Asset Management Insights from VRS

Hi, friends. Welcome back to another episode of Peer Connections, the podcast series brought to you by the Global Peer Financing Association, also known as GPFA. These podcasts offer our GPFA members and global beneficial owner friends a forum for information sharing and discussion on topics most important to them. And we hope you, our listeners, appreciate the insights, best practices, and transparency offered from our members and industry friends about securities, finance, or related investment areas. Now let's get into the episode. Welcome everyone to another episode of Peer Connections. My name is Chris Benesch. I'm a Senior Portfolio Manager here at the State of Wisconsin Investment Board. I'm also a board member and the Treasurer of the Global Peer Financing Association. GPFA tries to bring educational information and opportunities to our membership and the industry at large. Today, I have joining me Brock Bell from the Virginia Retirement System. Brock, welcome. Excited to be here. Thanks, Chris. So Brock, you've been at Virginia for a little more than a year and a half. Tell us a little bit about your role there and where you were prior. Sure, happy to. I'm the Director of Treasury at VRS. We're the state pension fund of Virginia, as you mentioned. We run about $126 billion in total assets across public and private markets. I work within our Portfolio Solutions Group, which is a cross-asset team of investment professionals and portfolio managers. I manage the core treasury functions like liquidity management, cash and collateral optimization, counterparty risk and financing across all asset classes and also manage an enhanced cash investment strategy. Very interesting. And prior to VRS, where were you in the industry? So started in the securities finance industry right out of college. I graduated from Princeton in 2006, started my career at Barclays and their sales and trading program and spent the first 10 years of my career at Barclays, Morgan Stanley, and JP Morgan, all in different types of securities finance trading roles. I built up the treasury and portfolio finance function at Capstone Investment Advisors, the multi-strategy hedge fund for about six and a half years, and was also head of treasury at Hidden Road, a multi-asset prime broker, before coming down to VRS about a year and a half ago. VRS decided they wanted to employ leverage, which was a new initiative for the fund. And they brought me in to build out the treasury function. Great. We're really excited to have you join us today. And certainly your perspective coming from the sell side will be incredibly valuable as we talk through some of these trade ideas. So Brock, why don't you tell us a little bit about your structure at Virginia Retirement System, how VRS employs leverage and how you're involved in some of these strategies? Sure. So we run about $126 billion in total assets across public and private markets. On the public side, we have public equities and fixed income. And on the private side, really have three main private asset programs. And that's real assets, which is largely real estate and infrastructure, credit strategies, and private equity. We also have an allocation to what we call diversified strategies. These are meant to diversify the return streams and the risk exposures across market cycles in different investing environments. And there's really two different types of diversified strategies. One we call risk responders. These are generally things that are negatively correlated to the rest of the plan assets. You could think of something like tail risk protection as a good example of basically something that's long volatility, when there's a big shock to the market or a big drawdown, we would expect these to perform well. The other is what we call return enhancers. These are things that aren't negatively correlated to the rest of the plan assets, but are completely uncorrelated to the rest of the plan. And here, you really have traditional hedge fund strategies. So things like relative value, volatility, global macro, and different types of arbitrage strategies. We also have a small allocation to cash and a few other things. I think it's really interesting to talk about our motivations and rationale for using leverage. And it's much different than how most hedge funds and many other levered funds use leverage. And I think it's also different than how a lot of people, even people that have a lot of experience in financial markets, tend to think about it. So when most people think about why you'd use leverage, really what comes to mind most frequently is just enhancing returns. So you think of something like a pretty plain vanilla treasury cash versus futures basis trade. Typically, those are pretty thin spreads. You might be looking at something like a 25 basis point P&L forecast. So if you are looking at that potential trade, you need to lever at 40x just to get a 10% or an attractive annualized return. The VRS, the motivation and the rationale for leverage is quite different. There's really three or four main reasons why we want to deploy leverage. One, to free up capital to invest in private assets in our diversified strategies. Two main reasons for this. One, it diversifies returns and reduces the risk of the overall portfolio. So it's a little counterintuitive, right? by taking leverage, because we're investing in things that are uncorrelated or even negatively correlated to the rest of the plan, we're actually reducing risk in the portfolio. Second is the illiquidity premium. So particularly in private markets, you lock up money over a longer period of time, you expect to get higher returns. The second one is it gives us additional liquidity for retiree disbursements. In the state of Virginia, looking at our actuarial projections. And this goes for most of the country where you have a lot of baby boomers retiring. We're expecting our retirees to go up and therefore our monthly retiree disbursement estimates are also going up. So this gives us additional liquidity for that. Third, it gives us a dry powder facility. For example, if we see a new investment or a new opportunity, or we want to take advantage of a drawdown period where assets are at attractive prices, we're not in a position where we have to sell one asset to buy something else. We're not a for seller. We can simply tap into our available funding resources and make those investments. Finally, just as an auxiliary benefit, we do expect it to be a positive carry trade. So in most years, we expect that our investment returns are going to exceed the cost of leverage. And so over time, we expect it will increase returns. That's an incredible opportunity set that you guys have developed. I'm curious, as you developed your leverage program, did you enter it knowing you would have those different strategies employed or has it been an evolution as you've employed leverage? I would say it's been an evolution. The things that I outlined, that was really the rationale and the strategic plan. And then coming in the things I've been working on and building really is making sure that we're able to get access to funding through different funding channels, different account structures, and a variety of liquidity providers and counterparties. That's great. Maybe talk a little bit about how you access some of those liquidity channels. Historically, BRS has a longstanding securities lending program. One way we're able to access liquidity and funding is through a mechanism called cash release. Basically, what we're doing is we have the ability to borrow back cash collateral on the back of our public equity and fixed income securities loans. So that's been a core funding source for us, something that we've had in place for a while. We've also onboarded several new ISDA counterparties for index swaps and single security total return swaps. One thing that we're also working on is prime brokerage, something that we expect to launch in the near future. So Brock, from the beneficial owner's perspective, how would you think about utilizing the swap capability in regards to how it interacts with your balance sheet or other positions you might have on? I think there's a few different motivations that you have from a beneficial owner or from a buy-side perspective, why you'd be motivated to move a position from cash to swap or vice versa. One of the biggest considerations is obviously going to be a better financing rate. So I think a good example of this, let's say that you have a cash equity long position, either at your PBE or custodian, where it's trading special, and you're not getting a market rate. In this case, you could sell your physical cash equity, buy it on swap with a swap dealer who's willing to pay you something close to that market spot rate and be able to monetize that value. Another benefit would be reducing margin. So for example, if you have a cash equity position that sits within a portfolio or within a margin methodology where you're hit with a concentration or diversification add-on, and you can move it to a swap dealer where it has better standalone margin or a natural risk offset with the rest of your swap portfolio, you're basically going to be able to reduce margin of both sides. So capital efficiency, freeing up capital being an important benefit there. Dividend and tax treatment, that's something that depending on your tax jurisdiction, your trading, that could be a consideration as well. Another important one is return metrics. So it's obviously important to be a good partner to your counterparties. You want to make sure that you're ensuring you have a healthy, mutually beneficial mix of business. Dealers are often very transparent with names that are good fits and bad fits. They'll communicate that with you. They'll publish things like Axelus. So being able to improve your return profile as a client, that's something that could have a positive impact across the whole firm. Another big one is customization. One of the benefits of a swap wrapper is that you're able to customize all the different terms of a trade. So I think a couple of good use cases for this would be getting a termed financing rate. As we know, the securities lending business, PB.