Skewed risk for CalPERS’ absolute return portfolio

The underperformance of the CalPERS’ risk-managed absolute return strategy indicates the portfolio may be too heavily weighted towards macro, currency, commodity or directional risk than the investment committee originally set out to achieve, according to a review by Wilshire.

Wilshire’s annual review of the internally-managed program, while generally positive of the team, process and systems, alerted the investment committee to the possibility of an overweighting to these strategies after analysing its performance and investments.

Wilshire does not have much interaction with the underlying direct investments made by the RM ARS team, however, in 2009 and 2010 it reviewed the list of underlying funds in each of CalPERS’ six funds-of-funds and according to a paper presented to the board “were surprised by the number of “macro”, commodities and currency funds in the portfolios”.

Wilshire says, over the past few years the performance of the RM ARS program has not lived up to the “absolute return” portion of the acronym.

“There is a potentially riskier than anticipated investment selection process – about 20 per cent of monthly returns exceed the bounds of plus or minus 2 per cent. While we would expect a few outliers over a five-plus year track record, 20 per cent seems high. The investment committee should understand the level of risk experience in this program may not be the same as what was anticipated when this program was created,” the paper says.

Performance is negative for the last three years, and below benchmark for the last five (4.2 per cent versus 8.7 per cent), and the consultants says this track record indicates a far greater correlation to broad market movements, beta, than might have been intended at the time of the program’s creation by the investment committee.

“This performance begs the question of the nature of the investments in the RM ARS portfolio.

“Hedge funds come in many flavours, and the fact the performance for the HFRI index was down significantly and then rebounded strongly in virtual lock-step with the stock market should not imply that every hedge fund has equally poor performance.

“CalPERS performance, is reflective of the funds of hedge funds universe in general, but is it reflective of what the investment committee expects of this program?” the report says.

“This raises the recurring issue we have discussed with the investment committee regarding the proper role of RM ARS and hedge funds in the asset allocation process. The performance of the RM ARS portfolio over the last few years has not mirrored global equities or global fixed income closely but it also has not been completely uncorrelated.

“Should RM ARS continue to be an allocation from within global equities or should the allocation to hedge funds be chosen by the investment committee as if it were a distinct asset class?

“The academic arguments regarding whether hedge funds are an asset class or an implementation strategy notwithstanding, the return and risk profile of RM ARS is sufficiently distinct from every other investment within CalPERS’ portfolio that this does merit some discussion.”

CalPERS investment team, together with its consultants, has been looking at an alternative asset allocation modelling. In its most recent classification it has identified five broad asset classes under the alternative classification: growth, income, real assets, liquidity/hedge, and inflation. These five asset classifications were determined in September, and are a refined version of the March classifications which were: growth, income, government bonds, market neutral, inflation-linked, and liquidity.

As part of the review Wilshire visited the two external consultants – UBS in Connecticut and Pacifica Alternative Asset Managament in Newport Beach, as well as the Rock Creek fund of hedge funds in Washington DC.

Beginning in 2009 the consultant reviewed five of the non-US external fund of hedge funds managers on-site. The non-US managers reviewed in 2009 included 47° North in Switzerland, ERAAM in France, Ermitage in UK, PAAMCO, formerly KBC in Singapore, and Visions in Hong Kong.