Before joining Moneta, I spent three years as CIO of the Policemen’s Annuity and Benefit Fund of Chicago. During this time, the fund hovered between $2.6 billion and $2.9 billion, was approximately 24% funded and had a negative cash flow drag every year (cash inflows < outflows) of around $120 million, or approximately 5% of the overall fund.
The annual benefit payments represented over $700 million with an annual cost-of-living allowance that exceeded 3%. So inflation was very real for this fund, even at a time when the run rate of inflation (around 2%) was substantially lower than it is today.
The fundamentals of running such a fund looked challenging at best — and disastrous at worst. But there was still quite a bit that we could do even if we felt on the precipice of collapse at times. I focused on framing the negative cash drag as a “spending rule” and began to orient the portfolio just as an endowment or foundation might with a similar spending rule of 4% to 5%. There were some key lessons learned that are important for all investors to know, particularly as we face an uncertain (and inflationary) future. These include:
Cash is king: Every month began with checking the cash account and planning for month-end outflows. This triangulation between cash on hand, cash flow needs and investment return was essential, and investors should never lose sight of their cash needs when focusing on total return.
Sweep cash flow across the existing portfolio: Because we needed to take cash out of the portfolio every year, we began to look for the low-hanging fruit — existing cash flows that we were automatically reinvesting instead of sweeping. We quickly switched to sweeping cash flow from our fixed income and public equity portfolios (dividends). This also served as an effortless rebalancing exercise — as we were overweight public equities, clipping the dividends served as an easy way to rebalance across the entire equity portfolio on a quarterly basis. Sometimes, cash flows are there, hiding in plain sight.
Seek out additional cash flow-generating investments: We began to specifically seek investments that generated cash flows — ideally contractual cash flows such as franchise fees, rents, infrastructure payments (such as road tolls) and coupons on private credit — and constructed a series of cash flow-driven sub-portfolios. As we targeted a yield of at least 5%, these investments presented diversifiers, ways of mitigating the J curve (on private investments) and steady sources of cash that were not market-sensitive. We also looked in our equity portfolios toward higher-yielding dividend strategies and specifically requested a distribution share class or to receive our income on a quarterly basis.
Regular portfolio cleanups: In a portfolio forced to work hard to meet a target return and generate cash, dead wood, such as legacy private equity investments, offered little upside. We sought to clean up the portfolio through selling legacy interests on the secondary market, which gave us fewer line items to monitor and a much-needed cash infusion.
Avoiding cash drag: Although cash was king, too much cash could also be a drag on returns. So we sought out short-term, enhanced cash solutions and even liquid “proxies” for investments, such as infrastructure and real estate, to ensure that the cash was working even when it was on hold and pending drawdown.
Protecting against inflation: Just as a public pension plan is highly exposed to inflation, so, too, are individual investors. Building inflation-resilient elements (such as real estate, real assets and other inflation-linked investments) into the portfolio is key to offsetting inflation shocks.
Protecting against interest-rate movements: Many of the private debt investments used were floating-rate debt, meaning that they were not as exposed to interest rates as traditional, core-fixed income.
Stay focused, ignore noise and stay true to your mission: Despite the longer-term strains on this fund, I focused relentlessly on the day-to-day challenges of investing and achieving the target return, maintaining a long-term investment perspective at all times and not sacrificing the broader fund mission. In this case, that mission was to allocate up to 20% of the assets to emerging and diverse manager groups. Each investor may have a different objective and mission in addition to achieving a target return. My experience is that it’s possible to “walk and chew gum” at the same time, investing with purpose even as existential threats loom.