It’s All About Diversification: Asset Allocation Unveiled
Every four years, the Teachers’ Retirement Board’s Investment Committee undertakes an asset allocation study. In November, the conclusion of CalSTRS’ 2015 Asset Allocation Study is set to take place pending a final decision from the Teachers’ Retirement Board. The board holds exclusive control over the investment and administration of the Teachers’ Retirement Fund.
For those of you who did not major in finance or a related field, it’s helpful to understand that executing the CalSTRS investment policy is akin to steering a massive ship; we must plan years in advance to shift assets globally. It is a process that requires a high-level of educated assumptions. We at CalSTRS take great care in working with the world’s most highly regarded investment professionals in determining the best course to steer us through this process.
In the world of finance, and all things investment-oriented, everything you do is predicated on how well, or not, you manage your assets. Within this framework, it’s all about diversification, diversification, diversification. But what does that mean exactly?
First, the strategy up for consideration would create a new diversifying asset class, Risk Mitigating Strategies. The proposed RMS class would comprise a combination of different investment strategies in assets that include long-term U.S. Treasury notes and other alternatives. Its purpose would be to offset potential declines within the Public Equity, Private Equity and Real Estate asset classes. But why do we need to do this and what assurance do we have that our actions are appropriate?
What is being proposed is a modest reallocation of capital to different asset classes to better diversify the portfolio and preserve capital. We arrive at this, and other recommendations, through a series of synthesized investment models that are run as part of the Asset Allocation Study. In addition, we, along with our investment consultants, conduct years of detailed, analytical research in order to select an investment strategy that we anticipate will continue to meet the funding needs of the system.
Based on our experience and observation, we believe the market environment is changing. Monetary policy is changing and we have just experienced one of the longest bull markets in the history of the Standard & Poor’s 500. These current conditions further support why diversification away from a portfolio heavy in equities is prudent. However, we will remain predominantly in the equities market.
Second, lessons learned from the dot-com bust in 2001 and the economic turmoil from the 2008-09 crash serve to remind us of how heavy losses during significant market downturns can negatively affect the fund. It is precisely because of these past lessons that we anticipate significant downturns could occur again and do harm to the fund. We believe a better-diversified portfolio will experience much smaller losses in a stock market sell-off should another downturn occur, without adversely affecting returns in a potential stock market rally.
From an investment perspective, one of the biggest challenges that public pension funds face is to experience asset, or funding turmoil at exactly the same time your plan sponsor experiences the same challenges. In this situation, both the fund and its sponsor grapple with depleted funds. This is akin to a two income family where both income earners lose their jobs on exactly the same day. Who pays the bills now?
The objective of the proposed RMS is to judiciously reduce this cycle of economic codependency as much as feasible. The idea is to mitigate risk to the portfolio in such a way that in a time of market crisis, potential damage to the overall portfolio is minimized and what does get damaged can recover as quickly as possible.
Keep in mind, the CalSTRS 2014 Funding Plan, enacted in AB 1469, gradually increases contributions from all the plans contributors, employers, members and the State of California over the next several years. In the meantime, the fund still has a liability that is being paid down. This subjects the fund to more sensitivity around asset return volatility.
In this situation, what you don’t want is for the plan to be in a status where it could experience more underfunding due to market losses when assets have not yet fully recovered. Thus, if potential losses can be mitigated, and the recovery time of the plan reduced, then an environment where the plan can continue to meet its liabilities exists.
Lastly, we at CalSTRS are stewards of the hard-earned savings California’s educators contribute towards their retirement and have entrusted to us. CalSTRS is a long-term investor and ultimately our goal is to generate returns sufficient to meet the plan’s liabilities for the benefit of our members. We treat this responsibility with diligence and integrity.