Diversifying Asset Category Investment Policy Statement

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Contents

A. DIVERSIFYING ASSET CATEGORY INVESTMENT OBJECTIVE
B. BENCHMARKS
C. INVESTMENT GUIDELINES
1. Investment Descriptions
2. Risk and Diversification
3. Investment Vehicles
4. Co-Investments
5. Investment Vehicle Concentration
6. Liquidity
7. Distributed Securities
8. Performance Evaluation
9. Investment Period to Ramp-Up
10. Rebalancing to Guidelines
D. MONITORING
E. POLICY HISTORY

A. DIVERSIFYING ASSET CATEGORY INVESTMENT OBJECTIVE

The Diversifying asset category seeks to achieve the following investment objectives:

  • Help preserve capital in periods of market distress, particularly in periods of low and falling growth
  • Enhance diversification by exhibiting low or negative correlation with both equity and credit markets
  • Maintain a positive return profile over time

Asset classes within the Diversifying asset category include:

  • Fixed Income
    • Core Plus Fixed Income
    • U.S. Treasury
  • Absolute Return

Asset class target weights within the Diversifying asset category are as follows:

Asset Class Minimum Target Allocation Maximum
Fixed Income 12% 16%

20%
Absolute Return 5% 7%

9%
Cash 0% 1% 2%
Diversifying Asset Category   24%  

Fixed Income

The Fixed Income portfolio seeks to achieve multiple investment objectives as outlined below:

  • Moderate income and cash flow generation
  • Diversification for SCERS’ portfolio, and in particular, as an “anchor to safety” in periods such as a recession, when growth/risk assets fall
  • A source of return enhancement
  • Liquidity

The Fixed Income portfolio is unique because accomplishing the investment objectives will not be based on one singular investment strategy or underlying asset, but rather by virtue of the construction of the Fixed Income portfolio and the sum of its components. As an example, credit investments achieve some of the objectives such as moderate income generation and a source of return enhancement but may detract from objectives of diversification and liquidity. U.S Treasuries on the other hand, lack return enhancement; however, they provide meaningfully toward the objectives of diversification and liquidity for SCERS’ overall portfolio.

Absolute Return

The investment objective of the Absolute Return portfolio is to emphasize a lower sensitivity to broad market performance (i.e., less correlated returns), while still generating a positive absolute return profile over time. Absolute return strategies within the Diversifying asset category tend to have less long-biased equity and credit exposures, with lower standard deviations, lower equity and credit beta, and lower correlations than more growth oriented absolute return strategies.

Cash

SCERS maintains a dedicated 1% cash allocation that is part of the strategic asset allocation. The dedicated cash allocation serves as an additional liquidity tool, to help ensure liquidity is available to meet SCERS’ pension obligations, particularly in a stressed market environment. SCERS, like many public pension plans, is a mature plan with negative cash flows, meaning member benefit payments going out are greater than employer and employee contributions coming in on an annual basis. The dedicated cash allocation assists in closing the gap between annual benefit payments and contributions in an environment where investment earnings fall short of the assumed rate of return.

SCERS also has additional cash within the portfolio that is separate from the dedicated cash allocation. The ‘other’ cash is not part of the strategic asset allocation and is comprised mostly of the pre-funded annual employer contribution that funds monthly benefit payments, capital used to fund private market capital calls, investment management fees, and other plan expenses. SCERS’ Overlay Program eliminates cash drag by investing the ‘other’ portfolio cash into positions that replicates SCERS’ target portfolio. In contrast, SCERS’ dedicated cash allocation is not invested by the Overlay Program.

B. BENCHMARKS

The Diversifying asset category total performance is evaluated by applying the investment performance of the individual asset class benchmarks weighted by the strategic asset allocation targets weights. The Diversifying asset class benchmarks are as follows:

Fixed Income

Performance of the Fixed Income portfolio is expected to exceed the weighted average return of the benchmarks for the underlying Fixed Income sub-asset classes as outlined below:

Public Fixed Income Segments Benchmark Weighting (relative to total Fixed Income)
Core Plus Fixed Income Bloomberg Barclays Aggregate Bond Index

75%
U.S. Treasury Bloomberg Barclays US Treasury Index 25%

Performance of each segment within the Fixed Income Portfolio will be benchmarked as follows:

  • Performance of the Core Plus Fixed Income investment strategies are expected to exceed the Bloomberg Barclays Aggregate Bond Index.
  • Performance of the U.S. Treasury segment is expected to perform in line with the Bloomberg Barclays United States Treasury Index.

Absolute Return

SCERS Absolute Return Portfolio Benchmark Time Period
Policy Index Benchmark HFRI FoF Conservative Index, net of fees and expenses 3 to 5 Years
Long-Term Objective 90-day T-Bills + 2%, net of fees and expenses > 5 Years

Over the medium-term (3-5 years), performance of the Absolute Return portfolio is expected to exceed the HFRI FoF Conservative Index, net of fees and expenses. The HFRI FoF Conservative Index will also serve as SCERS’ Policy Index.

Over the long-term (greater than 5 years), the objective of the Absolute Return portfolio is to exceed the 90-day T-Bills plus 2%, net of fees and expenses.

Cash

Asset Class Benchmark
Cash Overnight LIBOR/SOFR

Performance of the dedicated cash allocation is benchmarked against the overnight London Interbank Offered Rate (LIBOR), which is the benchmark that establishes overnight borrowing costs for banks.

  • LIBOR is being phased out in mid-2023, replaced by the Secured Overnight Financing Rate (SOFR), which is the benchmark interest rate for dollar-denominated derivatives and loans.

C. INVESTMENT GUIDELINES

1. Investment Descriptions:

Fixed Income

Investments within the Fixed Income portfolio is authorized in a broad array of sub-asset classes and strategies including, but not limited to the following:

  • Cash and cash equivalents
  • Treasuries
  • Agencies
  • Agency and Non-Agency Mortgage-Backed Securities
  • CMBS
  • Asset-Backed Securities
  • CLO’s and CDO’s
  • TIPS or other inflation-linked securities
  • Investment Grade Debt
  • Municipal securities
  • High Yield Debt
  • Bank Loans
  • 144A and Reg S securities
  • IO’s and PO’s
  • Hybrid and Capital securities such as preferred equity and trust preferreds
  • International / non-dollar fixed income securities
  • Emerging Markets Debt
  • Foreign exchange

The key segments of the Fixed Income portfolio are described below:

Core Plus Fixed Income

Core plus bond strategies allow for greater flexibility including: (1) ability to invest in a broader set of exposures across ‘plus’ segments that are higher yielding and diversifying bond sectors such as high yield, bank loans, non-agency MBS/structured credit, and non-U.S. securities; (2) ability to increase/decrease exposures between ‘core’ and ‘plus’ bond segments in order to increase/decrease exposure to sources of yield or safety, as well as; (3) focus on managing interest rate risk with greater flexibility to adjust duration. Since the security holdings and risk characteristics tend to have deviations with the benchmark (Bloomberg Barclays Aggregate Bond Index) within set limits, core plus bond strategies help to provide some diversification to equities and fulfill the roles of an “anchor to safety” and liquidity, while attempting to balance more capability to generate moderate income. The addition of the ‘plus’ sectors provide for greater diversification across sources of yield but may detract from the strategy’s ability to be a diversifier to equities as the ‘plus’ sectors are more correlated to equities and the business cycle.

U.S. Treasury

U.S Treasuries are considered “anchor to safety” assets, and one of the most diversifying components of a portfolio, often generating positive returns when equity returns are negative. Historically when equity assets have been down significantly, investors have tended to gravitate toward safe haven assets such as government bonds, and particularly U.S. Treasuries. Another advantage of having Treasury exposure is that it is one of the most liquid segments of the markets, providing a source of liquidity for SCERS’ overall portfolio. U.S. Treasuries will tend to underperform in a rising interest rate environment.

Absolute Return

SCERS’ Absolute Return asset class has a target allocation of 7%. Absolute return strategies tend to emphasize a lower sensitivity to broad market performance, particularly equity markets (i.e., less correlated returns), while still generating a positive absolute return profile over time. Absolute return strategies also tend to have less long-biased equity and credit exposures, and lower standard deviations and correlations than more growth oriented absolute return strategies.

SCERS’ alternative assets consultant breaks the absolute return universe into the following investment strategies. A well-diversified absolute return portfolio will contain allocations to each of these strategies at varying target weights.

  • Equity Long/Short – Strategies where there is a combination of long and short positions primarily in publicly traded equities, with a net market exposure less than that of the overall equity market. Strategies may be focused on U.S., non-U.S., and/or specialty mandates.
  • Event Driven – Strategies such as activist equity, risk arbitrage, merger arbitrage, distressed debt, credit, and other event-driven strategies.
  • Credit/Distressed – Strategies that typically utilize fundamental credit analysis to invest in below investment grade, stressed, or distressed corporate and asset-backed credit. Managers may take long and short positions in mispriced debt instruments and may become actively involved in a restructuring process.
  • Market Neutral – Strategies such as equity market neutral, fixed income arbitrage, and convertible bond arbitrage.
  • Global Macro – Strategies such as all market portfolios, opportunistic long-only, managed futures, currency, dedicated short selling strategies, or other specialty strategies.
  • Multi-Strategy – Strategies where absolute return funds invest using a combination of previously described strategies.

Examples of the more diversifying and uncorrelated absolute return strategies that typically reside within SCERS’ Absolute Return portfolio include market neutral, global macro, and multi-strategy strategies, but can also include the other strategies such as equity long/short, event driven, and credit/distressed strategies.

However, in practice SCERS will categorize individual strategies based upon each fund’s expected characteristics, including risk, market sensitivity and market exposure, not by a fund’s stated strategy, so each absolute return segment could include a variety of fund strategies.

Cash

The Cash allocation can be invested in a variety of investment vehicles, including, but not limited to the following:

  • Investment instruments that offer a risk-free rate of return.
    • Short duration government bonds (i.e., 90-day Treasury Bills).
    • Demand deposit account (DDA) that pegs itself to overnight LIBOR rates (LIBOR is transitioning to SOFR in mid-2023).
  • Cash management funds.
    • Have the potential to generate marginally higher yields than the risk-free rate, but also contain exposure to market risks including duration, interest rate, and credit risk.

2. Risk and Diversification: Diversification by investment strategy and geography, including target allocation and ranges.

The construction of the Diversifying asset category is important because a well-developed portfolio can add diversification to the overall SCERS investment portfolio, which is heavily weighted to assets that have higher return and volatility expectations within the Growth asset category. Distinguishing characteristics of the Diversifying asset category are: (1) a wide range of investment strategies across several underlying segments, mostly within the publicly traded markets; and (2) exposure to diversifying absolute return investment strategies with higher levels of leverage in the form of total notional gross exposure.

The targeted and range of investment exposures within the various asset classes are shown below. It is also anticipated that SCERS will seek diversification with respect to investment strategies within the asset classes where warranted.

Fixed Income

The Fixed Income portfolio is constructed in a way to achieve multiple objectives, with each allocation helping to fulfill the different roles and objectives including: (1) moderate income generation; (2) diversifier to growth assets; (3) a source of return enhancement; and (4) liquidity. Allocations across the strategies are also designed to provide sufficient diversification by sources of yield, by bond segment, and by geographic region. Accordingly, the asset allocation within the Fixed Income portfolio is targeted to be significantly diversified across fixed income bond strategies as outlined below:

SCERS Fixed Income Portfolio Construction
Asset Class Minimum Target Allocation Maximum
Total Fixed Income 12% 16% 20%
Core Plus Fixed Income 9% 12% 15%
U.S. Treasury 3% 4% 5%

Absolute Return

Absolute return funds represent a distinctive investment style that is different from traditional, long-only funds. A fundamental difference is that absolute return fund managers emphasize absolute, rather than relative returns, and they may also use a wider range of investment techniques, such as leverage, short selling, and derivatives to achieve their objectives. This greater level of investing flexibility results in a wide range of strategies that produce different risk and return characteristics between the strategies and provides the opportunity to diversify risk.

SCERS shall strive to invest in a sufficient number of managers and set constraints on the size of each absolute return manager compared to the Absolute Return portfolio and the total portfolio. This will provide some protection and spread the unique risks of absolute return funds across a larger base. These risks include operational risk, headline risk, event risk, liquidity risk, counterparty risk, leverage risk, and reduced transparency.

Accordingly, investing in a large number of funds and strategies across the aggregate Absolute Return asset class can assist in achieving the Absolute Return portfolio’s objective of emphasizing a lower sensitivity to broad market performance (i.e., less correlated returns), while still generating a positive absolute return profile over time. For the Absolute Return portfolio, the target number and range of funds, and targeted geographic ranges are shown in the table below.

  Diversifying Strategies
Portfolio Objective Positive absolute return profile over time with limited sensitivity to broad market performance

Target Allocation

 7% of total assets
Allocation Range 5% to 9% of total assets
Number of Funds Target 12 funds with a range of 8 to 15
Non-U.S. Exposure Expect 20% to 50% non-U.S. exposure

Within these guidelines, Staff and consultant will allocate funds within each investment style in a manner that, in their judgment, enhances SCERS’ ability to achieve the investment objectives of the Absolute Return portfolio over the long term. In the event exposure to an absolute return style becomes overly concentrated, Staff is authorized to rebalance assets in a manner consistent with the implementation protocol for Absolute Return as described within SCERS’ Master Investment Policy Statement.

Diversification by selection of individual funds: SCERS will strive to select individual absolute return funds based on their ability to diversify SCERS’ total fund:

  • Low correlation to equities
  • Uncorrelated alpha sources
  • Low beta compared to equities
  • Low kurtosis in the return distribution (smaller extreme returns both positive and negative).
     Positive skew in the return distribution (larger and more frequent occurrences of positive returns versus negative)
  • Ability to be up or exhibit significantly less downside in declining equity markets
  • Capability to manage tail risk

Diversification across geographies, business sectors, and asset classes: It is expected that absolute return managers will actively, and oftentimes quickly, change the composition of portfolios to take advantage of opportunities in the markets. Accordingly, it will be important to actively monitor and understand the dynamic absolute return environment relative to more general objectives, making portfolio changes when necessary, rather than reacting to rigid guidelines. This should allow SCERS to capture the benefits of allowing absolute return managers to execute their strategies without compromising the objectives of SCERS’ aggregate fund or total portfolio. These general objectives include:

  • Geographic diversification in non-U.S. regions
  • Diversification across sectors and industries
  • Diversification across asset classes

Minimum size of absolute return managers: Requirements for absolute return funds to register with the SEC and provide greater shareholder transparency and reporting have increased, along with operating costs, benefitting larger funds with the in-house capabilities to manage these issues. However, small and mid-sized funds can often perform better, particularly during the phase when the absolute return partners are more focused on generating returns to build initial wealth. To balance these considerations, SCERS will invest in absolute return funds with minimum assets under management greater than $250 million.

Absolute Return Risk Considerations:

There are several risk considerations specific to the Diversifying Absolute Return portfolio:

  Diversifying Strategies
Portfolio Objective

Positive absolute return profile over time with limited sensitivity to broad market performance
Risk Target Standard Deviation < 25% of global equities
Market Sensitivity Target an equity beta < 0.2 
Target equity correlation < 0.5
Market Exposure Total notional gross exposure < 750%
  • Absolute Return Risk Targets: Absolute return portfolio risk is often measured by standard deviation. The target standard deviation for Absolute Return is less than 25% of the MSCI ACWI Index.
  • Market Sensitivity: Common measures for market sensitivity for an absolute return portfolio are beta and correlation. The equity beta target for the Absolute Return portfolio is < 0.2, and the equity correlation target is < 0.5.
  • Market Exposure/Leverage: Within absolute return, leverage may be utilized by underlying absolute return managers as part of their strategies, but it will not be employed at the total portfolio level.

Leverage at the total Absolute Return portfolio level is the aggregated amount from SCERS’ underlying managers and will be defined as the total notional gross exposure, which is equal to the sum of gross long notional exposure plus gross short notional exposure, expressed as a percentage of total invested capital. Total leverage for the Absolute Return portfolio will not exceed 750%.

In addition, leverage utilization will be monitored within each individual hedge fund and investment manager to ensure appropriateness given the respective strategy.

3. Investment Vehicles: The vehicles for investments within the Diversifying asset category reflect the broad scope of investments.

Fixed Income

Investment vehicle options for investing in the Fixed Income portfolio include separate accounts, in which assets are custodied at SCERS’ custodian, and/or commingled funds, including limited partnerships, limited liability companies, offshore corporations and mutual funds. Determinants as to whether SCERS will invest in a separate account versus a commingled fund include availability of a separate account option, complexity of the underlying assets, whether individual country markets require opening (i.e., emerging markets investing via a separate account), fee levels, and transparency.

Absolute Return

Investment vehicles for absolute return investments are typically separate accounts and/or a variety of commingled vehicles, such as limited partnerships, limited liability companies, or offshore corporations.

SCERS may also invest directly in fund-of-funds (FoF) vehicles. In these vehicles, the FoF invests in absolute return partnerships on a discretionary basis. FoFs will own the underlying absolute return partnerships and SCERS obtains contractual rights to the FoFs’ portfolio through a limited partnership. A FoF will have investors other than SCERS.

SCERS may also invest in separate account relationships or fund of one structure established with one or more fiduciary oversight managers. These managers will make commitments to absolute return limited partnerships, or other entities such as limited liability companies or offshore corporations, either on a discretionary or advisory basis.

4. Co-Investments

A co-investment is a direct investment in an underlying portfolio company where a manager offers investors the opportunity to invest directly in an underlying company alongside the fund investment. Investments may be made in companies that are either U.S. or non-U.S. domiciled. Co-investments are considered separate investment strategies within the Diversifying Asset Category.

For example, a co-investment could be in any of the asset classes but are typically most prevalent within the absolute return strategies. Therefore, co-investments will be categorized according to the underlying strategy and geography and will conform to the guidelines outlined in the above section on risk and diversification. SCERS will seek to allocate toco-investments on an opportunistic basis. It is expected that these investments will constitute a small portion of the overall Diversifying asset category, and any underlying asset class, if any. Any co-investments will be implemented according to the implementation protocols of the asset class in which it resides.

5. Investment Vehicle Concentration

Fixed Income

SCERS shall typically not comprise more than 20% of an investment strategy’s assets under management at the initiation of the investment. Post-investment, SCERS shall monitor the investment strategy asset base, and SCERS’ concentration relative to the asset base. An exception to this guideline is an investment in a separate account, whereby SCERS may be the sole investor. In these circumstances, SCERS will endeavor to ensure that it does not generate a majority of the firm’s overall profits.

Absolute Return

SCERS shall not comprise more than 20% of any one investment vehicle at the initiation of the investment that is a limited partnership, limited liability company, or offshore corporation. The exception to this guideline is an investment in a FoF or a separate account, whereby SCERS may be the sole investor. In these circumstances, SCERS will make reasonable efforts to ensure that it does not generate a majority of the firm’s profits.

6. Liquidity: Overall, the Diversifying asset category will maintain varying levels of liquidity based on the underlying sub-asset classes.

Fixed Income

Investments in fixed income offers varying degrees of liquidity depending on region and bond sector, however, liquidity is generally high relative to other asset classes. Treasuries and core bond segments tend to offer the greatest liquidity, while credit-oriented investments and emerging market debt tend to offer less liquidity.

Among investment vehicles, investing through separate accounts typically offer the highest liquidity, as the underlying assets are owned by SCERS, and are held at SCERS’ custodian. While the underlying assets of commingled funds offer high liquidity, there is the potential for less immediate liquidity when redeeming assets from a commingled fund. This liquidity can vary from immediate to monthly liquidity, depending on the structure of the fund.

Absolute Return

Individual absolute return fund investments may have specified liquidity parameters defining lock-up periods and withdrawal frequency. Liquidity risk is managed by monitoring and maintaining a schedule of the liquidity of the individual absolute return funds and aggregating it at the total Absolute Return asset class level.

SCERS may want to take advantage of fee discounts that may be available for funds offering a longer lock-up period or a different share class under certain circumstances and dependent on the underlying characteristics of the absolute return fund. In addition, SCERS may want to invest with absolute return funds that possess strategies where a longer investment horizon is necessary and appropriately matches the illiquidity of the underlying assets invested. While SCERS may want to take advantage of investing in these opportunities, it is not appropriate for the Absolute Return program to consist entirely of illiquid vehicles. Accordingly, guidelines are outlined below to both capture the opportunity set and balance the need for liquidity.

SCERS may invest in absolute return funds that permit voluntary redemptions (Evergreen Portfolio Funds) and absolute return funds that do not permit voluntary redemptions (Self-Liquidating Portfolio Funds).

SCERS shall allocate a minimum of 50% of its capital (at market) to Evergreen Portfolio Funds with quarterly or more frequent liquidity (after applicable “lock ups” expire)

SCERS may not allocate more than 15% of its capital (at cost) to Self-Liquidating Portfolio Funds.

With regard to the capital allocated to Evergreen Portfolio Funds, SCERS may not allocate more than 25% of its Absolute Return capital (collectively, at market) to Evergreen Portfolio Funds that impose a “lock up” (determined either based on the date SCERS first invests in such Evergreen Portfolio Fund or with respect to each investment in such Evergreen Portfolio Fund by SCERS on an investment-by-investment basis, as applicable, and not from the time of any capital commitment to an Evergreen Portfolio Fund) of greater than or equal to 2 years. SCERS may not allocate to Evergreen Portfolio Funds that impose a “lock up” of greater than or equal to 3 years without the consent of SCERS’ Board.

In order to facilitate liquidity, SCERS should reasonably limit a portfolio absolute return funds’ ability to use side pockets. Side pocket investments should not exceed 10% of SCERS’ total Absolute Return portfolio at fair market value.

Cash

Cash offers the highest liquidity of any asset within the SCERS portfolio and should typically be available daily.

7. Distributed Securities

Within the Fixed Income asset class, SCERS shall typically seek receipt of distributed securities from investment managers. For separate accounts, assets are custodied at SCERS’ custodian, which SCERS can liquidate at its own discretion. For commingled funds, SCERS generally prefers to receive distributed securities, which it can liquidate at its own discretion. The exception is for those funds that require that shares be redeemed from the fund, or if it is more prudent to have a fund redeem shares.

SCERS shall avoid the direct receipt of distributed securities from individual absolute return funds. However, if such receipt is unavoidable, SCERS shall ordinarily direct the sale of securities distributed by its investment vehicles through a third-party broker dealer as soon as practically possible and strive to not impair the value of the security.

8. Performance Evaluation

  • Performance of the Diversifying asset category will be evaluated quarterly against the weighted average of the policy index benchmarks outlined in the ‘Benchmarks’ section above.
  • Individual investment vehicle performance will be evaluated on a monthly and quarterly basis for Fixed Income and Absolute Return.

9. Investment Period to Ramp-Up

It is recognized that it can take multiple years for segments of the Diversifying asset category to be fully invested, and that there may be deviations from the previously mentioned targets during the ramp-up period. During the ramp-up period for the Diversifying asset category, and subsequent to reaching the target allocation, SCERS’ Overlay Program will re-balance the Diversifying asset category to the target allocation, using the designated Diversifying overlay proxy within the investment guidelines for the Overlay Program.

10. Rebalancing to Guidelines

It is anticipated that the majority of changes to rebalance the Diversifying asset category will be made on a long-term basis. SCERS utilizes an Overlay Program, managed by a strategic overlay manager, to equitize cash and to rebalance asset categories within SCERS’ total portfolio, including the Diversifying asset category. Rebalancing occurs quarterly, unless upper or lower bands are breached intra-quarter, in which case rebalancing occurs upon the breach of a band.

D. Monitoring

Through the monitoring process, Staff and consultant will extend the initial due diligence into a formal quarterly, semi-annual, and annual process which regularly seeks to determine whether the manager is meeting the Diversifying asset category’s, and its underlying asset classes, investment objectives and other requirements.

In the broadest sense, the monitoring process is intended to determine whether the initial reasons for selecting the strategy and investment vehicle remain valid. The monitoring process will disclose whether there has been any material deviation from the investment philosophy and process; the personnel responsible for managing the investment vehicle are still in place; the organization continues to be stable; performance and risk meet expectations; and the investment vehicle manager adheres to its investment and other requirements.

The underlying principle of the monitoring program is to determine whether all risks to which SCERS is exposed through the use of outside investment advisors have been identified, understood, and, to the extent possible, controlled. The monitoring process focuses on four areas:

  • Compliance with reporting and valuation requirements
  • Continuity of investment philosophy and process
  • Stability of personnel and organization; and
  • Performance and risk management

Staff and consultant will aggregate investment vehicle data and perform analysis on the overall Diversifying asset category, and its underlying asset classes, paying careful attention to individual investment vehicle allocations and strategy/sector concentrations to strive to achieve proper diversification across the Diversifying asset category. Staff and consultant will also conduct ongoing portfolio reviews and due diligence with the respective investment vehicle managers. Reviews can take place in person, either at SCERS’ or the consultant’s office, or the investment manager’s office, or through a web conferencing platform (i.e., Zoom). Investment manager site visits will be performed to confirm that appropriate infrastructure is in place to support the investment process. Staff and consultant will provide the Board with regular performance reports and advise the Board of other matters as appropriate.

If, during the monitoring process, SCERS identifies areas of the Diversifying asset category that are not compliant with the objectives, guidelines, and constraints, identified in this investment policy statement, then reasonable efforts will be made to cure the deficiency. These reasonable efforts will consider the illiquidity of the asset class and transaction costs to be incurred compared to the risk of non-compliance.

Absolute Return Monitoring

Monitoring risks specific to absolute return funds: Investing in absolute return funds brings additional risks, which will be managed and mitigated through a combination of factors including: (1) the asset allocation and guidelines set forth above (diversification across managers and strategies); (2) due diligence of Staff and consultant on individual funds; and, (3) ongoing monitoring and active investment management by Staff and consultant. This includes:

  • Addressing transparency risk, or the reluctance of absolute return managers to report individual positions, particularly short positions. While absolute return funds may limit transparency at the position level, SCERS’ consultant will hold conference calls to review individual absolute return portfolios on a monthly basis. In addition, both the consultant and Staff will be measuring and monitoring exposures in aggregate, e.g. at the level of investment strategy, regions, industries, countries, and portfolio. Leverage, net exposures, and counterparty risk are all monitored at the fund level and portfolio in aggregate.
  • Addressing counterparty risk, specifically related to the counterparty/entity, including prime broker, that an absolute return manager selects to hold assets or execute investment transactions, and the risk that the absolute return manager will not be paid or able to reclaim assets held by the selected counterparty. Counterparty risk will be assessed in the due diligence and monitoring process by measuring and quantifying the level of exposures inherent in the absolute return investment strategy and operations, and evaluating the measures, processes and other risk controls of each absolute return fund by comparing funds to a set of industry best practices. As part of the assessment, it is important that SCERS understands where the absolute return manager’s assets are held, understands the types of investment transactions being made and securities held by the absolute return manager, evaluates the measures being taken by the absolute return manager to mitigate and manage the risk exposure relative to the best practices of the investment industry, and have a monitoring process that will assure that the risk exposure continues to be within an acceptable range and that the absolute return manager is continuing to execute its risk mitigation and management program properly.
    As part of the due diligence process for potential absolute return funds, Staff will provide a due diligence questionnaire (DDQ) to any absolute return manager that SCERS is considering for investment. The DDQ has a range of legal, business, and regulatory questions; however, for absolute return funds it also has several questions related specifically to counterparty risk. Monitoring and oversight of existing absolute return managers related to counterparty risk will include:
    • Contractually mandating transparency to the metrics necessary to gauge risk exposure.
    • Regular reporting of risk exposure and risk management information.
    • Periodic meetings with the manager to re-assess the risk mitigation and risk management program, and to discuss risk exposures and any recent developments
  • Addressing liquidity risk, or the inability to redeem immediately from a fund due to hard to value investments, side pockets, lock-ups, and gates. SCERS’ consultant monitors the liquidity based on the days to redeem and the individual manager limited partnership agreements. These factors are incorporated into the due diligence process and part of the decision to invest in a particular fund.
  • Addressing operational risk, or the risk of failure in operations outside of the investment strategy. SCERS’ consultant has developed a specific in-house unit to assess a hedge fund’s legal, financial statements/audits, compliance, custodian(s), prime broker(s) and other service vendors, operations, administration, trading functions, asset valuation, and conduct background checks. Alongside the consultant’s due diligence, Staff will help select absolute return funds by sourcing funds, interviewing managers, and visiting managers on-site to assess the front- and back-offices.
  • Addressing headline risk (the risk of an absolute return fund attracting negative media attention leading to investors redeeming). Return dispersion and concentration in a niche strategy or concentration in a small number of investments (the risk of any manager’s particular strategy notworking as in past periods), event risk (the risk of a sizeable investment loss due to a market event, personnel loss, or regulatory issue), are all part of the due diligence and monitoring process and partly mitigated by guidelines and expectations for diversification across managers, strategies, geographies, and industries.
  • Monthly: Staff will leverage the consultant’s monitoring process, a process that entails frequent contact with the absolute return managers. The consultant typically reviews each absolute return fund’s investor communications and calls the absolute return managers monthly to discuss the fund’s organization, strategy, investment process, portfolio characteristics, and performance drivers. Staff will supplement this review process by analyzing the performance and risk of the individual absolute return managers and the overall absolute return portfolio and reviewing absolute return fund investor communications and the consultant monthly reports.
  • Quarterly: The consultant will produce supplemental quarterly reports that contain performance and risk statistics for the individual absolute return funds and the absolute return portfolio, and portfolio characteristics, including strategy allocations, geographic allocations, and leverage, for the individual absolute return funds and the overall absolute return portfolio.
  • Annually: The consultant will conduct periodic onsite visits at each absolute return manager’s office, but no less frequently than annually, or through a web conferencing platform (i.e., Zoom) if an onsite visit is not feasible. Individual absolute return funds will be re-evaluated annually from both an investment and operational perspective and there will be updated due diligence reports issued. There will be a review of individual absolute return funds’ annual audited financial statements. Staff will conduct conference calls/web conferencing calls with managers and/or conduct on site due diligence at least annually.
  • Other: The consultant assigns ratings to all absolute return funds as part of its monthly monitoring process. These ratings include placing funds on a “Watch List” where serious organizational or performance concerns exist and the recommendation to terminate a relationship. These investments are not necessarily expected to lose money over their life, but in the opinion of the consultant there is a more likely chance that returns will fall short of expectations. Watch List funds are subject to more intense scrutiny. The consultant will provide Staff with a Watch List report for any absolute return placed on the Watch List. As a final step, the consultant may recommend that SCERS exit (redeem) from the fund investment. Absolute return funds can have redemption features that require notification months in advance or limitations such as gates, penalties, and side pocket restrictions. The consultant will assist Staff in developing an exit strategy. A final recourse would be to seek a secondary sale if redeeming is not possible.

E. POLICY HISTORY

DATE DESCRIPTION
   
10-20-2011 Board adopted Hedge Fund asset class investment policy statement
07-10-2014 Board adopted Fixed Income asset class investment policy statement
11-05-2018 Board adopted reformatted and consolidated Diversifying asset category investment policy statement
03-20-2019 Amended Diversifying asset category investment policy statement
03-18-2020 Amended Diversifying asset category investment policy statement
06-15-2022 Amended Diversifying asset category investment policy statement