The investment team at the Kentucky Retirement Systems (KRS),which includes the Kentucky Employees Retirement System, the County Employees Retirement System, and the State Police Retirement System, is preparing for what they believe is a coming recession, by looking for opportunities to invest in distressed assets. It is also lightening its public equities exposure, moving more fixed income and stocks into index funds and looking for partnership opportunities in private equity.
“There will be a distressed cycle, and I want to make sure we have plenty of dry powder for it,” said Rich Robben, the systems’ chief investment officer. Robben and his team are not wasting any time in doing so. “Governance structures take so long to make an investment that if we were to wait until we know the distressed cycle is here, and we could capitalize on it, it would be half over,” he said. “You have to be out in front of stuff.” Robben’s team is currently talking to managers about potential opportunities. “You get a bite out of that apple once every eight to ten years,” he said (see related article).
Not afraid to buy in the downturn
While Robben adheres to the “common sense approach of investing—buy low, sell high—”doing it in practice can be tough,” he admits. “You have to believe that the sky is not falling, that if it [the market] is down 30%, you should buy cheap, because they [the assets] will recover.” He also noted that while this strategy is easy to talk about, “making yourself do it can be difficult. That is why we rebalance every month back to our target, so that means selling the winners and adding to losers.”
As it turns out “selling the winners,” can also prove difficult. But Robben said it all boils down to self-control and not being greedy. He summed up his philosophy as such: “Pigs get fat, but hogs get slaughtered; there is no reason to be a hog.” As such, Robben is looking to sell public equities in particular. “It’s time to back away from the trough and find other places to get returns, after a 10-year tear,” he said.
Index your equities and fixed income
The Kentucky System, with approximately $17.6 billion under management, currently runs roughly 23% of its total assets in indexed strategies. “With the current review, we anticipate moving up to another 5% to 6% into pure indexed mandates,” Robben said. Of that 23%, 19% are in indexed equities funds and 4% in indexed bond funds. “We have an additional 13% of or assets in what we would consider “indexed” core fixed-income mandates, but these are not technically pure indexed investments,” Robben explained.
At the end of March 2019, KRS had 37.5% of assets invested in public equities. Of that 37.5%, roughly 19% is currently indexed, about half of the total allocation. “We will look at potentially bringing that indexed number up to closer to 25%, by the end of the year, which would be roughly three-quarters of the total public equity allocation,” Robben said.
Looking at a move toward PIMCOs Stocks Plus
KRS currently runs a $1.5 billion internal equity fund, indexed to the S&P, but it is considering replacing it with a product like PIMCO’s Stocks Plus, to enhance the return from those assets. Stocks Plus is a portable alpha strategy whereby investors get the equity beta from stock futures, and then port fixed-income alpha on top of that in order to generate alpha, Robben explained. “The idea behind the Stocks Plus effort would be to earn some incremental return,” Robben said. “We are just looking into the idea currently; it would be a fall initiative if we get the Board approval to move forward with the idea,” he noted.
The Kentucky system’s overall dedication to equity index funds is a simple one. “There is no reason to spend our time or fees on large-cap U.S. equities [active managers]; they can’t outperform,” Robben said. “Where markets are really efficient, it doesn’t make sense to spend time and fee dollars trying to outperform. It’s better off to take beta cheap as we can get it,” he said.
The decision is also a practical one: “We have an investment staff of four, so we need to be cognizant of where we spend our time,” Robben said. “We want to spend staff time looking for managers and strategies that have the best chance of outperforming. Fundamentally, we want to focus our staff on managers and strategies that can move the needle by producing meaningful alpha. For example, should we focus staff time on determining if a core fixed-income manager can consistently produce 50 basis points of excess return over the U.S. Aggregate, or trying to find a specialty finance manager who can produce returns of LIBOR plus 700 basis points? Obviously, we want focus on the specialty finance manager,” he said.
The majority (70%) of the fund’s core fixed-income, which accounts for 18% of total assets is also indexed. “About 70% of our core-fixed portfolio is invested in what I would call enhanced indexed strategies, where the managers don’t take duration bets, but try to add idiosyncratic alpha via security selection,” Robben said. “With flat yield curves and low yields and public bonds for which the dispersion between the bottom and top managers is 40 basis points, it doesn’t pay to be active there,” he said.
In February, The KRS investment team presented to the Board, during which they explained that they would like to see 50% of the portfolio’s total assets indexed. “We want to get the cheapest beta you can get and set it and forget it,” said Robben. The Board responded favorably to the presentation, he noted.
Active management in the private markets
The private markets are where KRS is looking to dedicate most of its time and fee-spend on active management, in particular on areas that are less efficient. Robben believes in the Efficient Market Hypothesis. “An efficient market is one where all participants have equal access to all necessary information. In efficient markets, it’s hard for a manager to generate alpha because by definition the manager has no informational advantage,” he explained. In “the private markets, we can be strategic, like with our partners,” said Robben.“As a fund, we bring an incredibly long time horizon and very deep pockets, an almost $18 billion pool of assets, so that is my proposition to the market. Capitalize on it where you can be strategic,” he said. Robben also believes that “there is value for a manger to say that they have a state pension fund on the client roster; I want to capitalize on that,” he said.
When choosing a private equity partner, KRS tends to focus on investing with smaller, more specialized asset managers as opposed to larger money managers within its private markets’ portfolio. “Our investment would be less meaningful to the Aries [Capital] and Blackstones of the world, but pretty meaningful to other people; so you want to fish in the right pond, so that you can be meaningful capital to your partners,” Robben said.