The Allocator: Chris Ailman of California State Teachers' Retirement System

July 09, 2010   Suzy Kenly Waite

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Calstrs’ CIO discusses the market outlook, the search for the perfect manager and why the third largest pension in the U.S. is investing in hedge funds for the first time.

At $130 billion in assets, the California State Teachers' Retirement System is the third largest pension in the United States. But in terms of its approach to investing in hedge funds, the pension lags far behind its peers.

The $199.4 billion California Public Employees' Retirement System first started investing in hedge funds in 2002 and now has $6 billion invested with the funds, while the $132 billion New York State Common Retirement Fund made its first hedge fund investment in 2005 and now allocates $3.8 billion to various managers. By contrast, Calstrs has invested only 1% of its assets in what it calls alternative strategies—and that money is mostly invested in distressed strategies and Treasury Inflation Protected Securities.

“Because we’re one of the largest funds that hasn’t embraced hedge funds and drank the Kool Aid, we get made fun of on the school block,” Calstrs' chief investment officer Christopher Ailman joked.

But that is about to change. In a world where markets are more correlated than ever, diversification has become critical, and Ailman’s believes hedge funds are the way to achieve it. Calstrs is searching for a consultant to help it select hedge funds and is evaluating a variety of strategies. Ailman is particularly optimistic about global macro, commodities, and funds invested in infrastructure.

In the near term, Calstrs will allocate $250 million in up to five global macro funds, but the pension’s goal is to increase its hedge fund allocations to 5% of total assets, or $6.5 billion. Ailman is confident that if the hedge fund investments generate consistent returns, that allocation will only increase. “This is a marathon, not a sprint,” he said. “In a marathon you don’t win in the first mile or even in the middle.”

Ailman joined Calstrs in 2000. In addition to managing the pension, he oversees seven directors and 96 investment professionals. AR Staff Writer Suzy Waite caught up with Ailman to discuss the market outlook, the search for the perfect manager and why the third largest pension in the U.S. is investing in hedge funds for the first time.

AR: Calstrs is entering hedge funds for the first time. Why now?

We do have investments in distressed debt funds, of which some could be categorized as hedge funds. We also have investments in corporate governance activist funds.

With that as a backdrop, our interest in traditional hedge funds is really coming from a broad review of different strategies that we think could add value and diversification. We think global macro looks particularly interesting. We’re not going to invest in a mess of hedge funds. We’re specifically looking at global macro, both systematic and pure active, and this will be our first allocation to global macro.

Why have you waited so long to seriously invest in hedge funds?

Calstrs is a very education-focused fund. We obviously represent school teachers in California, so the board is comprised of people interested in education. We tend to study things before we run out and invest in them. Our fund has a history dating back 20 years of not wanting to start out with newest idea out of Wall Street. We like to see how it performs and see some track records.

I applaud some of the universities, particularly endowments, that were early in global macro and did well. We’re a large public fund with a different liability scheme and a different structure.

We’ve also, for a period of time, avoided things we view as too high cost. That’s partly why we’ve been slow at looking at hedge funds. We view them as business structures that are a high cost and put the investor in a position of weakness or disadvantage to the general partner.

If you think hedge funds are expensive, what are you planning to do about fees?

Calstrs will negotiate the best fee structure we feel is both fair for our partners and which maximizes long-term value for our members.

How do plan to get started?

We’ll invest $250 million over the next nine months in three to five managers. We recognize that that’s a small allocation for us, but obviously people are willing to talk with us because of our sheer size and in the hopes that the allocation will grow.

It’s an opportunity to see how global macro performs for us. If it adds value and reduces risk for the fund, we’ll expand the program over time.

Why global macro? What opportunities do you hope to exploit?

Clearly the lesson of the decade—not just 2008, but the entire decade—was that there is more correlation amongst equity markets, credit markets, stocks and bonds around the world. Institutional investors are looking for more diversification and a different return pattern.

We think global macro is a good strategy simply because it should be able to not just add returns, but reduce risk by increasing diversification.

What are some other strategies that you’re considering?

We like the idea of inflation sensitivity, so our board approved an investment in commodities. We’re looking at all different types, not just managed futures. We’re also doing research into micro finance and will be allocating to infrastructure-focused funds.

I’ve always liked convertible arbitrage and M&A arbitrage, but the spread has contracted as people entered into those markets. Still, I think we’re coming into an era where M&A arbitrage might be an interesting place. We’re coming into a cycle with private equity where we’ll see more acquisitions and strategic mergers between companies and subsidiaries.

What is in the portfolio right now?

Fifty-four percent is in global equity (long only), 21% in fixed income, 13% in private equity, 10% in real estate and 1% each in absolute return and cash.

Our absolute return bucket is a bit of a misnomer. It’s basically a bucket in which we put lots of different types of assets. Most of that 1% is an inflation sensitive portfolio, which is TIPS. Our allocation into global macro and any hedge fund would land in the absolute return portfolio.

You’ve said you would like to eventually get to a 5% allocation in hedge funds. How long will that take?

That’s where our sheer size comes into play. Moving this portfolio around is like steering a huge cruise ship. You don’t want to throw the wheel to one side or another because you’ll disrupt everything. You’ll also create a wake—e.g., transaction costs—which just is a drag on the portfolio. It’s a challenge for a portfolio this large to be nimble. That’s something we aspire to be, though.

Will you invest in startups or more established managers, such as those running $5 billion or more?

If you look at our other asset categories, we very much believe in a blend of long–term, established firms as well as new firms.

That said, normally we talk to startups. We’re very interested in them. Now we’re kind of on a clinical trial, and we’re looking for a small handful of funds with an existing track record that we can really sink our teeth into.

We tend to find that with new firms, the people are very hungry, very focused on alpha. Their name is on the door, they have a lot at stake.

You’ve discussed the advantages to investing with new firms. What are the disadvantages?

It’s challenging for a firm our size. I’ve had that experience of being the majority of someone’s assets under management. And if things aren’t going well and you want to pull out, you’re pretty much going to put them out of business.

What are the disadvantages to investing with an established manager?

A lot of times, a large chunk of the portfolio is their own money and often, they want to invest your money on different terms and conditions. Suddenly you’re secondary, and that’s pretty clear, especially if it’s a different pool of assets and not commingled. You get a little worried about where the loyalty lies, how they’ll allocate it, where will the best idea go, and when they run to the exit, where will it go.

What we also find with bigger firms, and I call it the “CFO syndrome,” is when you get to be pretty big and you hire your CFO, sometimes they talk with the traders, and the discussion moves away from investment ideas and comes around revenue flow, income levels, fee levels, and everyone becomes more benchmark aware. We find that as a negative.

Some managers will come in and tout that they’re benchmark aware. To me, that’s a big red flag. That means they’re risk adverse and are just trying to get a more stable revenue stream. I can get market returns for almost free. What I am looking for is skill that is repeatable over time.

You see these firms ebb and flow over culture, structure, and sometimes the skill just leaves the building, even if there’s no change of personnel. It becomes an interesting challenge. Everybody talks about the people, process and philosophy, but what we really focus on is the culture. It’s the subtle changes in culture that are very difficult to measure, but it’s the culture of the office and the people that’s a leading indicator.

What would cause you to redeem?

The simple and obvious signals are key departures and mergers in the money management business.

But we look for the subtle changes within the dynamics. You can only get that from being in the office. You can’t get that from having the senior people visit you. And you can’t get that from a one hour meeting in their corner glass conference room. When I go to meet managers, I’ll wander off and around the office. I encourage my staff to do the same, and to sit in the office for several hours working at one of their desks. In the first hour everyone is on guard, but after that, you see how people deal with things.

Are you planning on investing direct or going the funds of funds route?

We’ll be going direct; we’re not doing funds of funds. I view that as fees on fees.

I think one of the things we are skillful at is performing extensive due diligence. We have a lot of good analytical tools and we have the people to analyze firms and investment processes to help us try and cull between people with luck and people with skill.

What we’re looking for is sustainable performance. Not a short term run or even a good cycle. We want reputable, sustainable performance.

What are the disadvantages of funds of funds?

I know I’m a bit critical of them, but you have to recognize the position we’re coming from as a very large investor with a lot of resources. For a smaller shop or fund, I could certainly understand going that direction and getting that institutional help. You’re also getting access to some of the best and brightest funds.

But it also gets back to our philosophy on hedge funds; which is they are not just a bucket asset class. They are a bunch of different investment strategies that fall under our existing asset class structure. You’re either fixed income, equity or asset allocation strategies, and so a fund of funds in deploying all six broad categories doesn’t fit that philosophy. We would rather take our equity team and look at market neutral and long/short, or take our fixed income group and look at convertible arbitrage and fixed income arbitrage.

Traditional funds of funds don’t fit our philosophy. We’ve been investing in private equity for over 20 years and investing in real estate for almost two decades. We’ve shown that we have some level of skill in discerning between shops that have a solid investment philosophy and have the right people and structure to succeed.

What strategies are you avoiding?

I wouldn’t say we’re avoiding anything specific. We generally tried to avoid areas where everyone else is rushing into. Sometimes the herd mentality is wrong. We like investing in things that other people are tending to move out of.

For example, lots of our peers have been reducing or eliminating their currency active management strategy. We’ve been adding to our currency overlay.

What are some areas that everyone else is rushing into now?

It’s interesting now. I see people in a holding pattern. I wouldn’t describe it as shell shocked or frozen, I think they’re in a holding pattern. It’s so uncertain where these markets globally will head.

There are real, deep systematic issues plaguing Europe and the U.S. and difficulties with the Japan market still. It’s really tough to figure out. We all know the BRIC story. It’s tough to figure out how the global GDP will turn it out. Right now, sovereign debt is at historic highs. That’s an area that’s worrisome. Meanwhile, U.S. interest rates are at absolute historic lows.

In the past year, high yield is still at historic ranges, but they’ve made great returns recently. I don’t know if that means you should put more money there. It’s a very challenging market and very tough for investors.

Suzy Kenly





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