The following interview, first published in the Journal of Indexes , examines the reasons Arizona's retirement system helped launch a quartet of ETFs with iShares, the fourth of which is going live on July 18.
The $31 billion Arizona State Retirement System recently made news in the ETF world when it became the first pension plan to provide the seed money for three new low-cost ETFs that hit the market in mid-April. (A fourth is still in registration.) The iShares MSCI USA Momentum Factor ETF (NYSE Arca:MTUM), the iShares MSCI USA Size Factor ETF (NYSE Arca:SIZE) and the iShares MSCI USA Value Factor ETF (NYSE Arca:VLUE) all track indexes from MSCI’s Risk Premia family of factor-based indexes, and each comes with an expense ratio of 0.15 percent. The Arizona pension fund seeded each of the funds with $100 million.
JOI chatted with Dave Underwood—ASRS’ assistant CIO and head of equities—about the pension system’s foray into ETF funding and how ASRS is navigating the current market environment.
JOI: How ASRS is set up? What are your typical numbers?
Underwood: We are, in a sense, a multi-employer plan, not just state employees. The plan traces back to the ca. 1943 (AZ) Teachers’ Retirement System, which in 1955, joined the ASRS, which was created in the mid-1950s to provide retirement benefits for state employees, university faculty and employees of counties and municipalities. Today the ASRS membership includes the state of Arizona, the three state universities, community college districts, school districts and charter schools, all 15 counties, most cities and towns, and a variety of special districts. ASRS today has somewhere around 550,000 members, of which 200,000 to 220,000 are active participants and about 100,000 to 115,0000 are active pensioners.
JOI: How well-funded are you right now?
Underwood: We’re in the high seventies in terms of the funding ratio percentage. Another way of saying it is that we’re a good house in a bad neighborhood:The plan is very liquid, with 35-year horizons, so we’re comfortable with that level.
JOI: Would you talk a little about ASRS’ decision to seed three of BlackRock’s iShares?
Underwood: That actually was part of a collaborative process that we’ve been working on for about three years. The idea was to be able to create some type of an overlay program to enable us to adjust the factor-risk exposure of our combined equity set.
It’s less about alternative beta, although we do have a strong appreciation of it. It’s more that these tools (i.e., the risk-factor ETFs) are a means to an end.
We have long used a Barra analytics platform and we could see what our exposures across our total public equities component looked like in terms of risk factors such as momentum, size, quality, leverage and so forth. We were looking at ways to physically adjust the portfolio to align with these risk factors appropriately. But it becomes expensive reallocating assets, and it takes time to do that. And wrapped around that is the relative lower persistency of active strategies versus passive or beta strategies. The interest in ETFs on our part came as a result of realizing that by one, or just a few, trades, we could conceivably adjust this exposure in order to neutralize the structural active factor risk building up systematically across the total equities component.
We originally met with Russell late in 2011 about their risk-factor ETFs, and in early 2012, began to develop a program. Russell announced later in 2012 that it would exit the factor ETF space. Due to our relationship with BlackRock, we approached them with the conceptual program we had developed thus far. BlackRock queried their institutional clients about potential similar interest in access to risk-factor-specific ETFs, and found definite interest. MSCI, another of our strategic partners, likewise solicited opinions from its institutional clients. They also found broad interest. Concurrently, we began working with Joe Mezrich of Instinet/Nomura, about developing a signaling mechanism for identifying risk-factor regimes. Nomura is one of the few investment banks in the forefront of alternative beta research.
These relationships allowed us to put together essentially a collaborative partnership and design what we call the “Equity Asset Risk Factor Paradigm.” We repurposed a portfolio already with BlackRock that had been originally envisioned for the now-defunct Russell ETFs, or similar vehicles.
Funding the iShares ETFs wasn’t something we did out of the goodness of our hearts:Everyone involved needed something, and it just worked—all the planets were aligned, so to speak.
We’re employing the risk-factor ETFs as an overlay strategy on our total equity construct. We intend to adjust the proportions in a given factor-specific ETF or ETFs to address our active risk and the directional regimes of the risk factors. We believe we now have a vehicle with which we can easily accomplish that.
You should note that there’s also a quality-factor ETF in registration right now that will track the MSCI USA Quality Index from MSCI’s Risk Premia index family. The portfolio has been set up, and will convert to the ETF over the summer. We funded that portfolio at the same time as the other iShares ETFs.
JOI: How did ETFs fit into your portfolios before you seeded the funds?
Underwood: We have not used ETFs in any meaningful fashion previously, although our external GTAA (global tactical asset allocation) managers do employ them. We do manage some alternative beta strategies internally and more cheaply than what can be done externally, certainly far less expensively than heretofore-existing ETFs. Also, with ETFs in and of themselves, we were just a little too big to really use them in-house. We had the latitude in our in-house portfolios to use them to equitize cash, but we found index futures were more fluid and involved lower tracking error.
Very much to their credit, BlackRock, in the course of developing the risk-factor iShares ETFs, listened to our and other institutional investors’ suggestions and priced these ETFs at 15 basis points.
JOI: How much of the ASRS portfolio is indexed or passively managed?
Underwood: Excluding our GTAA investments, we’re in about the low to mid-sixties in terms of overall percentage of what I would call beta or passive—essentially pure index—across the asset classes in which we use passive management. Just to give you some hard numbers, we’ve got about $16.5 billion of the total plan in what we categorize as public equities. And we’re at $30.8 billion in total assets, with roughly 55 percent in public equities.
In the domestic large-cap equity subclass, we’re roughly 80 percent indexed, but in small-cap, we’re about 30 percent indexed. Across all public equities, on a combined basis, we are about 62 percent indexed.
We’re a hybrid, in a sense, in our public equity classes. We manage domestic equity assets internally, essentially replicating pieces of the S'P 1500. We have an S'P 500 portfolio, midcap growth and value portfolios, and a small-cap portfolio. A prior S'P 500 sampling portfolio was split last year into two pieces and repurposed 60 percent to replicate the MSCI High-Dividend Yield Index and 40 percent to replicate the MSCI Minimum Volatility Index; they operate together in a systematic fashion. The relative proportion between the two portfolios can be adjusted within 20 to 80 percent ranges, depending upon the volatility of the equity markets. We can also move assets from the other part of the beta portfolio set, the S'P portfolios, to increase this component, or shrink it in more traditional market environments.
Externally is where we use active management, and that’s a mixture of quantitative and fundamental disciplines. However, we don’t manage indexed non-U.S. portfolios in-house—BlackRock does that for us and replicates the MSCI EAFE, EAFE small-cap and emerging markets indexes.
In general, we start with a big beta component across the system, although its relative size shrinks within various asset subclasses.
JOI: Do you use more active management when you feel there are more opportunities or inefficiencies in the market?
Underwood: That is the mode we’re in now. Every three years, the plan redoes its Strategic Asset Allocation policy, or SAA. It’s essentially the blueprint of all the asset classes in which the plan can invest. Around each target allocation are bands providing some latitude for rebalancing as well as permitting some tactical latitude to address current markets environments.
Both the 2009 policy and the SAA that the board adopted as of last July 1 called for some adjustment downward in the U.S. equity component. In implementing the latter policy, some of that increment went to non-U.S. equities, with the balance ceded to private market classes—private equity and real estate, which have targets of 7 and 8 percent, respectively.
Historically, the active/passive proportion was closer to 50/50. We now just have a passive 50 percent minimum for the domestic equities class and a passive 30 percent minimum for the non-U.S. equities class. We invest in U.S. markets and non-U.S markets separately; we don’t have a true global mandate, although we do have most of what comprises that designation. Regardless, we look at the two asset classes as a combined system, not as separate arenas.
We—and our internal philosophies and the principles of the investment management division are really endemic—start from the viewpoint that the markets are generally efficient. That’s not to say that anomalies don’t exist or that there aren’t periods where there are strategies that can extract excess return over time, possibly even alpha. But those are in the minority. Our strategic asset allocation is really an exercise in putting together—from an expectational basis, and a risk-adjusted basis—something that keeps us on track for our actuarial return. We’re still an 8 percent return type of plan.
In those categories I mentioned, it’s important to try to at least get the benchmark return. The greater certainty of passive management and the lack of consistency with active management mean we have to have a higher beta component.
JOI: Overall, how do the asset classes tend to break down in the portfolio? Do you have any allocation to alternatives?
Underwood: We have broad delineations of equities, fixed-income and inflation-linked assets—three broad categories. Within equities, the vast amount of this is public equities, for which we have targeted a 33 percent allocation to domestic and a 23 percent allocation to non-U.S.
We have a 7 percent target allocation to private equity. We also have an element for which there’s no stated target, but which does have a 3 percent maximum allocation:We have named it “opportunistic private equity,” where there’s some temporal aspect to the strategy that we can exploit to our advantage. We prefer not to have a hard-target minimum on it that could force us into suboptimal timing or substandard strategies.
Equities—inclusive of private equity—have a target of 63 percent of the portfolio, and we have bands that outline a minimum of 53 percent and a maximum of 70 percent allocation.
Moving to fixed income, we have a 25 percent target and with symmetric bands around that of 15 and 35 percent. Within fixed income, we have again a breakdown between U.S. and non-U.S. In U.S., we have core and high yield, representing a combined target of 18 percent—at 13 and 5 percent, respectively.
The other 7 percent is made up of a target of 4 percent for emerging market debt and 3 percent for private markets debt. We also have—like we have in equities—a placeholder for opportunistic debt. There’s no minimum, but there is a maximum cap of 10 percent.
In the inflation-linked asset class, we have a target of 12 percent. We have both real estate and commodities, with commodities having a 4 percent target; real estate is 8 percent. Bands around that are 4 percent on either side, at 8 to 16 percent.
Operating separately outside of that, we have two GTAA mandates with two managers who can invest in the same asset classes I mentioned earlier. However, they can allocate more fluidly between the asset classes within their mandates than can be done physically across the overall plan portfolio. The GTAA managers have the same ranges as the plan’s SAA, and the same categories. They can’t invest in an asset class outside of those categories, but within those asset classes, they can move around. Essentially, they have the same fence lines to run along and the same distance between those fence lines, but they can run between the fences faster.
We don’t use GTAA as an overlay, but as a means of tactically expressing a market viewpoint through a mechanism that allows a quicker response.
JOI: What do you see as the challenges in navigating the current markets?
Underwood: As I mentioned earlier, we revisit our strategic asset allocation via a three-year review process, although we will take intra-period environments into consideration. That allows for keeping long-term goals in sight while addressing near-term changes in the capital markets.
From a tactical, near-term standpoint, the situation has changed from the more volatile markets we saw for a while. We’re seeing correlations between and within asset classes start to fall, getting back to, I wouldn’t say a normalized state, but certainly a less frenetic one.
But it’s still about how to garner the returns to be on track for a long-term goal, in a low-return environment. That’s the biggest challenge. Part and parcel of that then is the question of whether there are attendant risks that are being amassed as a result of not just the U.S., but all central banks and their respective quantitative easing programs. Are there bubbles that are accumulating as a result?
It takes managing risk, but also being mindful of what’s happening out there, and being able to sidestep or insulate to some extent from those potential shocks that are relatively unknown. We do use risk management analysis, and it forms a part of our tactical views. We express our current tactical view within the ranges that we’re allotted. In doing so, we’re trying less to outperform the market than to extract the risk premium of each asset class and manage risks that could build up.
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