The Journal of Indexes sat down with Dhvani Shah, who became the CIO of the Illinois Municipal Retirement Fund last December, to talk about her fund’s allocations and how it uses index strategies, among other topics. IMRF is the 51st-largest pension system in the United States and the second-largest (and one of the best-funded) public pension system in the state of Illinois.
JOI: How does your team approach the investment process?
Shah: We have an annual review of our investment policy statement, real estate policy statement and strategic asset allocation. That’s an opportunity to fine-tune things as needed. We also conduct an asset liability study about every three years. Actually, the next one is scheduled for next year, 2013.
Within our public market portfolio, we have active managers, as well as index investments. For example, within domestic equity, we have about $3.5 billion in index investments, which is about 43 percent of the large-cap portfolio, and 32 percent of the total domestic equity portfolio, which is $10.9 billion.
We have a mix of active and passive management in each of the major asset classes. In international equity, we have $1.7 billion in index investments, which is about 41 percent of the international large-cap, and 35 percent of the international portfolio. In fixed income, we have $1.3 billion in index investments, which is 19 percent of the fixed-income portfolio.
When you total those three categories, you come to about $6.7 billion, and our public market portfolio is about $24.1 billion, so that is about 28 percent in indexed assets. I believe there’s room for growth in the indexed portion of the portfolio. The only time you should be in an active strategy is if you believe that there’s a source of alpha—that the strategy can outperform. When we conducted our international equity rebalancing earlier this year, we were looking at not just the new managers we were adding, but also at that active/passive mix.
In that rebalancing, the international equity portfolio stayed at about 67 percent active and 33 percent passive. In the original scenario, passive management was actually going to go much lower, but we made that decision to not bring it down so much. When we evaluate managers, we keep that passive index option in mind. We are comparing their performance not just to themselves and their peers within the active space but also to indexed portfolio performance.
JOI: Are you using a core-satellite approach, with index-based investments at the core?
Shah: Yes, that’s exactly right—that’s exactly how it’s been built.
JOI: What kind of indexes are you using as the basis for your passive portion of the portfolio?
Shah: In the domestic space, we have a growth index, a value index and a market-cap index. In international equity, we have the MSCI EAFE index. We’re looking into whether we should be also thinking of ACWI or the emerging index, and so on. Within fixed income, we have the Barclays Aggregate Bond Index.
JOI: Do you believe that a passive strategy can be effective in emerging markets?
Shah: It’s under consideration. Right now we have only one manager in the emerging markets space. One of the things we may decide is whether or not we need to add another manager in this space. When we do that project, we will definitely consider the passive index option. That’s when we do a much deeper dive. I don’t discount it right at the front, so it will definitely be considered.
The reason is there is a huge fee difference, and you have to keep that in mind. With active management, the outperformance is there, but is it on a consistent basis? When we evaluate that segment, we will definitely be looking at the emerging markets index option.
JOI: Have you ever looked at fundamentally weighted benchmarks as opposed to the more traditional market-cap approach to indexing?
Shah: To date, we have not done that. When we do our asset liability study, which is scheduled for early next year, that is one of the issues I will have on the table. The simple fact is index investment in general is more cost-efficient, and so you want to make sure you’re considering all options when you rebalance your portfolio, and not only think within the active management space.
I don’t know how accepted that concept is, but it’s going to be a good conversation with our consultants. But you know what? The active mandates are not just going to be a given assumption. Passive index options are going to be part of the deep dive in the consideration for anything that we do in the public market.
JOI: Are there any asset classes in particular where you think that indexing is probably not an appropriate approach?
Shah: I don’t expect to use index investing in alternatives. With our public markets portfolio, if we are looking at a segment within the public markets to revise because it’s out of range or we want to change the manager lineup for some reason, the index options will be part of that project.
JOI: Do you use ETFs at all?
Shah: We don’t currently have them in our portfolio, but I think we’re going to be talking about them when we do our asset liability study and discuss the strategies. I don’t know if I have a strong feeling one way or another.
JOI: Do you believe in the concept of the “new normal,” that we’re in for a long period of a slow economy with very low returns?
Shah: I think some of that is going to come through in the capital market assumptions when we do our annual strategic review. That’s where our long-term investing nature comes into play. We’re not going to make wholesale changes, but it’s certainly going to come into play as we do our strategic plan: What are you really expecting for the next few years? How do you want to make some changes?
We have a very long investment horizon, and we’re going to keep that in mind, because you don’t want to be on the wrong side. You don’t want to completely have a negative short-term outlook and substantially change your portfolio when you have a much longer time horizon.
JOI: How are you finding reasonable returns in the current environment? Has it been more difficult of late to meet your growth targets?
Shah: With multiple allocations in domestic equity and international equity—42 percent in domestic equity, 19 percent in international equity—certainly the market movements affect our returns. And we have 31 percent in fixed income. The market environment definitely has an impact on the shorter-term returns. But over the long term, we also have other asset classes where we’re hard at work, such as real estate and alternatives. In June, we completed a recommendation regarding our hedge fund review, and we’re making some changes there. We went down from three fund managers to one, and it will be a separate account strategy, so we can keep our entire portfolio in mind as far as the long, short, credit and macro strategies. It’s going to be much more customized to our overall portfolio.
JOI: Have you reduced the allocation to alternatives, or have you just put them all under one manager?
Shah: We have a 6 percent target for alternatives, and we’re actually under target. The hedge fund allocation increased slightly during a review earlier this year; it went from roughly $375 million to $500 million. We also continue to put some capital into private equity and real estate fund investments.
It all comes back to a long-term planning horizon. Within public markets, you want to make it run as efficiently as you can, and really think about what strategies you’re in. Then you also want to make sure within alternatives that you’re attracting top-quartile managers, because with below-top-quartile managers, between the fees and the liquidity issues, you’re better off not doing that. We will selectively add commitments in the alternative space to the extent we believe that there are strong managers.
JOI: Can you speak in general about how your asset allocations may have shifted in the last few years? Have there been any major changes?
Shah: Within the broader major asset classes, it has not changed much. It’s been pretty standard as far as the equity, fixed income and alternatives mix. We are underallocated in alternatives and real estate. In the past few years, they did a real estate surge, and we’re getting a little bit closer to the target.
JOI: Is the eurozone crisis affecting how you approach your international allocation?
Shah: The international equity rebalancing that we completed did get funded around that time, but net/net, our allocation to international equity was the same. Some of the money moved from international growth to international value, but from a portfolio perspective, we were not any more or less than we were before in terms of overall international allocation. We expect to stay at our current 19 percent. During our manager reviews though, we do talk in-depth about how they’re handling it, what they are doing—especially with active managers who are taking a subset of the opportunities. It does come into play at the individual manager strategy level, but at the portfolio level, our allocation’s the same.
JOI: There’s been a lot of talk about different municipalities filing for bankruptcy, and it looks like it’s happening more often. Does this affect the way you do your job, or what your concerns are when you’re thinking about meeting your goals and how the portfolio is invested?
Shah: We think of it in terms of risk factors: Every investment has its inherent risk. But we do believe that it’s part of the risk we expect our fixed-income managers to take into account. In our reviews with the managers, nothing major has come up as a discussion point as far as a poor performance attributed to some bankruptcy. We believe it’s being properly managed, and it’s a risk factor we expect to be accounted for.
JOI: How do you interpret Warren Buffett’s recent decision to stop insuring several billion dollars’ worth of municipal debt? Does that seem like a bearish or a bullish move as far as municipalities are concerned?
Shah: I’m not really changing anything in the portfolio based on that. I didn’t think in terms of compartmentalizing it as a bullish/bearish move. Our active managers may use that information and work on the portfolio slightly differently within their investment guidelines. It’s really the macro environment you have to keep an eye on.
JOI: IMRF is well-funded, especially compared with some other Illinois pension funds. Can you talk about how your strategies or how your structure may have made that possible?
Shah: Our members and employers have contributed the required contributions when they were due, and I think there’s no substitute for that. If you don’t pay your bills today, it’s just more expensive tomorrow. And if you look across the country, the public pension plans that are in stronger positions are the ones that are getting their contributions on an annual basis. I came from New York State Teachers before I joined IMRF, and they are also in a similar position with strong funding for that very reason.
Why is that important? It comes back to the investment program itself. You asked earlier if we had to change our allocation in a major way in recent years. No. If you’re in a strong funding position, you can then be thoughtful about your strategic plan and your asset allocations, and spend time executing on that plan, the strategies, all that work that’s involved in managing a portfolio. You can spend all your energy doing that. I think that a strong investment program, without the foundation of strong funding, is hard to execute.
If you’re not getting that contribution, that means you’re basically borrowing from the fund to pay a payment, and the fund is short. Now you have less to invest, because the fund is smaller. You have to have a much higher return than your actuarial rate of return because you have a smaller base than what you should have had. It just compounds that problem.
JOI: If by some chance, IMRF becomes underfunded, how would the difference be made up?
Shah: Every employer has a unique contribution rate. Every employer has their own separate account, so we know what their assets and liabilities are. Our actuaries calculate what they need to contribute, and then IMRF collects the payment from the employers. Our employees also contribute a fixed percentage of their pay each month to help cover the cost of their benefit.
The way a defined benefit pension works is when someone retires, we have every single dollar we need to pay that person their benefits for the rest of their life. We also have a separate reserve for retired members, and that’s always 100 percent funded. That’s sort of unique to IMRF.
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