we decided to Move back to New Mexico and get married, and I did, and so the first job I landed after graduate school was working for the New Mexico legislature and working in their finance committees. I started work, and my boss came to me, and he said, hey, look, I'm not satisfied with the amount of work we do on the pension funds and our sovereign wealth fund. Do you think you can handle this? And I was like, sure, I'll take it on. And so I jumped on in New Mexico. We have two pensions, the public employees pensions, and then the teachers pension. And then we have a 20 plus billion dollar sovereign wealth fund that's been funded from oil and gas worlds for the past few decades. And so I started just analyzing and understanding them and And boy, everything just kind of clicked for me. And 12 m…

AI assessment note: “first job I landed after graduate school was working for the New Mexico legislature”

Q beliefs and truisms in many public pension funds are the challenges of governance. So it's one thing to have a thoughtful investment model. It's another thing to actually get it done. So what was it that you saw at SWIB that you tried to bring back that allows you to take some of the constraints that many public pensions have and then implement them in the same type of seat?

A Yeah. I think what I realized and learned is that governance is central to success for any institution, but particularly for public pensions. And I think the governance at SWIB is unique in two ways. First of all, the pension system is separated into two parts. There's the pension administration organization, and then there's SWIB that's really just the asset management piece. And so it allowed SWIB to actually act and function and talk and walk more like a private asset manager. And so what that led to was having a board that was highly professionalized, small, and focused on the strategic role that they had, and having that strategic role, and setting strategic goals, and then delegating down to staff, and making sure that the staff had clear goals, clear evaluative metrics, and had the resources to achieve those objectives, but in addition to that, had the resources to attract and retain talent. And so those were the key pieces that I've seen for SWIB that were big successes for SWIB and elsewhere outside of, in Canada, frankly, the Canadian plans kind of have that same model as well.

AI assessment note: “the pension system is separated into two parts... pension administration organization, and then there's SWIB”

Q That key phrase you said, the resources to attract and retain talent. How does that work in a public pension fund?

A Yeah, it's difficult. When you look at the public pension plan landscape in the United States, I would say about half of the pensions have the ability to pay an incentive compensation for, for pensions. Most are still stuck on government focused pay bands, right? And I think they create a misalignment with what pension investment staff are trying to create. So I think you have this dichotomy. You have some plans that have nice alignment with incentives and the ability to pay folks relatively Well, relative to the industry. And then you have this other half who are still stuck in the past of how they pay and think of the value proposition for its investment staff employees. And so for that other half, it becomes a difficult thing to attract and retain talent because you have to compete. You know, you have to compete not only against those other 50% in the public pension world, but you got to compete against endowments, foundations, and corporate pensions. And, and so it is a challenge. And in my experience, I think that's been one of my biggest challenges in the role that I have today.

AI assessment note: “about half of the pensions have the ability to pay an incentive compensation”

Q So let's turn to the investment side, and I guess the first question I would ask is given those realities of the challenge in probably being able to attract and retain quality people, how does that influence how you think about the investment process?

A I think there's a couple of things. One is when you build out your investment process or your investment team, I think there's a couple of things, you know, from our standpoint, we take on the philosophy of let's separate alpha and beta and not only public assets, but also private assets. Let's be risk managers and risk allocators first, and then not capital allocators per se. And so that's kind of where we start. But then the second thing is, is, you know, okay, how do you implement? You could either implement through internal means or through external means. And so when you kind of have a A strained personnel or strained compensation structure, it's very difficult to do any internal asset management. And the internal asset management mainly helps in cost reduction, and it saves quite a bit of money over a five to 10 year period of time. So we actually end up being a hundred percent external. And so what's important for me is to have a staff and a talent base of our staff that is very versed and seasoned about how to buy and structure external strategies. And so when I actually Find the talent because of our strange personnel situation. I tend to skew on the younger side. And so what I tend to do is I offer more, the value proposition I offer folks are you have more autonomy, you have more ability for innovation and growth and learning, and that is an attractive substitute for…

AI assessment note: “strained compensation structure, it's very difficult to do any internal asset management.”

Q What are the types of managers that you prefer?

A In our alpha score, I would say there's a couple of things. I think from a quantitative point of view, a manager that their return stream is really oriented towards idiosyncratic risk. If we are able to break down their return stream, they have a modest amount of beta in their excess return stream. They have a modest amount of factor exposures. And they really have mostly idiosyncratic risk. I think that's really important. The second thing is I like managers that really build a moat that have really have a sustainable edge to what they're trying to do. And then they build their entire business around that sustainable edge. But in addition to that, they take risk with high conviction, meaning they really focus a lot of their risk and capital into their best ideas. Not into their second tier ideas. And so they're able to allocate that capital and allocate that risk to their best ideas very well. And I think that's actually a key attribute to sustainable alpha production for managers is not just that they can find a good idea, but that they're allocating the right amount of capital to those good ideas and not to necessarily the second tier ideas. So then I think the other piece is qualitatively is I really appreciate a manager that has high alignment to us. And I think alignment means that we're in the same boat. They have skin in the game. They eat their own cooking. They have a…

AI assessment note: “from a quantitative point of view, a manager that their return stream is really oriented towards idiosyncratic risk.”

Q How do you in your seat, or probably in any public pension setting, think about something brand new, like people are talking about the whole digital asset world now with the rise in price of Bitcoin and the other cryptocurrency assets. How do you think of a clearly an idiosyncratic potential return stream, but also in a public pension fund setting?

A It's difficult, and again, and I think the reason why that's difficult is in a public pension setting or any long-term institutional asset owner think, should be thinking over the long term, you know, and to me that's 10 plus years, 10, 2030 years, and so when you do that, um, We don't buy something and look to trade it, buy it, put in the portfolio, and sell it a year later. That's just, that's just something that we're not going to do, and, and quite frankly, I think folks that do that, there's a light track record and success for that. So when you're actually looking to put a strategy into your portfolio, you're expecting it to be in for five, 10 plus years, and so when you do that, I think you need confidence that it will Not necessarily perform, but it will behave how you expect. And so something that's brand new, there's truly no way to expect how it's going to behave over the next five to 10 years because there's no data to back it up. It's truly a speculative endeavor. I don't want to pick on Bitcoin, but let's say new thing A, how does it perform in an inflation scenario? How does it perform in a growth scenario? Heaven knows, right? And so, when you're building a portfolio of betas and alphas that are based on allocating diversified risk, where do you plug something that's brand new when you have no clue how it's going to perform in different economic environments? In…

AI assessment note: “something that's brand new, there's truly no way to expect how it's going to behave”

Q Let's dive in a little bit on the manager selection process. You know, as we mentioned at the top, a little bit resource constrained, competitive world. So how do you go about trying to find the managers you want to have that generate alpha?

A Take a step back and let's talk governance first before I go into manager selection. So as I started, one of the first things that I engaged our board with was I said, Hey, look, If we're gonna try to do things better, the first thing we gotta do is we gotta change our investment governance. So what our governance looks like today is our board makes three decisions. They set our overall risk tolerance, they approve our risk budget as what I've been talking about, and they set benchmarks. Everything else gets delegated down to staff. So the manager selection process is delegated entirely down to me and our staff. And so what our marching orders are is Implement the risk budget, basically. Maybe do a little better. And so manager selection, it turns out, works pretty well in that governance structure. So I'm fortunate that I have staff that are quite skilled and knowledgeable about the external manager universe and being able to build unique fund of one structures. And so what we've done is we've built a pretty thorough internal process of manager diligence. So I'll have staff, which I call my alpha team, They're focused on each one of those three business lines that I mentioned, and so they kind of lead the process, and they lead diligence, and we work with, in parallel, we work with consultants in each one of those buckets to kind of help us along in terms of sourcing, etc. But…

AI assessment note: “we've built out a very detailed diligence process, and then what we do is we also create an alpha score”

Q And when you're playing with an asset size that big and you get into the private markets, how do you pick where to go after your spots?

A I think the private assets are more of a challenge. And what I'm going to say is, I kind of talked a little bit about my initial start into this industry, but part of it was building the hedge fund portfolio back in. And if you go back to hedge funds, you know, a decade or decade and a half ago, it was an industry that was a little bit more black box and you just kind of signed up for things. And between now and then, hedge funds have really institutionalized, right? It's really matured as an industry, really transparent, et cetera. When you go to the private asset world, and particularly, let's say private equity, I think private equity is where hedge funds were like a decade ago or so, right? It's a very more networking type industry. You kind of sign up. I think private equity and the private asset classes are going to institutionalize and mature going forward. I think data quantitative analysis is just really burgeoning into those private assets. Similar to what happened in hedge funds a decade or a decade and a half ago. And I think that's really going to change how allocators look at and select managers. For instance, and I'm going to give you an example for us. We actually have a paper out on this that we produced with Landmark Partners. We focus a lot on direct alpha and excess value. I think a lot of investors, if not almost all investors, when they buy a private equit…

AI assessment note: “We focus a lot on direct alpha and excess value... We look at direct alphas, KSPMEs”