CalSTRS, the U.S.’s second largest public pension fund by net assets, has emphasized decreasing the cost of operating its portfolio to maximize returns and control risks.
The costs of operating the portfolio include external asset management fees and internal operating costs, and these costs are highly correlated to the net asset value of the total portfolio.
According to the pension fund’s cost report, “costs can fluctuate significantly each year depending on the life cycle of the underlying investment and/or the investment pace of the strategy. CalSTRS is a long-term investor and as such, return and cost data is more meaningful when compared over long time periods.”
In 2021, CalSTRS spent roughly $3 billion on overall costs, 38% of which was carried interest, 44% of which was external costs and 17% of which was internal costs. Total portfolio costs increased by 20% in 2021—as the portfolio returned 29%—while carried interest paid out to general partners at external private asset managers increased by 69% during the year, as exits in private investments were up in 2021.
During a presentation of the 2021 Annual Investment Cost Report on November 3 at CalSTRS’ board meeting, Shifat Hasan, director of investment performance and compliance at the fund, shared that “the total costs of 2021 were a little over 88 basis points.” Over the year, portfolio costs, in basis points, relative to the net asset value decreased, while the total costs in absolute dollar terms increased.
A large factor contributing to a pension’s total costs is how heavily it is allocated to private assets. Private markets and active strategies generally carry higher fees than public markets and passive strategies. In 2021, CalSTRS’ 32% allocation to private assets stayed relatively flat to slightly decreasing, having a negligible impact on costs.
The spread between gross returns and net returns in private equity were highest at 302 basis points. As a result, “the biggest and largest opportunity [for cost savings] is within private assets, specifically, private equity,” Hasan said.
CalSTRS’ collaborative model, which focuses on managing more assets internally and leverages CalSTRS’ external partnerships to achieve similar benefits, has saved the fund more than $1.2 billion in costs since 2017, according to the plan’s own reporting.
The model’s most significant savings come in carried interest, often up to 20% of profits are paid to externally managed private assets, but not for those managed in house. Carried interest is therefore an important cost to suppress, as private market costs, including carried interest, accounted for more than 90% of the fund’s expenses in 2021, while these assets made up only 32% of the portfolio.
According to the fund’s cost report, “the collaborative model reduced portfolio costs by 9% [in 2021]. Most of the savings was due to an increase in the allocation to co-investments. The number of co-investments grew from 135 to 188 over the year. This allocation to investments with lower fee structures accounted for almost 8% of the savings.”
Mike Dunigan, associate portfolio manager at CalSTRS, said at the board meeting that, “the collaborative model has two components where we achieve savings. The first part is really an economics of scale portion. We have operating expenses that are more fixed portions of our portfolio costs; those aren’t going to appreciate at the same rate as net asset value growth, so we get about 1% from that portion.”
“The bulk of [the savings] came from allocating more towards private assets, and while doing so, [the pension fund has] continued to shift towards co-investments where possible,” Dunigan said.
In 2021, external management costs were approximately $1.3 billion, compared to that of $516 million for internal management costs.
Depicting the gap in cost structure, internally managed investments accounted for 67% of the portfolio’s total net asset value yet only accounted for 28% of the total portfolio costs last year.
The costs roughly equate to a 163 basis-points-per-dollar cost ratio for externally managed private assets, compared to 112 basis points per dollar of assets for internally managed private assets. Similarly, externally managed public assets cost 48 basis points per dollar, while internally managed public assets cost 3 basis points per dollar.
According to Hasan, in 2021, the pension reported its highest capture ratio ever at 94.1%. “[This] means that we kept 94 cents of every dollar of returns,” she said.
Ashby Monk, executive director at the Stanford University research initiative on long-term investing, said the collaborative model is “a means of doing innovative things with peers in illiquid and alternative assets as means of reducing costs. [This] collaboration makes innovation easier and cheaper.”
Dunigan said, “boiled down to 2021, the model saved $437 million. $290 million of that came from management fees, and $146 million came from carried interest. Over time, we are increasing the rate we are saving, and this is coming from a ramp-up in private assets.”
The cost-saving mechanisms added an excess return of 16 basis points to the overall pension’s portfolio in 2021.
Monk’s conclusion on the CalSTRS collaborative model is that “it’s not really just insourcing … it’s innovation!”