Scott, you're the CIO of CalSTRS, which has 390 billion assets under management as of last calendar year. And last time we chatted, you said that you were positioned in a very interesting place as an organization to take advantage of AI revolution. What did you mean by that? AI, hugely transformative, right? It can transform virtually every company, sector, industry, even countries with that technology. But if that weren't enough in and of itself, we're living in a multipolar world, meaning that countries more and more are doing what benefits them the most, right? And so that is changing and rewriting the supply chain deglobalization. Many countries are spending more on defense. We're also on the path net zero. And so there's an awful lot of investment that needs to go in decarbonizing energy and moving the world to net zero. So, I mean, what strings all these together is a tremendous fixed asset spending boom that is going to be a dominant theme alongside this transformation with the technology and AI. You talk about uncertainty, and that sounds like a negative, but sometimes patient capital, when positioned correctly, could take advantage of uncertainty. Is CalSTRS positioned to take advantage of this uncertainty, and if so, in what way? You're exactly right. If we think about this tremendous transformation and tremendous uncertainty, I think the keys for CalSTRS to be successful are, number one, to create greater diversification in our portfolio construction, to be more dynamic in our asset allocation, and the third, liquidity management. Roughly half of our portfolio is in private markets, so it'll be crucial for us to be able to manage our liquidity. And what I mean by that is when the markets are down 30, 40, 50%, we want to make sure that we have the type of liquidity where we can be providing capital when others are not. And that's when we can get the best discounts in the market. What does it mean to position $390 billion defensively? I ask myself and my team two questions. Is there a better way for us to construct the portfolio in thinking about the beta risks that we're taking? And the answer is yes. And I think in a more dynamic, more diversified way, number one. And then the second component of that would be, well, how can we do better in generating more value or alpha in sourcing, selection or structuring? So it's really two. The one fun approach is two parts. I think your question around ABF, it moves into this first element of if we think about the tremendous opportunities and risks that are happening with this transformation and uncertainty, how are we going to position the portfolio more dynamically across the different beta risks? And I would say that for us, what we're moving into, you know, as we think about this higher correlation between bonds and stocks, we have to be thinking about how can we truly then diversify our portfolio if our fixed income portfolio becomes more correlated to our growth portfolio. There's a tremendous fixed asset boom that we see going forward in energy, energy transition, power, because it has to, you know, you need the energy and the power for all of those areas of increased manufacturing, AI, the data centers, defense spending, you name it. Right. But also it's infrastructure writ large, because as you think about more of that happening within our country or every country that needs to be transported through, you know, rail and all these different mechanisms. And so we see a large opportunity there. The former CIO of Northern Trust, Thomas Swaney, and one of the things that they figured out is as investors were chasing more returns from their 60-40 portfolio, they kept on wanting to return more and more on the bonds, aka they kept on wanting to get into riskier and riskier bonds, what Michael Milken called junk bonds, coined that term in the 80s. And then lo and behold, if you do that to an extreme, you end up with 100% correlation. So you end up with a 60-40 portfolio that is as risky as 100-0 portfolio, but just returns lower. So this idea of just doing 60-40 or just pushing the envelope in certain sub-asset classes could end up being actually inferior than even the most traditional, even non-diversified portfolio. Absolutely. And that's why we're very selective when we think about private credit, the subsectors of it, because it's a wide space. There's some areas of private credit that are definitely more diversifying to CalSTRS than others. I think ABF, for example, and infrastructure are two of them. But we're also very selective in who we partner with. We do think there will be a credit default cycle. And then it boils down to, you know, what is the default going to be and what are the recoveries going to be with our partners? The other element that we're very careful to do, and this was something that was part of our efforts, And we've talked about this in the past with the Cloudman model that we very much want to control the risks and the structures. And having more control gives us more opportunity to pivot at the right times. So that's an element. But to your theme of, you know, thinking about how you can really truly diversify the portfolio, what's correlated, what's not, we also are increasing our footprint in uncorrelated assets. And so these are elements that are part of our risk-minigating strategies portfolio. We have hedge fund-like strategies within that area. And we think that it's going to be a good time to flow into that. Again, if we think there's going to be a higher correlation between stocks and bonds, infrastructure, private credit, uncorrelated assets. The other area that I think is going to become less correlated over time is just regional diversification. So if you think about the globalization era that we've been in, we saw a lot of correlation amongst countries, but I think that's going to diverge. Is that because everybody was trading with everybody and it was essentially just one big country globally? You know, if you just looked at the U.S. companies, they had supply chains within all the other countries. Their revenues were being earned globally. But as every country now is starting to diverge in terms of their monetary policy, in terms of their own countries' initiatives, I think there'll be less correlation. And I think there's going to be a greater opportunity to diversify regionally. Expert calls have always been one of the most powerful ways to build conviction. But today, investors are asked to cover more companies, move faster, and do it with leaner teams. With AlphaSense AI-led expert calls, their TGIS call service team sources experts based on your research criteria and lets the AI interviewer get to work. The magic is in the AI interviewer, purpose-built and knowledgeable-based information to conduct high-quality context-rich conversations on your behalf, acting as a trusted extension of your team. Then they take it one step further. 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I still think that it's going to be very important to take advantage of this transformation in AI and technology. We'll do that through our growth portfolio, through global equities and private equity. I think we're going to maintain that, but diversify the portfolio in some of these areas. You mentioned earlier, retail, sovereign wealth funds, all these new pools of capital coming on board. Do you worry that some of these assets might be overbought and some assets might not even be worth investing in? That will happen, right? As more capital is moving in and you've got to be attuned to the cycle. One of the things that I think we do well here is price assets. I mean, that's the nature of what we do. You guys have insourced that? We have insourced a lot of it, or we have developed strategic partnerships across our set to be able to assess that in better and better ways. But if I look at the second part of our one fund approach, it's really about how can we source, select, and structure the best asset deals that we can across the platform globally, across any different type of asset class. And so part of this journey began with the collaborative model, which was our efforts to bring more of our assets in-house directly. And so today, call it 85% or more than 85% of what we do in the public markets, we do internally. If I looked at the private markets, we didn't think that we had the governance structure to build our own internal Blackstone, KKR Apollo. And so we would rather become the partner of choice and try to achieve similar benefits of lowering the costs, controlling our risks, and essentially developing more value or alpha with these partnerships. And so there are a lot of lessons learned there that are informing our approach for the one fund. And I just highlight three of those lessons. The first lesson is that we didn't really have a track record of generating value above our benchmarks. Today, I can say we do. So if I looked at the last five years, fiscal years, we generated about 9.4% returns per year with about 76 basis points of alpha or 76 basis points above our benchmark returns. And so how did we do that? I think one of the lessons learned with the Cloudman model was that the majority of that was actually the sourcing and the selection, not the cost savings. And today I can say, hey, we saved over $2 billion of fees in the last year of record. We estimated $550 million of annualized savings in the last year of record. But the vast majority of that benchmark meeting came from the team's expertise, their ability to source and select better managers or better transactions directly. And so how did they do that? if we looked at the major areas, one was just this idea of partnering with them, being very opening, whether it be SMAs or co-investments or direct investments or joint ventures or even outright ownership of asset management firms, that will continue. Another area is what we call adjacencies. And so one of the things that we did well with our partners, and I think we need to do more and be more systematic, is that CalSTRS has been good at identifying the next sort of large scalable market with our partners. And so the earlier that we've partnered with them or joined venture with them when they've moved into new areas, we've made it, you know, create a deterministic amount of value for our teachers on that basis. It's a way to answer somewhat of a riddle, which is how do you invest a lot of money and have alpha and not be adversely selected? And one of the answers is you go early and you partner with someone, you put them into a new business line or a new business. And that way you could kind of sustain that alpha without being adversely selected. Absolutely. You know, and it's partnering with them in a bespoke way, as we mentioned. And the other area that we learned is what we're calling or terming platforms. And so because we deploy so much capital in an area, owning part of that organization or even developing revenue shares gets us not only in selecting the best assets, But, you know, it gives us an advantage in terms of sourcing with that partner. But we also partake in the growth, right? And so if we think about this larger supply moving into the private markets and alternative space, if we're able to anchor and also develop businesses together with platforms, then we're also partaking not only in the sourcing and selection, but also the growth of that entity. said another way, best way to be aligned with the general partners to essentially be a part of the general partner. Exactly. Yeah. And so those were two of the components, the cost savings and the alpha generation. One thing that I think will become incredibly important as we move forward in this next decade is control. And by that, I mean risk control. And so if I look at the public markets, I mentioned we have 85% plus direct investing control over those assets. Through our partnerships and these bespoke investments, 65% of our private markets, we estimate that we have that control of risk. What does that mean? If we think about all these transformations, just take AI as one of them, is a company going to win or is it going to lose share based on this transformation in technology? that kind of disruption within a 10-year time horizon today, I can't imagine a person that could say with accuracy who's going to win and who's going to lose, right? And so you need more control to be able to pivot or be more dynamic. And that's what I'm saying is think about it as an option. An option becomes valuable when the environment becomes more volatile, and then you need to strike that option. Especially today, there's this V-shaped recovery. Some of the best trading days are a week or two weeks after the worst trading days. And if you're illiquid, if you're gated up for a quarter, two quarters, you're going to miss, you're going to get the downside, but you're not going to be able to deploy and rotate in. So it's an underappreciated aspect until you gone through a crisis and then you like well what was I supposed to do I can definitively speak about right now the cost savings and the alpha or the value creation This third element there's going to be a time when I start to speak about it because it's going to become increasingly important. This idea of controlling risk within an environment that is changing so dynamically. I want to double click on your fees. I got to interview Steve Kaplan from University of Chicago and he has this Kaplan Shore Index. He answered the question, what is the equivalent of a two and 20 if you were investing into long only hedge fund. And on average, it's roughly a six, 6%, 600 basis points per year. And if you think about that in the public markets, that's just an amazing amount of fees. If a great manager might outperform by 100 or 200 basis points, that means you're starting every year at best minus 400 minus 600. So it is another riddle, which is how did CalSTRS last year, you guys returned 13%. How in the world do you do that on $390 billion? And the answer to that is structural alpha. How do you use your capital in order to drive down fees? And to some people, driving down fees doesn't sound interesting or it's not intellectually stimulating, but dollars and cents, it could have a massive, massive impact. What I loved about how we're implementing our, what you're calling structural alpha, is that we're not taking an additional market risk, right? We're trying to minimize market risk. Essentially, we're taking on more operational risk. There's more complexity in the structures. And so for us, there was a tremendous build out in this, not only in the investment staff, but the entire organization around how do we manage those increased operational kind of complexity risks around it. But we're able to dedicate the right resources and focus. And as we think about the future, I think it's the same element. I don't want to take additional market risks. I want to take sort of more complexity, more operational risk to the degree that we're developing structural alpha and we can mitigate those. It's almost like on one side, you have something very easy, but very risky. On the other side, you have something very hard, but do you risk and you have more control? So you have to pick. Do you want to make it very difficult to do internally in terms of processes or do you want to make it very risky? We've talked about this in the past. You know, I love the mission here. I'm part of it is my wife has been a teacher for over 30 years and all of her friends are teachers. And so that's in my mind as I think about the difficulty, because it's harder to be a CIO that is essentially trying to push through all this complexity. And there's a lot of change and evolution in getting the staff to move in that direction. But we all do it here, my staff as well as myself, because of the mission. We think if we could fund and secure the retirement for over 1 million teachers, I mean, that's something very exciting to wake up to doing that. When I saw your 13% print for last year, I breathed a sigh of relief. I'm like, Scott could go hang out with his wife and her friends and not be worried about being cornered in a brunch or a cocktail party. I always say, I always joke that either Calsters as well or I'm sleeping on the couch. I haven't had to sleep on the couch recently, so that's... That's good. You're good for a quarter. So I previously interviewed your predecessor, Chris Ailman. He's awesome. He was in your seat for 23 years. And one of the things I really double clicked with him on is co-invest and how to do co-invest at scale. We're talking about the structural alpha. Oftentimes, firms like CalSTRS will get zero and zero economics, get really preferred economics. What has worked for you in terms of co-invest and where do you see that evolving for CalSTRS? I mean, this was a journey I remember. I mean, Chris was a great mentor and coach and still is a great friend. I talk to him often. You know, I've learned so much from him when he was here. One of the first projects that he wanted to meet a lead was the collaborative model. And part of that, a big part of that was developing this co-investment program. And so I remember all the way back then, I mean, private equity, we had something like two and a half percent of our portfolio in co-investing. And today it's north of 25%, probably pushing to 35%. But really to develop that, it was all about developing the right experts. and Margot Wirth and others within the team, they did an amazing job of hiring the right folks to come in with the appropriate expertise. She also did a lot of training with the existing team. It was something that, even though it was at 2.5% of the portfolio, it was something we had been doing for a very long time. So we had a lot of internal talent as well. And then being able to take that expertise and really drive that through performance. I mean, I think some of the keys for her is not just sort of one and done, pick five, you know, really significant co-investments, but it was really developing it the hard way, having a diversified portfolio of a lot of co-investments over a long period of time. And they've proven to outperform our LP portion of it. So it's been very, very successful. Those were some of the keys is making sure that, you know, they're hiring the appropriate experts, setting up the right processes internally in the investment decision and their investment committees and then being developing a diversified portfolio and one that you know as I look across as a there there you know there's sort of different hotspots but having a diversified portfolio takes us through those challenges and again it's been an outperforming part of our portfolio that is probably the biggest factor of why our private equity has been outperforming as our co-investment portfolio How much of CalSTAR's secret sauce is the governance? A lot of the secret sauce is the governance. And I'm very blessed to have an amazing board who, you know, we've developed over years upon years, trusted relationship, and they've delegated a lot of the investment decision making to staff, virtually all the investment decision making. And so I think that this has been, you know, a great governance structure, has created a lot of flexibility, but also has helped us evolve over time. I mean, they've been there during the build out of the collaborative model. They've been with us through so many of these elements of our journey. Does that help in recruiting when you're recruiting talent, that governance, that decentralization, does that help you recruit the best? I think it does because what it enables us to do is we have delegated our authority all the way from the top, all the way down to our investment officers. And I think that's noticeable. And so you have so many people that are owning the decision at the right areas, right? Because you want the person who's on the deals to really have the most ownership. And so we have this very highly delegated model of authority, right? And so I get involved when the transactions are significantly large or the partnership is You come in to close a deal. Well, I wouldn't say, you know, like, hey, I just come in and close the deals. But I'm just saying that our delegated model works such that there's ownership up and down the chain. And that's what a great governance structure gives you. It's phenomenal for staff to get that experience to come in and be a decision maker as they approach, you know, partners in the market. the partners know that these are the people that they're going to be helping make the decision rather than it being usurped by somebody at the top What do you think about the evolving space known as venture capital For us it becoming more strategic I mean I think that one of the most more important things for CalSTRS is I look at the venture community and I look at the growth community as it's sort of now bridging between venture and growth. Why it's strategic is because, again, back to this idea that it's never been more difficult for us to look forward and think where the biggest profit pool is going to be developed over the next 10 years. I mean, part of this is the transformation. And so even me as a CIO, I'm very interested in understanding the AI native companies, what large areas are they targeting to try to make more efficient or take over. And so they become more strategic to us because having, you know, direct introductions to follow these AI native companies and understanding the data, you know, the hype versus the actual reality is becoming more important because as we think about this transformation, we have to, you know, distinguish between the two and then be able to value the underlying companies. form of information alpha going back a few months ago, if you knew about the software apocalypse, which not only happened in SaaS, private SaaS companies happened in the public markets, and I'm sure you had some exposure in the public markets. If you knew that ahead of time, you could position your portfolio in such a way to either blunt the damage or even be opportunistic. Absolutely. Absolutely. AI today is not just technology. It's everything, even to the extreme infrastructure real estate how are people going to locate where are they going to live and are they going to live in cities if it's if they have easy commutes and everybody's working remotely all these downstream consequences of AI integrated AI it affects everything in fact it's an interesting thought experiment which is what will AI not disrupt and the best answers I've heard are food baby formulas things like that but there's not many great answers to that question of what will AI not change I think you're Right. And I think this is one of the more important elements to focus on with your private equity partners. A lot of the focus has been on, you know, am I going to get my cash back? When are you going to exit these organizations? But I think the bigger issue is how are they going to use this technology to transform their own portfolio companies? And how are they thinking about their portfolios today? software being a big example, right? Because the private equity industry moved to call it a low amount of software exposure to 20 to 30% today. It's probably down from that given the valuations. As you look at your private equity partners, how are they going to be using this from an operational perspective, but then how are they thinking about their own businesses and portfolios. I'm going to ask you to pick from your favorite children, but not literally, but in terms of asset classes. I love them all. I know you're not supposed to pick sub-asset classes or asset classes, but certainly you have some more favor than others. What do you think is undervalued in the market today in terms of asset classes? And where would you like to see more managers and more opportunities? This question was asked when I joined CalSTRS and I literally did I'd say I love all the classic classes. I do think that if I look forward over the next decade, there's just going to be tremendous opportunity in infrastructure writ large. And so that's energy, energy transition power, and that's all the areas that are going to be facilitating this renaissance in manufacturing, the deglobalization, defense spending, AI, the renewal of the power grid, et cetera. So I think there's going to be tremendous opportunity, but it's also a great time to be invested because it's less correlated. Again, I think you get some protection from inflation, which is going to be an issue that could be episodic. And with the higher and more volatile interest rates, I think your bond portfolio is going to be more correlated to your stock portfolio. If I think about the largest growth for CalSTRS going forward, it's most likely going to be in infrastructure. Last year, as I mentioned, you returned 13% and I believe $360 billion at the beginning of the year, roughly like that. But certainly you made one or two mistakes throughout the year. What were those one or two mistakes and what's the lessons? One of the mistakes we made is we were thinking that the market was making a mistake. So as we were heading into a change in the administration in the beginning of January, we began to position the portfolio defensively because we thought that the threat and the actual movement into tariffs could be dramatically shifting the markets. And so that wasn't being priced in at all. So we began to become underweight equities. we started to move more into bonds and our uncorrelated assets. And that proved to be right, you know, come February and March. But I think the mistake was not getting, you know, back into the markets quickly enough and the veracity of the move up, you know, sometime in March and beyond. We did move up with the markets, but I can't say that we took advantage of it in the sense that we began with this head start of making money on the way down. And I think we didn't lose money overall, but we didn't get back into the markets as quickly on the way up. Timing is so difficult. I've interviewed some of the most famous public investors of all time. And the one thing that they all struggle with is what is the catalyst? How do you predict? You're right, quote unquote, right about the stock. But will the market normalize in a year, in two years? How long is it going to take for other investors to figure out the thesis? And it feels like that is more or less unpredictable. It's just something happens. There's this mimetic second order effect in the market. People start covering it and these stocks rise and fall based on fundamentals, but catalyzed by something that's almost impossible to predict. I've quoted you many times on the podcast, which you, more than anyone that I know, especially at this scale, you institutionalized having a prepared mind for a market correction or a market crash. And you figured out how to get the entire organization behind having this prepared mind because it's so underrated because it's so hard to not be reactive when things happen. It's why, frankly, militaries have war games and they simulate every single outcome. So when it happens, people don't panic and they know exactly what they need to do. you've been able to do that CalSTRS really better than anyone I've seen. Well, thank you. Yeah, I really appreciate that and credit the staff because I know the staff. That was the investment idea of the year in 2021? Yes, that was the investment idea. The investment idea of the year was to be ready for the next market crash, which probably has the highest ROI of any investment you could think of. Yeah, absolutely. So we've done a lot, I think, in the guise of liquidity that would put us in position to do that. And that's become part of our total fund management team. so they've been enhancing our liquidity tools and we've been preparing for having the appropriate liquidity and cash for those purposes but then it goes deeper than that as you know it's about the culture and the investment staff all being unified around this. Well Scott, thanks so much for sitting down with me again and for hosting us here in West Sacramento you guys have a beautiful campus looking forward to doing this again very soon. Absolutely, it's always a pleasure really look forward to speaking to you next. Thank you Scott. Thank you.
