Global equity funds own stakes in publicly traded companies, with returns driven by expected growth in corporate profits and dividends. Based on their high expected returns and liquidity, global equities have the largest allocation in the pension portfolio. They are also the largest contributor to the plan’s volatility.
For exposure to global equities, the State Investment Commission invests via index funds. This approach eliminates the potential for market out- or under-performance, and allows the fund to capture equities’ long-term returns cost-effectively. With allocations that generally match those available in the market, the global equity allocation is well diversified by country, economic sector and industry.
Private equity, an alternative asset class that ERSRI has invested in since 1982, gives the portfolio stakes in private companies. Similar to public equities, fundamentals of company performance drive the returns of private equity, making economic growth a powerful contributor to returns.
Private equity fund managers invest in private companies with the goal of enhancing their value over the long-term. Due to their long-term nature, private equity investments are held in limited partnerships managed by general partners, and are available only to large, sophisticated investors.
The portfolio’s investment in private equity is spread across five basic strategies:
Hedged equity strategies are designed to benefit from the stock market with considerably less risk. These fund managers seek to generate returns through understanding company dynamics and valuations.
Similar to global equity (long-only) funds, hedged equity funds own stakes in companies they expect to outperform. Differently they also sell short stocks that they expect to underperform. The goal is to gain more of the market's upside and less of its downside.
Equity hedge funds follow a wide variety of strategies. The State Investment Commission analyzes these managers based on their returns, risk, and adherence to their particular strategy. These funds broadly fall into two categories:
Generally structured as commingled private partnerships, these funds typically offer the ability to exit on a quarterly or annual basis.
Real estate funds acquire, manage and sell physical properties, including office, retail, apartment, and industrial buildings as well as more niche property types, such as student housing, self-storage and hotels. The primary goals of this asset class are to provide current income, risk-adjusted total returns, and diversification. The asset class benefits from both economic growth and inflation.
The portfolio’s real estate portfolio is invested in two types of strategies:
Core fixed-income securities are investment-grade bonds that generate returns from scheduled, fixed payments determined at the time of issuance. These cash-flowsinclude periodic coupon payments and repayment of face value at maturity.
Fixed income is traditionally a “risk off” asset class, performing well when markets reflect worry about the overall economy. During economic downturns, investors tend to value the more reliable cash flows from high-quality bonds. Investors accept lower average returns with bonds than with stocks as a result. It is unproven whether this traditional relationship will hold in periods when the Federal Reserve has used extraordinary measures to lower interest rates, as has happened in the wake of the global financial crisis.
Cash assets provide the plan with safety and liquidity. They offer the flexibility to meet payments and fund new investments. ERSRI pension payments exceed pension contributions annually by hundreds of millions so cash is needed to meet this shortfall. Cash also serves as a store of value until attractive new investments are identified and vetted.
Designed to be the lowest risk asset in the portfolio, cash is invested solely to preserve its value, with little to no expectation of returns. For every dollar in the cash account, the State Investment Commission (SIC) expects to get a dollar out at any time, regardless of market movements.
The portfolio’s cash assets are held in bank accounts and Rhode Island’s Ocean State Investment Pool (OSIP), a money-market-like vehicle for local governments. Investments are spread between different banks and OSIP, to minimize counter-party risks. Safety of principal and liquidity are the primary goals for the cash allocation.
Infrastructure assets are the essential facilities and services required for an economy to function. Electricity production and distribution, pipelines, sewers and waste management, airports, roads, bridges, ports, railroads, telephone and cable networks, and hospitals are examples. Private infrastructure funds can invest in assets that are privately owned (for example, electricity production) or privately operated through a government concession (for example, certain airports).
Funds generate returns through overseeing operations and managing relationships with governmental or quasi-governmental entities that regulate the assets. Rate-setting commissions generally allow operators to incorporate inflation escalators into their pricing, providing infrastructure investments with inflation-protection characteristics.
Private infrastructure funds can provide diversification to the portfolio, because the assets produce regular cash flows (current income) and have only modest sensitivity to economic growth. They tend to perform well during economic downturns and inflationary periods.
Similar to real estate, infrastructure funds can follow the following strategies:
Infrastructure funds can be either closed-end or open-end.
For this asset class, the State Investment Commission (SIC) has an investment policy that addresses not only the expected risk and return characteristics, but also includes a Responsible Contractor Policy. Evaluating how managers value their employees and local communities is part of the SIC’s assessment criteria.
Master limited partnerships are publicly traded stocks that own infrastructure assets related to energy and natural resources. Most typically, MLPs own oil and gas pipelines. With steady revenues based on volume or take-or-pay contracts, MLP earnings tend to be insulated from changes in oil and gas prices, though growth potential and stock prices are more sensitive to oil prices. Due to their steady cash flows, MLPs generally pay strong quarterly dividends (distributions). Escalators in contracts allow MLPs to increase their revenues in line with inflation.
Similar to core private infrastructure, the MLP allocation is expect to provide the portfolio with current income and inflation protection.
Global inflation-linked bonds (GILBs) are government-issued debt securities whose face value rises and falls based on the rate of inflation. In the U.S. these securities are called TIPS (Treasury Inflation Protected Securities) and they are adjusted based on the monthly Consumer Price Index. Other developed countries also issue inflation-linked bonds. The SIC seeks to invest in U.S. and international bonds based on the attractiveness of relative valuations. As of March 2015, the inflation-linked bond allocation has been limited to U.S. TIPS.
The GILB allocation is designed to protect the portfolio against unanticipated spikes in inflation. Historically the portfolio’s main asset classes, global equities and core fixed income, have not performed well in such environments.
Loans and short-duration high-yield bonds are rate-insulated credit securities that give the portfolio income paid from somewhat riskier corporations based on predetermined formulas. Loans are floating-rate securities, which means payments are based on a standard cash rate that resets daily (typically the London Interbank Offered Rate or LIBOR) plus an additional fixed amount (the spread). Because LIBOR adjusts quickly, loans do not bear the interest-rate risk inherent in core fixed-income securities (when rates rise, existing bonds with lower fixed payments become less attractive than new bonds issued with the new higher rates; thus the existing bonds lose value). Short-duration high-yield bonds have fixed payments, but because they are close to maturity and the receipt of principal that can be reinvested, they tend to trade down less when interest rates rise.
Both loans and short-duration high-yield bonds are issued by companies that ratings agencies (Fitch, Moody’s, Standard and Poors) judge to be riskier than safer investment-grade companies. High-yield issuers typically have more debt and more cyclical businesses. These companies are more dependent on economic growth and have some risk of bankruptcy during recessions.
The rate-insulated credit allocation provides diversification to the portfolio, since these investments will trade differently from the larger allocations to stocks and bonds. Whereas stocks will do best in periods of growth and bonds in slowdowns, rate-insulated credit will perform best in a steady-state environment, when their solid yields will stand out.
Absolute return hedge funds employ strategies that seek to generate long-term returns and mitigate risk, regardless of broader market moves. The funds invest across asset classes, including government bonds, other fixed income securities, equity indexes, commodities, and currencies.
Strategies followed by absolute return hedge funds include:
Similar to equity hedge funds, absolute return hedge funds are generally structured as commingled private partnerships with the ability to exit on a quarterly or annual basis.