Pennsylvania schools pension (PSERS) divesting from ILS in shift to equities

A long-standing pension investor in insurance-linked securities (ILS), the Pennsylvania Public School Employees’ Retirement System (PSERS) is planning a withdrawal from the sector, as part of a planned divestment of all absolute return strategies.

The Pennsylvania Public School Employees’ Retirement System (PSERS) has been allocating to insurance-linked securities (ILS) since mid-2011, when it made its first allocation to a strategy operated by ILS fund manager Nephila Capital.

Since then, the PSERS pension has allocated to a number of other strategies and built a portfolio of third-party manager operated ILS, catastrophe bond and collateralized reinsurance investments.

The ILS portfolio at PSERS has been valued at over $1 billion, so it is one of the larger ILS allocators in our listing of end-investors, but it has taken hits from catastrophe loss activity over recent years and had fallen to $835 million by the middle of this year.

Despite that, the ILS portfolio remained a core part of the absolute return portfolio, which is where most alternatives and hedge fund managers were categorised.

But, as returns have been volatile and these absolute return strategies have often diversified PSERS investments away from the equity markets that have soared in recent years, the pension’s board has opted to divest from all of its absolute return investments, in favour of ramping up its public equity allocations.

It seems counter-intuitive, to divest from diversifying asset classes that exhibit low to zero correlations with broader financial markets in favour of equities.

But PSERS believes that it can generate far better returns in the equity markets, while also paying much less in investment manager fees.

So the ILS fund manager allocations are all set to be wound down and divested from over the coming months and years, in a process that the pension said will take some time.

The The Board of Trustees of PSERS recently voted to approve the transition in investment strategy.

The allocation changes, which include the increase in public equities allocations and the elimination of all holdings in absolute return strategies (which includes the ILS funds), are expected to be implemented “over the course of months or years” the Trustees said.

The goal is to benefit more from soaring public markets, it seems.

“The Board’s decision to change the asset allocation by adding more public equity over time will help increase PSERS net investment income in positive market conditions,” explained Board Chair Chris Santa Maria.

But Santa Maria also noted that, “However, this allocation also increases slightly our risk profile in down market conditions.”

The roughly $72.5 billion pension fund had approximately $6 billion held in absolute return strategies, $835.2 million of which was in ILS funds as of June 30th 2021.

That ILS fund allocation had likely shrunk further by now, given the expectation that it will have suffered further impacts due to the European flooding and hurricane Ida.

PSERS had allocations to two of the retrocessional reinsurance focused ILS funds that will have been impacted by those events, RenaissanceRe’s Upsilon and Aeolus’ Property Catastrophe Keystone funds, so a decline in ILS assets is to be expected after those catastrophe events.

PSERS also has an allocation to Nephila Capital’s Nimbus weather focused ILS fund and its Palmetto reinsurance strategy, as well as to RenaissanceRe’s catastrophe bond focused Medici strategy and DaVinci Re vehicle.

However, PSERS has not targeted ILS specifically for divestment, rather it falls within the absolute return bucket that it is to eliminate all holdings in.

Most of this capital is expected to be invested into US public equities, which is where public markets have seen considerable gains of late.

“I look forward to working with the Board to implement this new asset allocation in the best interest of PSERS members and constituents,” Acting Chief Investment Officer of PSERS Bob Devine said.

Diversification, or a desire to allocate to uncorrelated asset classes, is not mentioned at all in PSERS statement on the divestment from absolute return strategies including hedge funds.

It seems likely this initial disposal of the absolute return portfolio may be a first step in a wider rebalancing of the pension fund’s portfolio, so it is possible that PSERS looks to build a bucket of diversifiers in a different way, perhaps through a stricter classification than was applied to the absolute return bucket.

Performance may not have been optimal for the ILS investments, due to catastrophe loss activity since 2017. But over a three-year horizon, the returns from the ILS strategies do not compare so unfavourably with other alternatives, or areas of the market like private equities, that PSERS allocates to.

But looking at the fees paid may provide an insight into why absolute return strategies have been singled out, as over the year to end of June 2021 the absolute return bucket drove investment expenses of $196 million from fees and profit shares.

That’s from a total allocation of under $6 billion, across the absolute return strategies, which compares for example to a $21.5 billion fixed income allocation that only drove $121 million of investment expenses, or a $17 billion global equities portfolio that only drove $93 million of investment expenses.

So, absolute return strategies have proved to be more expensive and over the last few years the public markets have delivered on returns on which PSERS feels it has missed out, which together with the fees paid look like the main drivers for PSERS’ allocation changes.