Imagine building your portfolio from scratch today. How similar would it be to your current portfolio? And what strategic and structural changes would you make?
Those questions were answered by Gary Smith, Head of Investment Strategy and Risk at the Alberta Teachers’ Retirement Fund.
In a fascinating presentation, Mr. Smith told delegates that about two years ago, his fund decided to embark on a thought experiment: “What if the world was such that we didn’t exist? We walked into a room and, in that room, there was a table with a piece of paper on it — for liabilities. Another piece of paper was a cheque for $17.3 billion” — the assets in the fund — along with a blank sheet and a whiteboard pen.”
That thought experiment led to more and more questions — which raised calls for a lot of answers. And it led to some very good results.
Mr. Smith laid it all out for the delegates.
The key questions: How do you construct the ideal portfolio from first principles, combining models from successful and progressive pensions worldwide? What are the innovative tools that will increase the use of alternative investments to optimize performance, balance risks, and achieve a mandate in an ever- unpredictable economy?
Before that exercise, ATRF had a 93% funded ratio and invested 45% of its money in alternatives with a front office of about 40 people. Some of the assets were managed internally, but the bulk of them were external.
So here is what happened when he asked more questions.
“How would you design your plan? What would we put on that sheet?”
Start with the funding policy, he said. “The need to be fully funded, the need to have affordable contribution rates and the need to have stable intergenerational equity.”
And fully funded is vital. “ . . . what we’ve chosen, with the 95% probability that contribution rates stay below 27% of pay.”
And how to dampen the volatility? His advice is clear: Understand the liabilities! That way, you can preserve your funded ratio more successfully through volatility. It is one of the critical keys, he said.
“The two questions I like to put are the things that drive our liabilities — can they be hedged? Secondly, should they be hedged to interesting questions that they need to pursue going forward? It is the latter — the risk factors — that becomes important.
So his fund went all-out to get the answers.
ATRF surveyed the world, looking at global best practices, consulting with global leaders and conducted numerous workshops. Its board of directors was fully involved which, as Mr. Smith says, is absolutely critical; otherwise, not much gets done.
Biggest question: how to hedge the liabilities? As well, how to ensure sufficient diversification?
“Why look at things across the asset class or rather across risk factors? We believe that the correlation across these factors is lower and more stable than the correlation across asset classes.” His conclusion on that point? “If you view the world through that lens, you can get a better diversification result from your portfolio or when you’re building your portfolio.”
Total fund management, he said, is the answer.
ATRF divided its portfolio into five asset class sleeves. And the return on the collective is critical; whether infrastructure and equity portfolios are fully balanced in less important than the portfolio as a whole. That required an approach to balance the various factor imbalances.
The key to that fund management is to diversify the total fund, rather than the individual sleeves. It means driving efficiencies by managing exposures at the top of the house.
Based upon ATRF’s experiences, what will happen to an organization that undertakes such changes? More people, more systems, more complexity and better investment infrastructure, he says. “This is a huge part of our effort to build out a platform to do all of this stuff.”
But, as he concludes, it works!
A very novel idea.