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Arguably, the most fundamental debate a chief investment officer engages in is whether alpha exists—and if it exists, can it be captured by resource-strapped teams competing for this alpha (a zero-sum game, of course) with the John Paulson’s of the world? For Don Pierce and his team of investors at San Bernardino County’s pension system, the answers are “yes” and “yes.” Here’s how they’re doing it.
“It started with Tim Barrett,” Pierce said when I met him in his San Bernardino office, referring to the ex-CIO who now runs the Eastman Kodak pension plan in upstate New York. The current CIO’s sun-soaked office was lined with, among other things, a copy of the aiCIO Forty-Under-Forty issue, which Pierce was featured in—not a horrible way, incidentally, to get on a journalist’s good side.
“When Tim was CIO, starting in 2003, we began a migration away from equities. Frankly, our board wasn’t keen on over-exposure to them after the dot-com bubble.” Over time, with the help of NEPC’s Allen Martin, the fund also sought to diversify—and simplify. “It’s just practical to trim the number of relationships for us,” Pierce said. “We have only so many hours in the day, and so many resources.” Like the Supreme Court’s pornography judgment, SBERCA “will know the right number of partners when we see it,” according to the CIO. “And we want partners who want to work with us—not those who just deign to let us in,” he added. “We want ideas and we want access.”
It’s one of these newer relationships that is perhaps most innovative—and speaks loudest to the idea that despite their limited resources, SBCERA thinks it can access alpha. In 2006, the fund—still led by Barrett—started working with Arun Muralidhar and his Mcube Investment Technologies (see page 63) on range-based rebalancing. Referred to interchangeably as tactical asset allocation or informed rebalancing, this program “uses valuation parameters to balance within a range of plus or minus 500 basis points,” Pierce said. “We wanted a low-turnover, valuation-focused model. And we wanted to be more active, within the confines of a pre-approved board policy.” Mcube provides the software platform, SBCERA staff input their investment ideas, and Russell Investments implements the active tilts via overlays. “Once you get into overlays, you’ll never go back,” Pierce beamed. “They’re extremely valuable when managing the portfolio.” Like clockwork, the phone rang. It was Russell calling, as they do every morning at 9:00 a.m., to check in.
Muralidhar, unsurprisingly, beams when speaking of how his software has aided SBCERA. “It’s essentially a GPS for pensions,” he asserted in mid-May. “In SBCERA’s case, it accomplished two things. They could show the board that the process they were adopting improved performance and risk management, so the board allowed them to widen the bands. Also, it gave the board confidence that within the bands, where the portfolio resided was explicit—and not just drift.” Muralidhar, who has strong opinions about what constitutes active investing, is vigilant about drift. “There are no non-market timers out there. There is only naïve market timing and intelligent market timing. In this case, [SBCERA] has replaced happenstance with intelligent insight on markets.”
This combination of theory and software largely rejects the trending theory of passive risk-balanced investing. “Valuation metrics help us decide whether we like assets and whether they’re attractive,” Pierce said. “It’s not anti-risk parity, per se, but it’s certainly different.” Perry went even further. “Risk parity is a dangerous construct,” he said. “If duration moves against you, you can get hurt. If historical relationships change, you can get hurt. It’s static. This program, the idea of being tactical within pre-set ranges, is the anti-static.”
In the first issue of aiCIO, Jay Vivian, the well-respected former pension manager at IBM, made clear the quandary faced by pensions. “It’s arrogance, nothing but the height of arrogance, for a plan sponsor with a small staff to think they can consistently pick hedge fund managers who can themselves produce alpha,” he said at the time. While Vivian’s outspokenness extends further than many of his peers, and while his tirade was aimed mostly at hedge fund selection, his central point still applies: It is exceptionally difficult for small pension teams to compete in the zero-sum world of alpha capture.
Perry, Pierce, and Muralidhar respectfully disagree. “There is no hedge fund manager or asset manager who is fundamentally smarter than any investment officer at a pension fund or endowment,” Muralidhar asserted. “However, because of the substantial fees paid to the former, they can invest in substantial resources to support their decisions, whereas the asset owners typically do not have the ability for a host of agency reasons to deploy similar resources to empower their staff. If you as the CIO tell your staff that they are not as smart as others (who have no greater intelligence, insight, or training) or as likely to succeed, then it is hard to imagine how you can get them to want to raise the bar and you will get mediocrity as a result,” he said. The implication: If a board gives its staff room to move within its asset allocation, and that staff takes it upon themselves to use the available technologies to avoid static portfolios, there will be a net benefit. While Vivian and other skeptics will disagree, the proof is (at least anecdotally) in the pudding: Since the inception of informed rebalancing in 2006, the program has produced annualized returns of nearly 26%.