- Sovereign wealth funds are inherently diversified from public equity, and Peter Madsen of the Utah SITFO encourages all investors to rethink the role of equity in their portfolio allocations.
- An extended time horizon shows the benefits of alternative investments. U.S.-based investors are particularly susceptible to a biased perception of stock market gains.
- Private credit and trend following are among the convex investment strategies that outperform benchmarks in periods of high volatility.
How do you allocate a multi-billion-dollar sovereign wealth fund? The view is usually long-term, but many of the strategies can apply to hedge fund managers and personal investors as well.
Diversification is the name of the game according to Peter Madsen, Chief Investment Officer of the Utah School & Institutional Trust Board Funds Office (Utah SITFO). “There are plenty of opportunities to generate equity-like returns,” Peter says, without putting everything into one basket.
Peter and his team manage about $3.5 billion in assets through land management and a financial portfolio. While not quite on the scale of national funds in Norway, China or the Middle East, the Utah SITFO is one of the few state-run sovereign wealth funds in the United States. Founded in 2015 with public lands, the Utah SITFO was allowed to diversify its holdings under a state constitutional amendment the following year.
To dive into the fund’s strategy, Peter joined host Alan Dunne for a Top Traders Unplugged Allocator episode about risk management, strategic planning and the pitfalls of over-relying on equities. It starts with a fresh perspective on investment goals.
Understanding the sovereign fund
The Utah SITFO exists for the benefit of public education. In 2023, the state’s public schools received a $101 million distribution for purchasing educational resources and hiring classroom aides. As with most endowments, the fund aims to keep its principal intact so it can generate returns in perpetuity. This leads to certain fund management constraints. In particular, the Utah SITFO can’t spend or distribute new contributions to the financial portfolio.
“We need to be mindful of volatility,” Peter explains. “Earnings are free to distribute or use for expenses, but not the corpus.” While the land management side of the fund aims to optimize and maximize revenue, the financial portfolio seeks to avoid unnecessary exposure.
Unlike a typical private hedge fund that measures performance against peer benchmarks, Peter’s fund focuses on a “CPI plus five” outcome, referring to a return 5% higher than domestic inflation as measured through the Consumer Price Index.
In some respects, it’s a modest goal. Compared to more risk-tolerant funds that chase double-digit annualized returns, the Utah SITFO’s strategy is a low-risk, low-volatility setup designed to win the long game. To accomplish this, the fund uses a defensively-minded allocation.
Strategy diversification
“When we run through our asset allocation every year, we do it as more of a stress test and thought exercise than actually looking to change what’s supposed to be a long-term target,” Peter says. The fund works with consultants and independent researchers to monitor industry trends and capital market assumptions to keep a stable distribution without breaching the investment corpus.
The fund tracks broad categories of growth, real assets, income and defensive investments with a low risk profile. “The defensive [allocation] has volatility, but it’s meant to not have [much] equity beta,” Peter notes. This includes cash, TIPS (Treasury inflation-protected securities), Treasury bonds and managed futures. Utah SITFO’s risk assessments include mean-variance optimization and a broader analysis of liquidity and inflation regimes.
In terms of real assets, Peter says, “We look for either short-duration contracts or exposures to inflation, as well as commodity exposure.” Again, while this includes some volatility, the mindset is to stay short on duration in order to hedge risk.
Even relative to many endowment-type investors, the Utah SITFO is low on equity beta. Alan asks, “Is that primarily driven by a concern around drawdown and the desire to deliver a more consistent return profile?”
For Peter, it’s simply a desire to diversify outside of equity. “We just don’t feel that it’s super important to load up on either public equity or private equity. The moderate amount of both is sufficient,” he says.
To be clear, equity is still the primary driver of risk in the portfolio, and 43.5% of the total allocation is given to growth assets (30.5% in public equity, 13% in private equity). But Peter takes a broader perspective on investments than a classic 60/40 allocation of stocks and bonds, a philosophy informed by a macro view of time horizons.
The test of time
For perspective, investment strategy predates allocating funds into a neat split of public equity and government-issued bonds. The Land Ordinance of 1785 designated a portion of each new U.S. township for public education — giving a land management portfolio strategy more than 150 years before the modern hedge fund.
“When you look back through longer periods of time, or just open your mind to what might be possible in the future, you’re not necessarily relying on any historical analysis,” Peter says. “You can make some assumptions that pretty easily look at different types of macro regimes.”
Many market analysts are predicting high inflation, high volatility for several years amid a sort of reset in the global financial system and prolonged geopolitical uncertainty. Debates continue about the wisdom of the 60/40 portfolio with all eyes on central banks, awaiting their next move on interest rates.
“Meanwhile,” says Peter, “there are lots of quality strategies that have some kind of carry or some kind of income associated with them.” Alternative investments, including real estate and commodities, can offer reasonable certainty in an otherwise chaotic financial environment, especially when considered over a long time horizon. For a sovereign wealth fund, that timeframe is often closer to 50 years than five — it’s truly building wealth for the next generation.
What about public equity?
And there’s the rub — not every investor has access to a multi-billion-dollar land management portfolio or, as is the case for other sovereign funds, a healthy stream of royalties from oil and gas. For those without the resources to expand heavily into alternatives, Peter agrees that a 60/40 or 70/30 portfolio could still be an effective allocation for positive returns. Yet he challenges all investors to consider their baseline assumptions about public equity.
“The number of public companies is shrinking,” Peter says. “As the economy grows more broadly, it’s more in the private markets.”
It’s not an easy trend to spot with big-name, tech-sector IPOs dominating headlines in the 2020s, but it’s true — the number of exchange-traded public companies has dropped by more than 50% since 1996. This makes it harder for investors to diversify with public stocks alone.
As access to private equity markets expands, many investors are seeking diversification outside of public exchanges. As global economic uncertainty remains high, cash reserves, income generation and defensive assets are popular choices for investors pulling money out of public equity. But especially for U.S.-based investors, alternatives often require a mental recalibration.
Removing the home bias
It’s practically a truism — given time, the stock market always goes up. 2024 is already off to a red-hot start with the S&P 500 index hitting all-time highs despite sustained inflation and the Fed’s hesitation to lower interest rates.
For allocators, of course, the question should be whether the stock market offers the best rate of return available. With the New York Stock Exchange and Nasdaq far and away the two biggest exchanges in the world, it’s natural for U.S.-focused investors to go heavy into stocks. Peter calls it a home bias.
“When you’re in the U.S. and U.S. markets have done so well from an equity perspective, you think the need for diversifiers is less important.” Historical analysis and backtesting may overemphasize public equity at the cost of seeking growth opportunities in the private space.
As part of its diversification strategy, the Utah SITFO invests across the spectrum of direct lending and performing credit. The fund favors loans to smaller companies with strict covenants in order to limit downside.
“We also invest in capital solutions or special situations type funds where they are to help out a stressed company,” Peter adds. A distressed business creates an opportunistic position that can benefit quickly if the company turns around.
Alan asks, “Are you in any way worried about something systemic [like volatility] in the private credit space?” But for Peter, it’s not a risky move at all. If anything, it’s a risk reduction.
Trading contrarian
“When we put that portfolio [of private credit] together, we’re trying to find strategies that have that convexity early on,” Peter explains.
An investment strategy is convex when it outperforms a benchmark at both extremes of a spectrum. Should the global markets crash and plunge into a recession, distressed assets have a smaller downside than major index funds and will potentially lose less money. If, on the other hand, the company is successful and the private loan generates an outsized return, the gain will likely beat the stock market average.
In this case, global volatility helps create convexity through trend-following strategies that buy on the upswing and sell in a downturn. Trend following doesn’t necessarily hope for extremes, but it can position portfolios well in periods of economic uncertainty.
“Macro tends to include some momentum trading, and sometimes it can be quite contrarian,” Peter says. But he does predict overall returns to stay competitive with forecasts from current capital market assumptions.
“I think you can expect a 6% or 7% return from a portfolio of trend and macro managers over the next ten years or so. That’s a reasonable, if not optimistic, assumption for global equities as well,” Peter adds.
Choosing a manager
For those interested in alternative asset allocation and trend following, what’s the best way to choose a fund manager? Peter advises looking for firms that mitigate behavioral bias and aren’t overly reliant on one primary decision-maker. Additionally, recent performance shouldn’t be the sole deciding factor.
“We [at the Utah SITFO] try not to look at if they’ve had good performance over the trailing three-, five- or seven-year period. We look at what the distribution looks like, or strategy type, and how it benefits the portfolio,” he says.
A sound long-term strategy could underperform a benchmark in any given year. With a long-term time horizon, the focus should be on a strategy’s growth potential and relative risk. Perhaps a manager who has underperformed in the last twelve months will outperform peers in the next few years due to better positioning.
In any case, a successful manager should be unafraid to challenge assumptions, and be open to having their own ideas challenged without feeling criticized. Whether you possess the resources of a sovereign wealth fund or you’re a self-taught retail investor, Peter adds, “being intellectually curious is probably the most important thing.”
For anyone stuck in a single investment framework, there’s no better time to challenge your own bias and explore something new.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.