He wasn’t looking for a moonshot, he was seeking the holy grail set of investments.
A few years ago, Bob Jacksha, chief investment officer of the $12.9 billion New Mexico Educational Retirement Board (ERB) fund, decided to add an asset category called “diversifying assets” that wasn’t global tactical asset allocation (GTAA) or risk parity. He sought a “perfect” set of assets: one that would diversify from equity risk and contribute to the fund’s return target of 7.25%, all while being a relatively stable investment.
2018 was a difficult year, with the S&P 500 index down 4.4%, smaller caps represented by the Russell 2500 index losing 10%; the MSCI EAFE (representing developed country stocks) losing 13.8%, and the Bloomberg/Barclays Aggregate Index (of investment-grade US bonds) returning 0.0%.
In a year when everything was taking a nosedive, ERB, which provides defined pension benefits to the state’s public educational employees, became one of the few funds to post annual investment gains in 2018, due in large part, to its alternative asset investments and its investment strategy. It posted net investment gains of just over $95 million for the 2018 calendar year, representing a return of 0.6%, net of investment manager fees. So, of course, we wanted some more details for our CIO readers.
As was often the case in 2018, the highest percentage of Jacksha’s returns (15.8%) were in private equity, followed by private real estate investments (15.6%), and real assets other than real estate (14.1%). During the year, however, ERB implemented a new category called “Other Diversifying Strategies,” in which reinsurance provided 11.4% and energy product finance returned 14.3%. Jacksha’s opportunistic credit returned 3.7%.
Jacksha, who started his job in New Mexico in 2007 with a 70/30 equity/fixed income portfolio, faces a common challenge among CIOs. Despite having returns of 7.5% over the last three years, 6.3% for the last five years, and 8.9% since July 1983, ERB’s funded ratio stood at 63.5% as of June 30. The fund faces a rigorous mandate to be fully funded in 23 years, but it will likely take far longer.
And so, the search for an aligned set of alternative investments was methodical. Designed to do well when markets are making modest returns and do well on a relative basis in down markets, ERB’s portfolio does has a planned sacrifice. “We expect to give up relative performance in strong bull markets, but to still participate in the upside,” Jacksha told CIO.
ERB used the popular sliding scale on risk and return: less risk for less returns but investments still had to have expected returns in excess of their hurdles of their overall target return of 7.25%. Jacksha preferred cash flow over capital gains, but he does take both.
Reinsurance, the practice of buying risk from insurance companies when they find themselves over-concentrated in certain geographic locations, became one of the first investments that fit his diversification and return profile qualifications.
“First of all, it’s not correlated with the stock market. It’s more correlated with natural disasters, hurricanes, what have you. In addition, it’s correlated with where you are geographically,” explained Jacksha.
It doesn’t fit the traditional private equity profile, and it won’t generate 20% to 30%, but if everything goes reasonably well, it will generate double-digit returns. For 2018, for example, some payments needed to be made because of hurricanes and California wildfires, but the year still generated a double-digit return from the Bermuda-based ILS Capital Management.
Although the fund does not have an environmental, social, and governance (ESG) mandate, Mitigation Banking, which buys thousands of acres to restore habitats, flight paths, wetlands, and streams, and sells credits to large building projects, including housing, industrial, and road projects, is on course to do quite well, at 10-12%.
Another of what Jacksha calls alternative-alternatives investments is energy finance in an EIG fund. And a recent investment with Orchard’s Liquid Credit Fund—think “structured credit investing in derivatives”—is structured to do well in a credit downturn, when the equity markets are likely going south.
The fund is also planning an investment in the aircraft leasing space (and essentially providing capital to purchase the aircraft and then rent it to the airline).
Private Equity, Hybrid Co-Investments and Small Manager Philosophies
Regarding its private equity investments, ERB generally avoids the mega buyout space, preferring smaller or middle-market deals where there is more of an operational bent than just the financial one. “They will put leverage on a company, but that’s not where they make the money. It’s more buying the company, improving operations, or adding additional acquisitions onto that company to build something,” said Jacksha.
ERB has some venture capital, but not a lot. “We’re building that up,” he said. “And we do have some other areas like mezzanine that we’ve done.”
Jacksha also does what he calls “hybrid co-investments.” It essentially means he doesn’t do everything internally. Using firms such as BlackRock for private equity or Hamilton Lane for real estate, within the hybrid structure, the management firm is the general partner but ERB retains approval authority on all the deals. “So, it does give us some selectivity and it gets our staff more involved in looking at the details, which is a helpful knowledge transfer, I think, and the fees are less,” Jacksha said. Fees are about half of what would normally be paid in a regular fund.
While we’re on the topic of fees: the relatively small pension fund doesn’t have the dollar-power to negotiate as hard with managers as, say, a California Public Employees’ Retirement System (CalPERS) with hundreds of billions of dollars might be able to. Instead, it will also invest $50 million to $100 million in smaller funds or hungry first-time funds. The new funds, however, must meet certain parameters. “We want to see some history with the team,” Jacksha told CIO. Lift outs of existing teams going into business for themselves are an easy consideration. And, sometimes, those who have worked together when they were in different organizations. “One of the important things is not just how smart the people are but how they work together. And obviously they have to have a demonstrated track record of some kind,” he said.
For real estate, ERB has categorically done mostly value-added and opportunistic investments, and avoided core investments and the typical 4% to 5% cap rates. The fund invests mainly in US and North American properties, with apartment buildings, medical office buildings, offices—the usual categories with a logistics fund that includes warehousing.
Infrastructure and natural resource investments extend internationally, such as a toll road in India, power generation in Latin America, and into Australia and Europe for timber, agriculture, energy, water, and, of course, the aforementioned mitigation banking.
Regarding his advice to other CIOs, Jacksha is quick to say, “None of my comments should be viewed as prescriptive. I am certainly not saying ‘this is the way to do it.’ If there is one thing I have learned from others while earning my grey hairs (before they deserted me, the hairs that is, not the other CIOs) in this business is that there is not one right way or one right strategy. There are a number of legitimate approaches. Develop a strategy that is right for your fund, your circumstances, and implement it consistently. Play to your strengths, do what you do well. Don’t do what you can’t do well. If you still need to do whatever that is, hire someone who can do it well.”
Regarding the past year, he said, “circumstances happened to play into our strategy on a relative basis and we were able to post a modest gain.” He emphasizes his most important, overriding goal of his strategy is to meet the plan’s actuarial target of 7.25% over the long run to meet the obligations owed to the plan participants. Predicting continued volatility for the year ahead, Jacksha says, “We feel that our strategy gives us the best chance to compound our long-term returns to achieve that goal and not lose our shirt in the interim,” he said.