NEWS

Interview by Muskan Arora

Donald Pierce, the Chief Investment Officer of $15bn San Bernardino County Employees’ Retirement Association has incorporated new ways of rebalancing his portfolio since joining the fund. He has always stayed away from real assets and as the market environment changes so do his sentiments towards the asset class. In this interview with Muskan Arora of Markets Group, Pierce explores red flags in manager, impact of fed rates and leaning sentiment towards real assets. 

Muskan Arora: In this system, you're responsible for introducing new balancing methodology. How did you do that?

Donald Pierce: When I was working towards my MBA at San Diego State, I learned that rebalancing was something I took a particular interest in. I had even written my thesis on some of the rebalancing methodologies. It only later came upas an opportunity to explore, when I joined SBCERA. 

Admittedly, when I first made this presentation to the Board at our off-site many years ago, which we have once a year, to lay out various ideas and strategies, they found it interesting but not quite ready for further review. That all changed when I met Arun Muralidhar, from MCube. He was introduced to us by State Street at the time. He had apparently had a lot of the same challenges and thoughts when he was at The World Bank.

He had developed a platform that would allow people to take back some of those rebalancing decisions, and to manage them using a rule set, sort of math, to be impartial in their decision-making. That was the jet fuel we needed to take back to Board. The contribution that our consultant made, Allan Martin, from NEPC at the time, who was our long-term investment consultant indicated,, "well, the test always works, so we need to test this out of sample."

He brought scientific rigor to the process, and not surprisingly, it passed that out-of-sample test. I think with that, the decision to move ahead and bring it to the Board as a fully engaged proposal was made, and then it was initiated in 2005. We went live with the program in July of 2006, with our overlay partner at the time, and still with us today, Russell Investments.

I think in a lot of ways, that program only happened when the CEO at the time, Tim Barrett, who's my former boss and mentor, had a willingness to let this happen and belief in its impact. I also had a consultant who was engaged and willing to consider it, and a technology partner that made it much better than some Excel spreadsheet. I think a lot of things contributed and coalesced to make the program work at the time.

Arora: Now, that sounds amazing. Has your portfolio been impacted by the denominator effect? What approach have you been taking to combat that?

Pierce: We have not had the same challenges on that front, but we've seen a major reduction in cash flows. We probably shouldn't benchmark it against 2021, but 2021 was a banner year for distributions, which meant that there were a lot of transactions happening in the private equity and private market space.

I think from that standpoint, we don't have any concerns, but we have seen a much-diminished capital return back to us.

Arora: What kind of strategies do you see suitable in this higher interest rate environment, and why?

Pierce: We feel that our particular portfolio is well positioned for this, but some of it was by accident, as we had thought long-duration bonds were terrible investments. It was because they had really low interest rates and a relatively flat-ish yield curve. However, even if it was a modestly steep yield curve, it was off of a base level of interest rates that were incredibly low and did not have an absolute return level that was remotely interesting.

We were driven, by a low interest rate environment, into credit, for a host of reasons. One is, we have an investment philosophy that is income-focused. We tend to be very opportunistic, and we want to have a value tilt toward how we evaluate assets. That has led us to remain in floating instruments. We remain there today, particularly given that we are in an inverted yield curve. I think it's novel.

I was telling the board recently that, during our last asset allocation discussion, where we effectively said that we'll focus more on implementation, really trying to improve the portfolio from an efficacy standpoint rather than making shifts in the asset allocation. An inverted yield curve is the least compelling time to make changes because you could have the curve shift meaningfully on you.

We opted to stay short duration in bonds, floating rate debt, and bide our time. We could have a case where that resolves itself, but I think what's interesting is, I believe, in March of 2024, we surpassed the last longest time period for an inverted yield curve. We are one for the history books, in a lot of different ways and in this marketplace.

Arora: With valuations changing, with higher interest rate, are you still able to have more current real-time valuations than other funds?

Pierce: Higher interest rates have brought us a number of excellent opportunities. I expect them to continue to offer a repriced asset pool that we can look at. Again, I'm less about other funds and more about what we are seeing currently, and higher interest rates, at least for SBCERA, have been incredibly beneficial. I hope they stay that way.

Arora: Can you dive deeper into why?

Pierce: We had issued a lot of longer-duration bonds and did not like real estate for a long time because cap rates were so tight. Well, when interest rates rise, those areas get particularly repriced, and depending on how the curve asserts itself, I think a lot of folks are assuming that short rates are going to come down. I would certainly put that at a much higher rate than the odd chance that rates go up.

There is the prospect that the long end could stay higher. If it does, it means that those longer-duration assets are going to face these longer-time-period interest rate pressures. From our standpoint, the ability to accrue income in this marketplace is where we really are seeing opportunities. Real estate will become interesting again.

I'm thinking less office and more multifamily, that were bought at a time when cap rates were much lower and borrowing costs were much lower. To the extent that those properties are currently getting their loans extended, but they're getting loans extended over a very short time-period. You could see borrowers that are not as well capitalized have to give up those assets.

We're hopeful that, working with our existing real estate partners, we will be able to participate in that marketplace, along with a lot of other people. It would be the first time really leaning into a real estate market, that we were trying to avoid for many years, and not because we thought they were bad assets, but because the price was too high.

Arora: Within your credit portfolio, what is something that you're watching to avoid risk?

Pierce: I'll tie it back to the discussion we had which is that you have a large group of investors that have used short-term debt. If you think about it, in 2021, they refinanced, they got a very good low rate. If they have a three-year tenure on that maturity, which is  due this year. If it was a five-year, it would be coming due in a couple of years. They are running out of time.

We think that opportunity, where borrowers who have exhausted all their leverage, will be an area where we can really lean into.

Arora: How would taking more risk look like for your portfolio?

Pierce: When I think about that, I would say that taking more risks would look probably more like we're getting into real estate and longer-duration assets. That would probably feel risky for me, since we haven't done it for so long. That's where I would say that that's the risk-taking we would do at this stage. It's hard for me to get excited about an equity market that seems rather ebullient already.

Arora: What credit strategies do you think are working well now, owing to the current market environment? How should allocators choose their credit investments?

Pierce: Generally speaking, these are long, first-lien instruments, or other instruments where you're getting a very good yield pickup. I would say distressed debt is an area that I'm not that interested in, or special situations because a lot of that has to rely on this resolution of things.

It's not to say people can't make money in that, because they can. The prospect that you buy debt at $0.40 and get part is always a nice two-and-a-half times multiple on money if you get it, but our experience has been that you never get that, and never in the four years that you think you're going to do it. In general, I would say the current pay credit strategies are things that we like. We like collateral that makes sense, as opposed to the stranger thing, being just esoteric assets.

Again, not to say that people can't make money in these areas. It's just not something that I feel like we must stretch to do.

Arora: Could you highlight a few red and green flags in managers that you look for?

Pierce: I don't know if I have a lot of green flags, but I definitely have a red flag. The red flag would be if you don't do what we ask you to do. In general, the red flags are when you have meaningful changes in the strategy and team, which isn’t particularly original, but it happens anyway. The thing that you must keep in mind is that every change, the manager's going to come and tell you what an awesome thing it is.

Even if they have no idea. That's where I think, and the consulting industry is well aware, and keeps up with this really well, is that those kinds of changes have knock-on effects. They may be better for you, but they don't have to be. The person that you're in a fiduciary trust relationship is going to try and sell you, because suddenly, it's not about the investment of the assets, it's the "How can we keep your business?"

We often talk about the business of investing, and the investment business. The business of investing is the management of the assets, and doing things right for your clients, whereas the investment business is about collecting a fee and making sure you don't lose clients.

Arora: Moving on to your fixed-income portfolio, the returns have been great, but I would love to understand how the Fed rates are impacting your investments.

Pierce: Well, as I shared, we had a long-time floating rate portfolio. In 2021, our fixed income portfolio had a duration of 0.25 years, less than one year. If you think about the aggregate, the bond aggregate, I think it was close to seven years. Every 100-basis point move, they took a 7% hit, and we took less than that.

In fact, we benefited from it, because we got a lot of higher income. There are limits to how duration measures, when you're mostly floating rate. The one thing I would say that has not stayed the same is that we were getting much better spread. I would say the spread has tightened. The overall absolute level of return that we're getting is much higher, but the spread component has tightened, more recently, much like the stock market runup. The risk appetite out there, for any asset, has improved.

Arora: Which sectors do you think perform well when such things are happening in the market, especially in the fixed income sleeve?

Pierce: We tend to look at assets on a very specific basis. When a manager comes to us with a proposal, it's usually at an asset level, and we can then evaluate that asset. It's much more of a bottoms-up evaluation.

Although we do have credit strategies that we would look at. Anytime BB credit instruments get above 1,000 basis points spread, I'm very interested. Naturally, they're not there right now.

Arora: Any sectors or strategies here that you think aren't performing that great?

Pierce: I just think emerging markets have continued to disappoint. If you had asked me 10 years ago with information about the pricing dynamics, here's the cash flows you should expect, I would expect emerging markets to have done much better. The dollar strength has been just unrelenting, with downward pressure on performance. The emerging market managers that have done and stated more dollar-denominated debt, have done better.

The emerging market equities have just struggled. We have a globally diversified portfolio, but it is not without some wistful regret.. It's the same thing as it is right now, which is that every time you look at it, you just say, well, it's always expensive, and then it stays expensive.

This cycle with a pronounced economic headwind that emerging markets have faced have been much longer than I would have expected.

Arora: How and why do you think Fed rates will impact your high yield and NAV loan sleeves?

Pierce: As I mentioned before, we do have a lot of floating rate debts. Now, we are highly in favor of the Feds staying where they are, or, if they would like, they could go higher. That wouldn't hurt my feelings one bit.

A NAV loan is a loan that you're making against a pool of assets, that what you hope is, at an attachment point or a loan to value point. To your point, if the collateral to which you are lending is losing value because of higher interest rates, then you just must make sure that your attachment point is well protected. Most of the time, when I see these NAV loans, and we do participate in them, the attachment points are rather low, like 15% to 25%.

There must be an immense amount of value erosion for the NAV loans to face impairment. The corollary is that you're probably not getting the really juicy yield, but it is a well-protected piece of paper. We think that for NAV loans if it's against a broader portfolio, you're getting cross-collateralization. It has a lot of features that are quite attractive.

Arora: Within both your credit and fixed-income portfolios, like private credit and fixed income portfolio, what kind of trends are you seeing in the market at the moment?

Pierce: I would say that the prospect of real estate debt collateral is much closer to being actionable, at least from my standpoint, because those values are getting marked much better and closer to reality. My personal view is that there's still a lot of hope that people don't have to take the full write-down, but eventually, they're going to have to come clean with the value of these assets.

Then, in which case, we'll have to lend against a much more properly priced asset. I would say that the big trend across the board is that, for years, we have underweighted real estate, and it feels like we're probably getting a lot closer to being able to lean back in.

Arora: Diving smoothly into my next question, because you've already spoken a bit about the sectors that you like, including multifamily. I would love to know what kind of strategies you are adding, now that you think of leaning back into it?

Pierce: Well, we have existing partners that will look at real estate equity, and I think in that space, our first move in real estate will be with existing partners, on a strategic basis where they can show us where to begin. When we hear, “The pipeline is amazing,” we happen to agree with that. A lot of times, we would get people who'd tell us, "The pipeline is amazing," and we would not agree with it.

I think from where we sit, the quality of the assets and most of our real estate partners are great as they pick good assets. It's much more about a price point. That's where our first foray into this space will be, is with our existing partners.

Arora: What is something that you're doing which is contrary?

Pierce: We still think cash has option value. I don't know if that's contrarian or not, but I say it often enough that it's the way I would talk about it before is that cash had option value. If you figure that if an asset falls by 20% and you have liquidity to buy it, and then the asset rebounds, the asset gets all the credit for all this return that it did, but poor cash never gets any credit for being the thing that facilitated it. In basketball, it's like the assist. Cash is like the assist in basketball.