David Villa became the chief investment officer at the State of Wisconsin Investment Board in 2016, and was named executive director and CIO in October 2018. He oversees the state pension's $109.5 billion assets. Prior to this, he was the CIO for the Florida State Board of Administration and worked for UBS Global Asset Management/Brinson Partners as an executive director and client relationship manager. He is recognized around the globe as an innovative and effective leader.
In this interview, he discusses SWIB's strong governance structure and why it's run like an institutional asset management firm; why he is very cautious about investing in China and India; and how SWIB plans on reinvigorating the investment office through the use of technology.
David Villa was named on Trusted Insight’s 2019 Top 30 Public Pension Chief Investment Officers.
Trusted Insight: State of Wisconsin Investment Board is an organization that is often regarded as your ‘best-in-class.’ What is the secret formula or strategy for success there?
David Villa: I don't know that there's a secret formula, but I can describe the parts that are important. I would start by saying SWIB has a strong governance structure and the Wisconsin Retirement System has a robust benefit structure. The board is independent and is empowered to manage the agency like an institutional asset management firm. The law also requires that most of the board members have 10 years of experience in finance and business. The governance structure empowers the staff to implement the investment structure. About 54% of the assets are managed in house. We have an investment team made up of 85 professionals and most of them are CFAs, PhDs, MBAs, and lawyers. It has the look and feel of an institutional asset management organization.
"SWIB is one of two funds that are fully funded in the United States. I believe our funding level is 103%."
The other thing that sets us apart is that the retirement benefit can be decreased if the 5-year rolling return is below 5%. We have a risk-sharing structure in which the beneficiaries take on risk and they have a promise for a base benefit. Their benefit can go up if the performance is good and it can go down if the performance is not good. However, it can only go down to the original base benefit. You can think of it as a participating annuity with a floor and that creates a very deep alignment of interest between the taxpayers, beneficiaries, state government, and the SWIB investment staff. SWIB is one of two funds that are fully funded in the United States. I believe our funding level is 103%.
Trusted Insight: You’re keen on active investment management. Do you believe other pensions can adopt and benefit from this approach?
David Villa: I believe there's a flow of capital out of active management into passive strategies. There's a flow of public equity capital into private equity and private real estate. The flows are large and the tide is basically forcing active managers to sell what they like and the indexes to buy what the active managers do not like. It has been a very hard environment for active management. I think the outlook for active management is actually quite good as a result of this.
"It's easy for other pension plans to adopt an approach that uses active management, provided they don't get anchored in the experience of the past five years."
It's very important for investors to look forward instead of backward to see the opportunity that is provided by active management. Active management had a very difficult time over the last few years, but I don't expect that to be the case over the next five years. It's easy for other pension plans to adopt an approach that uses active management, provided they don't get anchored in the experience of the past five years.
Trusted Insight: Your colleague Chris Eckerman mentioned that private equity will continue to deliver the highest returns of any asset class. Where else do you find opportunities to generate alpha?
David Villa: I think over the long term private equity will have a 2-3% premium over public equity as a result of lower agency costs and better governance. However, today, private equity is more expensive than public equity. I would expect the next vintage year or two to be disappointing. Another problem that we're experiencing today is that the flow of capital into private equity is driving up the supply of capital that is flowing into private debt.
Investors need to be thinking defensively about their commitments that they're going to be making over the next two years. But over the long term, I expect private equity to outperform public equity.
Trusted Insight: What’s your outlook on investing outside of the U.S., in markets like China and India?
David Villa: Well, I'm very cautious about investing in China and India. The challenge is to translate economic growth into earnings growth. There are big issues with corruption and the misallocation of resources. Chinese firms systematically erode quality to protect their margins and the country is willing to use force against its population. It's militarizing rocks in the South China sea. It's creating the string of pearls or Naval bases in the ocean. China prevents U.S. regulators from inspecting the audits for Chinese companies listed in the U.S. Pollution is a big problem in both countries. This will create a drag on valuations. I prefer to invest in China and India through private equity because the agency costs are lower and you get better governance.
Trusted Insight: How do you keep institutional knowledge and build upon that institutional knowledge? At the end of the day, are people your biggest resource?
David Villa: We try very hard to create an environment where people enjoy coming to work. I think people tend to stay if they like who they work for. They tend to stay if they feel they're being treated fairly. They tend to stay if they feel that their work translates directly into investment performance and people like to be compensated for their contribution. We have a culture that does not tolerate bad apples because we believe one bad apple will spoil the barrel.
Trusted Insight: You’re recognized as an innovative and effective leader. What is your approach/strategy in preparing for a low-return environment and market downturn?
We believe that a low-cost indexed public market asset allocation will return 5%, which is too low. If we have a meaningful allocation to private real estate, private equity and private debt we can get that return from 5% to 6%, which is still too low. In the past, we've targeted an active return of 48 basis points. If you add 48 basis points to six, you're just under 6.5%, which is still too low. We're targeting an active return of 80 basis points instead of 48 basis points, and now our expectations get up to 6.8%, which is very close to our target of 7%. One of the ways that we're increasing our active return is we are using what I call portable alpha 3.1.
"For the last five years, we've been in the process of transforming the back-office technology, data, and infrastructure. We're at the very early stages of looking for ways to use Robotic Process Automation (RPA)."
We took the old portable alpha strategy from the 1990s and we stripped out the market beta because we didn't want to pay 2 and 20 on naive market beta. We can create that essentially for free and we think we'll get 5% on the passive beta. Then on top of the 5% market beta that we create for free, we overlay a portfolio of hedge funds that has no market beta and we try to earn 2.5-3.5% above LIBOR. That gives us 7.5-8.5%, which is above our target. We add that on top of the policy portfolio and we have other active strategies. We hope over the next five years that we'll be able to get 6.8%.
It's still a very hard environment. Earlier I mentioned that our discount rate is 5%, so we're in a much better position relative to other pension plans who have a discount rate that's somewhere between 7-7.5%.
Trusted Insight: Has your investment office implemented machine learning or other technology that supports the investment process?
David Villa: Back in 2005, the board adopted a policy to modernize and reinvigorate the investment organization. For the last 12 years, we've been modernizing, reinvigorating and focusing a lot on that. In 2014, we realized that the front office was running far ahead of the infrastructure. For the last five years, we've been in the process of transforming the back-office technology, data, and infrastructure. We're at the very early stages of looking for ways to use Robotic Process Automation (RPA).
We onboarded a chief technology and operations officer who's spent some time at D.E. Shaw and other large asset management organizations. She's looking into these new technologies from a back-office standpoint, and we're looking at it in the front office. The story for us is less about AI and more about having an infrastructure that allows us to invest in between the cracks.
For example, we might go short a call on a stock and we might go long on the longer-dated call on the same stock. We might hedge the position by owning a high yield bond on that company. We have a trade and a strategy that is multi-asset and the traditional infrastructures can't deal with that in terms of accounting for that trade as a collection of positions.
In the last century, we'd have long-only equities and long-only bonds. Today, we're investing in between the cracks and we're long and short. The infrastructure that is needed is more complicated and the complexity is not linear. The complexity grows exponentially. There's a tremendous premium put on having an infrastructure that can cope with investing in the 21st century.
Trusted Insight: Some investors believe that the LP community could do a better job of sticking together and collaborating rather than competing. Do you find this to be a challenge that should be improved?
David Villa: Not really. I don't feel strongly about the LP community sticking together. On the one hand, I would worry about collusion and price-fixing. The important opportunity is for boards and trustees to pay up for high-quality professional investment talent to do a better job of identifying and backing best-in-class GPs, that can negotiate documents from a position of deep knowledge and understanding of the nuances of the documents.
A competent staff of professional investors can drive the negotiation of terms to be fair. If they can't do that, they should simply walk away. They should not engage in a wrestling match or arm wrestling to get low fees. There's no reason to force capital into bad deals when the staff is highly skilled and competent. Rather than placing the focus on LPs doing a better job of sticking together, I think institutional investors should invest in assembling the highest quality team of talent to select and choose the GPs that they're going to commit to.
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