The Seattle Municipal Employees Retirement System’s (SCERS) investment strategy is based on a focus on long-term assets. It eliminates hedge funds and commodities, and minimizes cash, which is not a risk-free asset for long-term investors. Instead, it invests in perpetual stocks, long-term fixed income, and real assets, which together make up three-quarters of its $4.1 billion portfolio.
“The bottom line is that those with long-term liabilities, like pension funds, should make money by investing in long-term assets like stocks, real assets and long-term bonds, while leaving short-term assets like cash, medium-term bonds and hedge funds to those with short-term liabilities,” SCERS CIO Jason Malinowski said in an interview with Top1000Funds.
Malinowski calls the strategy “debt-aware investing,” and the approach at SCERS originated from a board request six years ago for the investment team to think more about debt when assessing risk and performance. That request set off the starting gun for a conceptual and analytical framework, which was followed by an incremental approach that’s still not complete.
Over the next few years, events like the collapse of Silicon Valley Bank (SVB) strengthened Malinowski’s faith in his strategy. He uses SVB’s woes as an example of what can happen when an organization’s assets and liabilities are structurally misaligned — in this case, SVB’s holdings of long-term bonds (which suffered huge losses when interest rates rose) and short-term deposits.
“SVB was unable to balance long-term assets with short-term liabilities at a time when the opportunity cost of capital was increasing,” he explains.
With pensions, it’s quite the opposite: “With pension funds, members cannot withdraw their funds because their liabilities are long-term. If they invest in short-term assets like hedge funds or credit, the opposite asset-liability mismatch occurs when the opportunity cost of capital falls.”
He said the strategy involves a shift from thinking about the risk and performance of an investment portfolio to thinking about the risk and performance of the plan as a whole. SCERS liabilities are discounted according to expected returns, so the team needs to understand the relationship between investment performance and changes in expected returns.
“We had to switch our focus from asset volatility to capital volatility.”
Hedge Funds and Core Bonds
Malinowski got rid of hedge funds and reallocated money into stocks and infrastructure in 2019. Last year, he went a step further, reducing his core bond allocation and setting a new 5% allocation to long-term bonds.
While many CIOs have enthusiastically championed the uncorrelated returns of hedge funds, especially when bonds and stocks fell simultaneously in 2022, Malinowski believes there is enough diversification between stocks, bonds and long-term real assets to outweigh the need for hedge funds.
“Hedge funds have no role to play in a portfolio to fund long-term liabilities,” he says.
Plus, as a liability-conscious investor, a sharp sell-off in stocks and bonds in 2022 wouldn’t spook me.
“I had a different view on what happened in 2022. Asset performance was negative, but it was also a period of increased expected returns. Bond yields rose, and income yields rose. Assets did fall, but liabilities also fell because expected returns increased, and this allowed the pension calculations to work again.”
Liability-conscious investing also means Seattle loses out on bold allocations to high-performing assets such as private credit, which SCERS’ small allocation is capped at, though other investors continue to flock there.
But Malinowski is happy with his limited exposure. He believes one of the biggest risks in private credit for investors with long-term debt is reinvestment risk. “Once you get your principal and earnings back in three to five years, you’ll need to reinvest it in a new credit allocation. However, this will depend on the market environment at the time, which could lead to lower interest rates or credit spreads,” he says.
Strategy Background
This strategy has similarities to LDI, such as focusing on the entire plan rather than just the investment portfolio, and focusing on funded status changes rather than asset changes. However, LDI liabilities are discounted based on long-term bonds, and in a liability-aware portfolio, all long-term assets are attractive because they are matched with long-term liabilities.
“Certainly, we like long-term bonds, but we also like equities as a durable asset, and we also like real assets such as real estate and infrastructure.”
He says the strategy doesn’t dramatically reduce fees. SCERS’ long-term bond allocation is passive Treasury bonds, but fees from its equity and real asset allocations are still high. “With a 30% private markets allocation, the fees are going to be significant. This is not an effort to minimize fees.”
The strategy is unleveraged and easy to execute with a fixed income portfolio, which is important because it can weather any storm. Though he’s mindful of the need for liquidity and benefit payments, he says SCERS doesn’t need to have a ton of liquidity on hand. “We need to be conscious of how much liquidity we have available, but outflows are modest. Liquidity is not a meaningful constraint on the portfolio.”
Malinowski regularly fields inquiries from fellow CIOs wanting to know more. Many of the questions center around how he got board approval and how the fund initiated changes to its asset-liability study to switch to longer-dated asset classes. He believes the process is useful because it tests what SCERS has done and provides reassurance that it is not straying too far from its peers.
“I focus on how different we are. [to other funds]” he concludes.
