Colin Tate (left) and Stuart Brentnall

Australia’s second largest allocator to alternatives, NSW Treasury Corporation (TCorp) has successfully merged three underlying investment clients into a $105 billion total portfolio investment model, with a strong focus on clients’ objectives, according to chief investment officer Stewart Brentnall.

Leading an investment team of 70, Brentnall said the total portfolio approach and TCorp’s focus on strong culture and organisational structure was critical to its performance. The organisation is the financial services partner to the NSW public sector.

“We had the State Super defined benefit assets and investment process, icare, (formerly Workcover), and the TCorp funds come together,” Brentnall said at Investment Magazine’s Absolute Returns Conference earlier in September.

“As such, were posed with the question how to build one investment ecosystem which would deliver the best outcome to a diverse set of clients with differing horizons and requirements.’’

He spent time with the board to “distil out six investment beliefs which were board-owned” namely good governance, comparative advantages, total portfolio thinking, primacy of equity risk, active management and ESG.

Total portfolio approach

Five years on and the result has been a central total portfolio process and similar governance to several of the Canadian pension funds, where the board delegated heavily to the investment team, Brentnall said.

“We’ve built a bottom up, risk-factor based, total portfolio approach where all investment opportunities go through a competition of capital process to build portfolios which will meet the clients’ objectives subject to their risk appetite,’’ he said.

“We had to put in place the right operating system to support that, because this is a data-heavy process.  Naturally we focussed very carefully on getting the right capability into the right organisational structure with a collegiate culture to support a total portfolio approach.

He said the foundational steps for this were to understand the clients’ business and mission, their investment objective and most importantly their risk appetite.

TCorp has 14 diverse, “fit for purpose” portfolios. “We basically have a mission to deliver the highest amount of return for agreed risk for each client and there’s a role of alternatives within the interplay between those two,’’ Brentnall said.

Protective mechanisms

TCorp has three alternative investment approaches for funds that are particularly sensitive to left tail events through sequencing risk and those funds that have less binding constraints on volatility.

Firstly, for especially sensitive funds, the team purchased a small amount of insurance through equity put options designed to protect against extreme tail risk events.

“Those strategies appeared, for a few years, to be expensive insurance until February and March 2020 came along when TCorp was able to monetise $700 million of real liquidity to go back into client portfolios,’’ Brentnall said.

“(This) proved to be incredibly helpful to the two clients who had sensitivity to the left tail – for State Super this helped them continue paying pensions and for Workcover (icare), this helped them to pay insurance claims,’’ Brentnall said.

The second type of alternative strategy, defensive alternatives, outsourced to PIMCO Investment Management, still sought to deliver returns that would be negatively correlated to equities. “In the 12 months to June 2022 delivered double-digit positive returns,’’ Brentnall said

For the modestly volatility sensitive, funds the investment team also looked to assets that would deliver returns and lower volatility than equity risk and where the pattern of the volatility was very diversifying to equity risk.

This third strategy, core alternatives, has been described as “journey smoothers”, he said. “These strategies don’t always deliver positive returns but their volatility and equity beta and correlation is low enough mostly to deliver a positive return and, in market downdraughts to deliver a much more dilute negative performance than the pure equity drawdown.”

There is no silver bullet to eliminating concealed equity risk in alternatives, the investment team needs to do the hard work to properly understand the risk and return characteristics of what one is buying “in a lot of detail” as “many alternative strategies, in fair weather, look as though they have low equity beta and correlation while in shoulder and tail events suddenly develop much higher correlations.”

“The answer is getting in deeply with the partners and providers, understanding what’s under the bonnet, working through scenarios with them, testing them against one’s own portfolio and ensuring oneself that what you’re going to buy is correctly represented on the label. At the end of the day, it’s caveat emptor.”

No YFYS distraction

TCorp is not a super fund − although it manages the assets for two defined benefit clients − and thus is not governed by Your Future Your Super regulations which he compared to an English fox hunt, with dogs following each other’s tails, while not knowing where the pack is going.

“We have the luxury of being able to focus on our clients’ needs, with very little distraction over peer activities and their risk appetite. What’s measured is managed,” Brentnall said.

“There are so many considerations that YFYS funds have to bear in mind about how much tracking error they use, against an aggregated industry benchmark and how they budget to spend this tracking error. This is of limited relevance to a client specific objective or mission.”

Meanwhile measuring TCorp’s alternative strategies’ success was difficult because it was hard to find the right benchmarks. “Alternative strategies contain volatility, so it’s fair and reasonable that these are measured against a comparable benchmark, which is not a riskless straight line accrual of performance,’’ he said.

He said the benchmark had to diverge away from CPI plus, so the team looked for a benchmark for core alternatives that delivered an excess return above cash but had some equity risk, and, for defensive alternatives, had modest negative equity correlation.

“We also set ourselves a volatility limit and set ourselves correlation and equity beta constraints. It is those things against which we judge the results of the processes. Although it’s not much more than a year since we implemented these new strategies, we’re now seeing an outcome consistent with design which has exceeded those benchmarks,’’ he said.

“A more clearly thought through proposition for alternatives, partner and strategy selection as well as risk allocation have all paid off”.

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