INPERS CIO Scott Davis: Key To Making An Alternative-Intensive Pension Portfolio Work | Exclusive Q&A
Scott Davis is the chief investment officer of the Indiana Public Retirement System (INPRS), a pension fund with approximately $30.7 billion in assets under management, as of September 2016. He was appointed interim chief investment from September 2015 and officially assumed the role in June 2016. Previously he was the deputy chief investment officer and the director of public equity within the pension. Davis received a B.S. with honors in accounting and finance from the Kelley School of Business at Indiana University.
Mr. Davis was recently named on Trusted Insight’s Top 30 Public Pension Chief Investment Officers. He graciously spoke with us on November 22, 2016.
Trusted Insight: Can you tell me about the history of the INPRS? How has the investment portfolio changed over time?
Scott Davis: In 2011, the Public Employees' Retirement Fund and the Teachers' Retirement Fund merged into INPRS. That was the big turning point because we reevaluated what the imperatives and the objectives were for the portfolio. At that time, with a clean sheet of paper, we went back to the basics of what we were trying to do. The two things we were trying to accomplish were to hit the return target of 6.75 percent and to limit the employer contributions to the plan. With that focus in mind, there was a shift in investment portfolio to where we focus more in allocating risk instead of just dollars.
Prior to that, our portfolio was concentrated in equity exposure. Anytime you have a portfolio just concentrated in one asset class, you're susceptible to a drawdown if you're in an economic environment that doesn't work out well for that asset class. Realizing that might cause increases in employer contributions if we had one of those drawdowns, we thought a better way to go about it for us was to have a more diversified portfolio. Since then, we have tried to add more government bonds, inflation-linked bonds and commodities. All these different asset classes provide diversification from equity exposure.
Trusted Insight: What does your current portfolio structure look like?
Scott Davis: As of June 30, 2016, INPRS allocated 22.3 percent in public equity, 13.3 percent in private equity, 21.1 percent in ex-inflation linked fixed income, 7.4 percent in inflation-linked fixed income, 7.4 percent in commodities, 6.6 percent in real estate, 9.2 percent in absolute return and 11 percent in risk parity. Risk parity is an asset allocation strategy that provides more diversification than a traditional 60 percent stock/40 percent bond portfolio. These are all targets of the asset allocation approved by our board.
Trusted Insight: Ten percent allocation in absolute return seems aggressive for pension investors. Can you talk about your strategy within alternative assets?
Scott Davis: For us, alternative asset is anything that's not equities, bonds and credit commodities. Then we have private equity, private credit, real estate and absolute return. Generally, they fall into two buckets: one is strategies that are trying to outperform public markets or exposure that we can get in public markets; the other is strategies that provide diversification to those traditional markets. I think the latter is where absolute return or hedge funds would fall in for us. We are trying to find different return streams that we can't find anywhere else in the market, managers that play in multiple asset classes, and the big thing is no or little correlation to equities, credit commodities, etc.
It is a difficult endeavor to find those strategies. That's why we do ongoing sourcing of new ideas. We haven't yet filled up that ten percent target allocation in hedge funds, but we feel great about the managers that we have in the portfolio.
Trusted Insight: For the alternative asset strategies to be successful, you need to get access to the best managers. What criteria do you rely on when selecting external managers?
Scott Davis: Yes, and I think this is across the board, not just in alternatives, but also the public asset classes where we have active managers.
The first key thing is: does the manager have a competitive advantage? Then, if they do have that advantage, the second criterion would be: do they have a repeatable process, so they can continue to execute on that through time?
The third thing is, before we sign up with a manager: Do we have an alignment of interests where that manager wins only when our members win? Then, the final thing, which is a more recent change with our focus on risk management, is to understand what could go wrong. We always ask ourselves that with any manager or strategy to make sure we understand those risks as well as the upside potential.
Trusted Insight: Recently there has been a lot of mention in the media about the high management fees with hedge fund and private equity managers. Is that something bothering you?
Scott Davis: For every strategy, we are looking to negotiate fees to an appropriate level, and the level that, net of those fees, we can earn a return that's adequate to hit the 6.75 percent return overall. That's a focus across the board. We even have an analyst on our team dedicated to fee management.
Trusted Insight: How much fee reduction have you achieved with this effort?
Scott Davis: As I think about between private equity, real estate and absolute return. It varies strategy by strategy. Within private equity, a way to reduce fees is investing alongside general partners with different funds and investments. Within the last few years, we really built out that program with several managers.
Trusted Insight: Can you tell me about your current investment team? Are they more specialized people or generalists?
Scott Davis: I would categorize them more as generalists. In total, we have an investment staff of 15 people. We have a director overseeing real assets, one for private equity, one public equity, and so on. They all report to me. At the same time, we are trying to kind of breakdown the silos and increase collaboration across the team. We're sharing the best ideas and trying to reach the goal of building the best asset allocation possible.
Trusted Insight: That sounds like a pretty big investment office. How do you go about managing a team of this size?
Scott Davis: The key is giving those directors a lot of discretion and leeway to help mentor and manage those analysts that work with them. The reason we have a little more depth than most peer organizations is to make sure we have those succession plans in place. In case a director moves on or into a different role, we have that pipeline ready to go and people are ready to step into those director roles.
Trusted Insight: What trends in public pension investing have you identified during your career?
Scott Davis: I think the biggest change is that target rate returns start to come down, given the low yield or low interest rate environment. Everyone in the investment space, specifically public pensions, are under pressure to achieve these target rates return and find different strategies that I believe will achieve those. We're no different. We're trying to do that in a variety of ways across the portfolio.
Trusted Insight: Besides the low interest rate environment, what are other challenges public pensions are facing in today's market and the near-term future?
Scott Davis: I'm just thinking more about our specific objectives here. Like I said before, the big focus is to reduce the equity concentration. How do we get more diversified? How do we find those diversifying return streams? Whether it's absolute return or in risk parity or commodities and so on.
Trusted Insight: If you were to give career advice to young people who look to enter institutional investing or public pension in particular, what would it be?
Scott Davis: There are a few things that came to mind. I think the number one thing was to read as much as possible and become a student of history. I think recency bias is a very difficult thing to overcome in investments, in particular.
But if you're able to learn what's driven markets through time and even in different countries. That's a good place to start and not just focus on what's happened in the most recent past and forecast that going forward.
Another thing that I would recommend is to start a program like the CFA or CAIA program because I think that will help them figure out how interested they are in investments in the longer term. Those are painful programs to go through, and you have to dedicate a ton of time to studying for those. If you're willing to go through that process and you still enjoy investments on the other end, I think that's a good sign that you're probably on a good path for your career.
Trusted Insight: As you mentioned reading, are there any books or publications you would recommend the most?
Scott Davis: Yes, the number one recommendation that I have for any new analyst coming in for us is The Most Important Thing by Howard Marks. I think that it's probably one of the best books I've read on risk management.
To learn more about pension investing, click here to view the complete list of 2016 Top Public Pension Chief Investment Officers.