10.30.2013
By Terry Flanagan

Forward Spin

In one of his final interviews as New York City pension CIO, Larry Schloss expounds upon the pros and cons of running a $140 billion behemoth, and the future of institutional investment management

There are stocks and bonds, and there are the purposes of the asset classes, whether growth, income, or something else.

In in the view of Lawrence ‘Larry’ Schloss, former chief investment officer of the $140 billion New York City pension system, investment managers would be well-served to build portfolios based more on the latter consideration, and less on the former.

“In the institutional asset-management business, the biggest opportunity, or challenge, is breaking away from traditional asset-class labels,” Schloss said. “It’s better the more you can refine asset classes, perhaps into themes.”

Larry Schloss

Larry Schloss

Schloss noted that this investment approach gained traction in the wake of the 2008-2009 global financial crisis, when portfolios that were diversified by asset class proved to be not diversified by return. “Bonds are supposed to move differently than stocks. But when all hell breaks loose, they move in the same direction because people don’t want own financial investments,” Schloss said.  “Investment managers need to understand that and appreciate it better, and work much more across asset classes.”

Schloss spoke to Markets Media in a wide-ranging Sept. 11 interview from his office in the landmark Manhattan Municipal Building, a half-mile from the World Trade Center. Schloss, who was appointed CIO in January 2010, stepped down from his position on Oct. 18 to become president of $25 billion alternative-investment manager Angelo Gordon.

Performance Turnaround
The New York City funds generated an annualized return of 11.9% for the three years ending June 30, 2013, compared with a 10-year return of 2.8% when Schloss was hired, New York Comptroller John Liu said in a release announcing Schloss’ departure. The overall market was better in recent years, but the NYC plan also improved on a relative basis, moving from the bottom quartile of large-public-plan managers to near the top quartile.

“During Schloss’ tenure, the NYC Funds increased and energized the staff, and implemented new expanded asset allocations – focusing on increasing alternative assets designed to raise the Funds’ risk-adjusted returns and decrease volatility,” Liu said.

Before joining New York, Schloss, 58, had been head of private equity at Credit Suisse First Boston and then founder of Diamond Castle Holdings. His private-sector experience made him an exception among public-pension managers, and he made his mark on the city’s pension with several investment initiatives reflecting that experience, such as increasing allocations to private equity, opportunistic fixed income and real estate, and investing in hedge funds, leveraged loans and infrastructure for the first time.

To accomplish anything at a public investment organization, a prerequisite is an absence of discord between the investment staff and others with a seat at the governance table. That’s a large table in New York, where the pension fund pools money from the Teachers’ Retirement System, New York City Employees’ Retirement System, New York City Police Pension Fund, New York City Fire Department Pension Fund, and the Board of Education Retirement System.

“The biggest accomplishment was having a very constructive relationship with the five boards, and their trustees,” Schloss said. “It’s a complicated arrangement, but I think somewhere along the way, we all got on the same page and worked very well together. That’s not always easy because of different interests.”

“The second-biggest accomplishment was eliminating, as much as possible, anything that looks like politics in the investment process, and making it as focused on results as possible,” Schloss continued. “Third is increasing the professionalism, and the team, within the Bureau of Asset Management. We increased the team from 22 people to 37 people.”

But giant public investment organizations move more like battleships rather than speedboats, and there was only so much Schloss could accomplish in 45 months. The undone business will have to be taken up by Schloss’ successor, interim CIO Seema Hingorani, who was promoted from head of public equities.

Schloss estimated an overhauled asset-allocation process, including regular reviews and better reporting to the boards, is about 75% complete, and he was unable to consolidate  investment committees, which each meet monthly. “Essentially 90% of the investments they bring to the Board are identical,” he explained. “So if the investments are the same, the agendas are the same, and the goals are the same, we can increase our capacity by four days if we met once a month as opposed to five days a month.”

In Schloss’ view, the Big Apple pension plan’s biggest need for change lies in how it farms all money out to outside managers. Most large U.S. public pensions manage at least a portion of their assets, and some — such as the neighboring New Jersey Division of Investment —  manage most; it’s perplexing to Schloss why New York City, the home of Wall Street, doesn’t show up.

‘High-Cost Way’
“We’re the only public-pension fund of our size in the U.S., in the top 10, that manages no money in-house. It’s the high-cost way to do things,” he said. “We live in the world’s financial capital. We should be able to hire investment professionals to help us manage money in-house.”

Schloss cited Canadian public pension plans, which manage about 75% of their money in-house and are known as best-in-class for their sophisticated investment and risk-management processes. “I don’t know why we can’t start with 5%, 10%, or 20%, and work our way up over 20 or 25 years to a more meaningful number,” Schloss said.

Pay is another sticking point for Schloss. Public-pension funds in general don’t pay market compensation to their employees,” he said. “With pools of capital of this size, you should have the best people you can hire…Unfortunately, with a lot of public-pension funds, what they pay people is subject to government pay regulations.”

That tilts the balance of power toward outside managers who work for pension funds. “With a clean piece of paper, you’d think the balance of power should be with the people who have the money, which are the pension funds themselves,” Schloss said.

Schloss again pointed outside the U.S. for a model, in this case Canada and Singapore. “They pay their people very well,” he said. “They attract the best people to work for their pension funds.”

Regarding governance, Schloss opined that pensions’ DNA of long-term investing is at odds with frequent turnover among the people who are charged with ensuring that plans are actuarially and financially sound and can meet their obligations to present and future plan participants.

“One big challenge for public pension funds is staying focused in the face of changes in leadership, direction, or trustees as a result of elections,” he said. “Some public-pension boards are set up where every time their elected officials change, the boards change. That’s not the best way to invest money long-term, so to the extent you can mitigate that, so much the better.”

If pension comp was meaningfully increased and governance made less impermanent, “I think the returns would go up, and you’d help solve the pension underfunding in the U.S. more quickly and with greater likelihood of success,” Schloss said.

The New York City pension fund ranked as the world’s 16th-largest at year-end 2012, between Florida State Board and Ontario Teachers, according to P&I/Towers Watson. Its assets under management exceeds the gross domestic products of Vietnam and Hungary.

The mammoth size of the fund, by necessity, has a major influence on its investment style.

“When you manage $140 billion, your investment approach is to think long-term, act medium-term, and watch out for the short term,” Schloss said.

“The short term is, for instance, you can’t caught up day-trading $140 billion. The medium term is that you have to pay attention to the issues — if you worry about things like the collapse of the euro, you can rotate your portfolio away from some of that risk,” he continued. In the long term, “you’re always working toward a goal, and when you revisit the goal every three or four years you can change that goal.”

Manager Roster
The New York City pension plan farms money out to about 325 managers, including 110 who specialize in private equity. Variations in manager allocation are “huge”, according to Schloss.

BlackRock and State Street each manage about 20% of the plan’s assets via equity-index strategies. “It’s low margin, but it’s big dollars,” Schloss said. “We’re over 80% indexed in our U.S. equities. Public equities are in excess of 50% of our portfolio, so they have a lot of money. It’s a very efficient way for investors of our size to access the equity market.”

At the bottom end of the allocation scale, the city pension has set aside $400 million of private-equity commitments for ‘little guys’, who could otherwise get lost in the manager-selection process. The idea is to start small, perhaps with a $25 million investment, and then increase the commitment over time provided the manager succeeds.

“We have one person 100% dedicated to knowing the smaller managers,” Schloss said. “He’s out in the market all the time, and people know that if you want capital from the City of New York, there’s a place for smaller, emerging managers.”

Managers of any size who underperform over an extended period, or have personnel or organizational issues, can be terminated. Schloss said the the NYC pension plan has been more aggressive in cutting ties with investment shops. Additionally, as of September Schloss’ team was in the final stages of revamping the plan’s Request-for-Proposal process, which was the same for investment managers as it was for procuring pencils and school buses. [EDITOR’S NOTE: In a brief follow-up interview on Oct. 31, Schloss said the RFP revamp was approved the week prior.]

“Hopefully, a more efficient process will be approved by year-end,” Schloss said. “When I got here, the average time was 17 months to hire managers; now in a pilot program we have it down to five months…Under the old process, you had to apply, and if you didn’t apply, we didn’t know you and we couldn’t select you. The new process relies more heavily on each pension fund’s previously retained general consultant to help find the best managers.”

The target allocation for the New York City pension plan is 65% stocks and 35% bonds. The portfolio leaned towards equities and away from bonds and Treasury Inflation-Protected Securities in the year ending in September. “These turned out to be absolutely the right things to do: U.S. equity markets were up 20+%, we were over-allocated, and government securities and TIPS were down about 4.5%, and we were under-allocated,” Schloss said.

“We’re also growing our private-equity portfolio. We committed about $2.8 billion last year, which were some of our biggest commitments,” Schloss said. “As part of the asset allocation, we wanted fewer managers in private equity, and more money with fewer managers.”

In addition to improved investment returns during Schloss’ tenure, the New York City pension fund also reduced its annual target rate of return, from 8% gross to 7% net. With bond yields near historically low rates, lowering a pension plan’s ‘hurdle’ rate to a more realistic level reduces the chance that investment managers will need to reach for additional yield and possibly take undue risk in the process.

“I think 7% net over a long time is eminently achievable,” Schloss said.

Public-Plan Pros
As would be expected for the pension plan of the world’s 8th-largest city, the sheer number of end users can fill up a football stadium several times over. The city employee’s pension plan alone has more than 300,000 active and retired members; the teachers’ plan has 195,000 members; and the police plan has 79,000 members.

“We work for 700,000 public workers,” Schloss said. “When I worked in the private sector, I worked for probably 20 public pension funds, but I was a step removed because they were my clients. Here, I see them all the time. I see faces of teachers, firemen, police chiefs, transit workers. You feel good about managing their pensions.”

Another plus about working for a public pension is the influence that comes with managing a 12-figure pot, from which even a tiny sliver of an allocation can make a manager’s year. “You can talk to anybody,” Schloss said. “You can get the best managers on the phone. You can get the best person at the best manager on the phone.”

“People who work in public-pension funds have great access to investment minds,” Schloss added. “If you’re talking to the best investment minds about the best investment ideas, you should be doing very well.”

In all likelihood, some of those discussions Schloss had since 2010 were about re-thinking the entrenched convention of institutional investing by asset class.

“We have fixed-income managers and equity managers. They might be in the same firm, but inside that firm, there’s really no one marketing to us who says ‘Hey if you give us some capital, we’ll move it around’,” Schloss said. “It’s very hard to be $140 billion and nimble. But that’s really where you make a lot of money around the edges: having capital that goes where the returns are.”

Schloss said rather than categorizing by asset class, a logical approach might be to group assets into ‘buckets’, say growth in one bucket, inflation protection in another bucket, and insurance, or safety, in another bucket. Such a system better gets to the heart of what an investment is all about, he said.

Added Schloss, “people are trying to think about it that way, but still when you go to the other side, to the asset manager, he’s selling you a stock or a bond.”

Lead image credit: Flickr/Stig Nygaard

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