Pension Fund Wants Alpha AND Low Correlation

Pension Fund Wants Alpha AND Low Correlation

Please excuse me if what follows comes off as a rant.

Yesterday, Institutional Investor published a piece about the $31 billion Iowa’s Public Employees’ Retirement System.  It’s short – read it here if you’d like.

In it, Sriram Lakshminarayanan, the “Chief Risk Officer” at Iowa PERS says that the active managers that they are currently using are not taking enough active risk.

In other words, they have closet indexers.  The closet indexer issue has been a pandemic plaguing the investment world as the industry has become more bloated over the past few decades.

To that point, I can square with his thoughts.  If you’re going to use an active manager, they should at least be taking some active risk.  It’s only natural to be disappointed with a high fee indexer.  After all, they could have simply purchased the index.

Here is the problem, as Lakshminarayanan continued:

To remedy this problem, he said the pension fund will next week begin a search for managers that have demonstrated persistent alpha and low correlation to both equity markets and other managers within Iowa PERS’ portfolio.

My two simultaneous thoughts are:  “Good luck with that.” and “ARE YOU KIDDING ME?”

I get it; virtually everyone would like to have equity returns with minimal correlation (volatility), but few people come right out and say it.  Especially people that are in charge of a $31 billion pension fund.

I would hope that this position requires him to be a fiduciary, right?  Doesn’t he know this doesn’t exist?  Doesn’t he know that to have supposed alpha, you have to take more risk, not less??  Will we ever learn??

Taking this issue one step further, he mentions that they’ll look at the last 7 years or so for support of their requirements.  If the managers he is seeking are going to have alpha and the benchmark index has done nothing but go up over the same period, won’t the manager by default have a statistically significant correlation to the equity markets?

In the end, it probably won’t matter because I’ll be surprised if any managers even meet their requirements due to the point above, but mainly because it doesn’t exist.

At any point.

Ever.

Slight retraction: I suppose alpha with low correlation could exist in the short term, but certainly not over long periods of time that pension funds require which happens to be exactly what this guy is in charge of.

It’s well known that hedge funds just learned their lesson via the Warren Buffett bet.

But let’s say by some stroke of luck they do find a few possible suitors, how long until these managers underperform?

Every great manager has cycles.  So, if they’ve actually outperformed during the most recent period he is noting, isn’t it likely that they’ll go into their underperform cycle at some point in the near term?

When they do, what’s the plan?  To go back to the drawing board?  Who is going to foot the bill?  Won’t the state employees be the most likely source via lesser pensions or increasing their contributions?

Why does the Iowa board feel the need to do this anyway?  Because they already have a $7 billion unfunded liability.

The real problem is that they’ve waited too long to make this change to begin with.  Now they feel the need to throw a Hail Mary to “fix” the problem.  Are the Iowa state employees aware that this is what their Board is considering?  Hail Marys.

Having expectations like this is a recipe for disaster.  It pains me to see that this is the state of a public pension fund.  I can only hope for the sake of all Iowa state employees that the pension officers come to their senses on this one.

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