What the retirement system board was hearing from the institutional consulting world was very different. “We were told to underweight equities because returns would be low and risks were high. The world was saying that there was no way you could make a decent rate of return in stocks over the short term because returns would stay low,” Matson recalls. “But we thought corporate profits would recover fairly quickly. We were told risk parity was the new strategy that would outperform [in the post-crisis environment]. And we were told to overweight real estate before the crisis and underweight it after the crisis.”

The ASRS board also maintains a position in inflation-linked investments, and at this time Matson says they were hearing they should expect hyper-inflation or “at least high inflation.” Serendipitously for the state’s employees, the ASRS did none of the above. Matson, Connelly and the ASRS board also resisted the hard sell from some very smart people pitching hedge funds. Matson admits they have “a corporate view that is not supportive of hedge funds, but that is not to say [the funds] don’t work for other [investors].”

However, as fiduciaries, Matson, Connelly and other trustees are compelled to listen to a wide variety of investment views, including those diametrically opposite of their own. The screening process is intensely meticulous, and the fund typically selects only one out of three to five managers and/or strategies that it considers after rejecting an even larger number of institutional managers.

Hedge funds have several drawbacks. “We’re not comfortable substituting beta for alpha returns,” Matson explains. “Beta returns are more fundamental and stable and are driven by the economy.” He adds that most hedge funds have a benchmark of zero, which ASRS directors believe is inappropriate for long-term investments. Furthermore, Matson says the high fees associated with hedge funds and the level of transparency, which “on average is marginal,” were reasons enough to stick with their long-only stance. For his part, Connelly believes it is hard enough for a long-only manager to deliver alpha, and that much harder to do so going both long and short.

After being appointed chair of ASRS’s investment committee, Connelly, together with Matson, quickly began a push to change its governance structure. “Tom was a champion” of two changes in governance, Matson notes.

Trustees often sat on different asset-class committees and they decided to terminate that practice. “We had issues internally in terms of trustees involved in the decisions, frustrating the manager selection process,” Connelly says. “The big responsibility of the board was to do oversight, but they couldn’t stand back and hold staff accountable if they were involved in the process.”

Another issue that Connelly found particularly frustrating during the financial crisis was that there were remarkable investment opportunities, but the system followed cumbersome, bureaucratic procedures that forced the ASRS to conduct months of review before capitalizing on bargains like distressed credit that were omnipresent in early 2009. They streamlined the process so the pension fund could move faster when opportunistic situations arose.

“Tom is a strong practitioner who can make his case,” Matson says. “He is also a professional diplomat. He can debate, he can listen and he can incorporate practitioner and academic research into prudent decision-making. In that respect, he is an outlier.”

Like Matson, Connelly acknowledges that a $35 billion fund with responsibility to 550,000 plan participants needs to hear outside opinions that are at odds with their own. “I solicit opinions from staff, consultants and other investment professionals,” Connelly says. “If I have a real problem, I might take them offline. Things don’t always happen my way and that’s a good thing. You don’t want people to be bullied or hog the spotlight. Part of the fun is hearing different ideas and perspectives.”

The ASRS is on a June 30 calendar year, but since Connelly started chairing the investment committee the returns speak for themselves. In the calendar years ending June 30, 2010, through June 30, 2013, the fund generated returns of 14.9%, 24.6%, 1.3% and 13.1%, respectively. For the 10 months through May 2, 2014, it was up 14.3%. Compared with other pension funds with more than $1 billion in assets, the ASRS ranked in the top 8% over the five years ending December 31, 2013, and in the top 5% for three years. At the present time, Matson estimates the fund is about 77% to 78% funded, modestly above the median.

Today, Matson says the vast majority of global markets are fully and fairly priced—with two exceptions: private debt that, for whatever reason, is too big for most banks and too small for Wall Street banks to syndicate in bond offerings and certain classes of European equities, typically in the small-cap and value sectors.

Matson credits Connelly for convincing other trustees that tactical decision-making and focusing on fundamental valuations are the way to outperform. “Fundamentals always come back to drive prices,” Matson says.

Experiencing blistering growth at Versant while finding intellectual stimulation through public service at the ASRS has been an exhilarating experience for Connelly. He has learned some invaluable lessons from viewing the investment world through the lens of a public pension fund.

Probably his biggest surprise is the high caliber of the personnel at the ASRS. Many are CFA charter holders who are keenly intelligent and often more sophisticated than most advisors. They may lack an entrepreneurial bent and be attracted to the security that comes with public service, but Connelly says their abilities are underrated by other investment professionals.

Another takeaway for Connelly has been the process that institutional investors use to vet an investment, particularly in the alternative arena. The ASRS frequently hires more than one consultant and spends $80,000 or more before allocating assets to a private-equity fund or real estate property.

Connelly acknowledges that the literature on pension fund and endowment performance is agnostic. Some outperform, others don’t. Still, “an independent RIA doesn’t have access to the same kind of information or analysis,” he says, questioning how even a very large RIA firm could ever devote the time and resources to conduct a thorough analysis.

Public pension funds like Arizona’s are required to disclose voluminous amounts of information listing all their investments, while frequently publishing meeting minutes, sponsor presentations and consulting reports examining both liquid and illiquid assets. Connelly maintains that curious advisors could greatly expand their understanding of the investment world by researching this alternative universe. “You’ll never know what you’ll find if you poke around,” he says.

At a time when many public pensions face funding crises, Connelly’s venture into public service has turned into something far more significant than simply another smart RIA exploring his curiosity. It has been a chance to make a difference in a larger universe. “I’ve gotten to meet a lot of wonderful people,” he says.  “It’s been a privilege.” —E.S.

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