Volatility is a word that has become all too common the last couple of years when talking about the financial markets. With the country still dealing with the effects of the COVID-19 pandemic, market volatility caused by economic and world events, like inflation and the war in Ukraine, has caused more uncertainty.
Volatility in the financial markets is not new and is something the State of Wisconsin Investment Board is prepared to deal with through its diversified asset allocation and strategic investment management of the Wisconsin Retirement System trust funds.
“It is very hard to know in real time whether there has been a shift in the existing economic or market environment that will be persistent as opposed to transitory,” SWIB Executive Director and Chief Investment Officer Edwin Denson said. “The result is that at SWIB we have implemented an asset allocation that can help weather changes in market conditions without having to predict precisely when they will occur or if they are occurring.”
Denson added that the structure of the WRS is key in SWIB’s ability to implement the investment strategy it has. “The fact that the WRS is fully funded and operates on a unique risk sharing model means that we don’t have to chase every dollar of return as the risk climbs higher and higher,” he said. “Instead, maintaining a disciplined long-term asset allocation allows us to generate reasonable returns that help keep contribution rates for employers and employees stable and avoid large swings in annuity adjustments for retirees.”
An important part of SWIB’s investment strategy is active management. Active management is when an investor makes buy, hold, and sell decisions in an effort to control risk and outperform returns that would be generated by a passive or indexed portfolio. Over the last 20 years, SWIB’s active management and diversified holdings generated $34.3 billion for the Core Trust Fund above what SWIB would have earned by simply investing in a low-cost passive portfolio consisting of 60% global equities and 40% domestic bonds.
Along with active management, SWIB relies on the use of internal management to drive returns at a cost lower than the fees paid to external managers. “Using our own staff to actively manage the funds is a key cost-saving measure that helps grow the WRS,” Denson said. “We are currently managing approximately 50% of funds internally,” he continued. “By using internal active management with our current asset allocation, which is tilting towards sub-asset classes that have more expected active return, we increase the likelihood of meeting the return target for the Core Fund over long-time periods.”
In addition, the Core Fund uses a modest amount of leverage in its investment strategy. SWIB’s independent Board of Trustees has approved a leverage target of 15% for the Core Fund.
“We are using leverage where it can be combined with other assets in a way that provides the lowest level of risk for a given level of return,” Denson said. “Our goal is to leverage low-volatility assets to help manage risk rather than boost returns. The leverage helps reduce risk by supporting a higher allocation to lower risk fixed income securities and a lower allocation to equities at the same target return. This strategy is a small part of our long-term strategy of greater diversification and risk control.”
SWIB’s asset allocation, active strategies, internal management, and use of leverage to reduce risk are all important to generate returns in a low return environment.
“Ultimately, we are long-term investors,” Denson said. “The next 10 years will be challenging for the fund from a total return perspective because as returns on assets are generally expected to be low relative to longer-term expectations, in part because of higher than average realized returns from risk assets, like stocks, over the last few years. We believe in the strategy we have put in place that is designed to help withstand a low return environment by allocating our capital to areas we feel the most confident we can generate reasonable returns based on the risk we are taking.”