A Look Under the Hood

Summary

• A U.S. state pension fund board & staff met with a consultant to review survey results regarding their investment processes.
• The consultant utilized a two-by-two matrix to assess risk based on the plan's ability to bear risk (financial health & sponsor strength) & willingness to bear risk (attitude toward losses).
• The matrix defines four risk profiles: "capitalizing" (high ability, high willingness), "defensive" (high ability, low willingness), "protective" (low ability, low willingness), & "naive" (low ability, high willingness).
• The board survey indicated a moderate willingness to accept risk despite the plan's above-average ability to bear it, suggesting constrained returns but reduced exposure to extreme outcomes.
• 100% of board members agreed that risk exposure is necessary to meet objectives, though they prefer bearing normal market risks over opaque innovative approaches.
• Board members ranked their objectives with determining correct asset allocation first, hiring outperforming managers second, & beating peers last.
• The board strongly disagreed that losing money while others do is acceptable, emphasizing that success is defined by the ability to pay benefits rather than relative performance.
• Board members ranked the Sharpe ratio last among performance metrics & prioritized the ability to pay benefits over avoiding volatility in sponsor contributions.
• The author argues that long-term investors should focus on the risk of permanent loss rather than volatility, noting that volatility concerns often stem from external institutional or psychological factors.
• All board members agreed that the future cannot be foreseen, so the portfolio must be built to prepare for all environments rather than attempting to time markets.
• A substantial majority of the board expressed comfort with using leverage at 15-20% of plan assets.
• A slim majority supported allocating 25% of the portfolio to illiquid assets, provided all benefit payments & funding requirements can be met.
• Most members favored focusing on expected returns net of fees, though some argued that fee minimization should be a goal in itself.