The year 2010 will go down in history as one of reformation for the $205 billion CalPERS. In this, consultant and enterprise risk management reviews seem small in comparison to the overhaul of the fund’s asset allocation. Amanda White spoke with chief investment officer Joe Dear about the pension giant’s year-long asset allocation study.
A CalPERS investment committee workshop in May, which reviewed its capital market assumptions, marked a turning point in the big Californian fund’s approach to asset allocation.
The fund has embarked on a year-long asset allocation review that is more like a total engine makeover, and arguably one of the most important activities the fund’s investment staff, in conjunction with its board, have undertaken.
Not only is the fund reviewing its allocations, but the very assumptions that drive investments, with the potential outcome not just a tweaking of allocation bands but an entirely new way of investing in assets. In addition, it’s being done in a fully transparent and open dialogue with the board and the public.
“To the maximum extent possible we want to be transparent so our beneficiaries and others can see into the methods, assumptions and processes we’re using to develop the asset allocation,” investments chief Joe Dear says.
“There is no enduring proprietary secret that would be protected by trying to do it all behind closed doors and a lot to be gained by engaging people as much as possible.”
In March the investment committee kicked off the analysis with a review of the role of asset classes, concluding that CalPERS’ current asset class structure was heavily influenced by GDP growth and masked underlying risk exposures.
The recent May workshop engaged the board with a discussion about the underlying capital market assumptions, in an attempt to better understand the drivers of investments, portfolio behaviour and risks.
“The purpose of the May workshop was to explore the issue and engage the board in a more comprehensive way. In the past the board was just given the consensus assumptions and not allowed or asked to weigh in with a view,” Â Dear says.
The outcome of that process was an indicated set of return assumptions considerably lower than the current 7.75 per cent, at 7.29 per cent, a median of the work done by staff and consultants.
As a result of these first two steps, about a third of the way to setting new strategic targets, CalPERS is now running a parallel process with portfolio models built on the standard tools of mean variance portfolio optimisation, but also on an alternative factor model identified in March.
“One’s the fail safe, the classic method. The factor model is to try and do something to improve upon the asset allocation toolset,” Dear says.
“The factor modelling is to try and get a better grip on risk and account for some of the more extreme events that are possible.”
In this model, the CalPERS investment team identified six factors and about 11 security types or building blocks.
In this alternative asset classification the factors are government bonds (which includes government nominal and inflation-linked bonds as the building blocks), income (investment-grade debt, securities lending and credit enhancement), growth (public equity, private equity, real estate and high-yield bonds), inflation-linked (infrastructure, forestland, commodities), market neutral (absolute return), and liquidity (short-term fixed income).
“It is clear from recent experience that having a portfolio of equities and corporate bonds turns out to provide little by way of diversification if there is a major slowdown in economic growth, so economic growth is a risk factor,” Dear says. “We are trying to understand more generally the difference between real diversification and apparent diversification.
“The other issue people are aware of is the tendency of correlations to converge during times of stress, so you can model that by making certain prescriptive assumptions or you can try to build factor models that attempt to lay that out. And then the risk issues, do you want to design portfolios that have a maximum loss and see what happens there.”
The likely outcome is the CalPERS investment portfolio will move to this model, but Dear is hesitant to put any particular deadline on that move.
“I’m sure we’re heading that way, but what I can’t say is are we going to complete all that work so we’re ready to commit the organisation to a significantly different asset allocation methodology in 2010. That’s why we’re doing both. But we are devoting a considerable organisational effort. If we adopt that method, terrific, we’ll refine it, if we don’t finish the work to the level at which we’re comfortable implementing it, we’ll keep working it till we and our board are there,” he says.
He likens the move to the way a number of the large Canadian funds allocate with risk being the driving force of capital distribution.
“We’re moving to a risk-based asset allocation system, making allocations based on risk and not on asset, and then tying together shorter term decisions and even compensation to this risk-based, risk-budgeted system.”
Under this methodology, allocations to fixed income can rise compared to the type of investment by asset buckets that CalPERS does now. But Dear says it remains unclear whether there would be any increase to fixed income.
“In the factor model, fixed income falls into various buckets depending on whether it is corporate, mortgages or high-yield. It’s possible the overall allocation may increase but I genuinely don’t know. In my job, I’m sort of the last one to decide,” he says.
In this framework, there are applications of the risk parity approach to investing, Dear says.
“Are we likely to lever the whole bond portfolio? I seriously doubt it,” he says.
In more conventional terms CalPERS is moving to a higher emerging markets allocation, with allocations now mirroring the world market capitalisation, consistent with its move to a global equities allocation two or three years ago.
“There’s the question of whether to overweight emerging markets because we anticipate better growth over the long term, and then we immediately ask the question of what’s the right entry point. That’s what we are looking at. We’re asking the question: do you overweight emerging markets?” he says.
In addition to spearheading the asset allocation review alongside senior investment officer Farouki Majeeed, Dear, who has only been at CalPERS for 15 months, is pursuing other initiatives to make his mark on the organisation.
A drive towards transparency and the full participation of stakeholders have been enduring qualities of his career (see Theresa Whitmarsh’s article Building Value and Reputation with Stakeholder Management: The Case of Washington State Investment Board) and that continues at the large Californian fund.
“I accepted the appointment at CalPERS looking for a professional challenge, and I’m grateful I’ve found so much of it. It’s a great job, I have no complaints, I really enjoy it,” he says. “I want our beneficiaries to say I’m not worried about CalPERS, I’m confident. We’re working hard to keep that trust and grow it.”
Similar to many CIOs at US public pension funds, Dear is restricted by a “no growth budget” but his focus on the efficiency gains made by bringing down the costs of investment management is allowing for the redeployment of staff.
“I don’t feel limited at this stage,” he says. “We can demonstrate we’re managing costs as aggressively as we can, we’ve had some success there. Last month we told the board we had targeted $50 million of recurring savings in a plan to be done by early May, and we hit $100 million. We’ve taken out $120 million of costs, effectively 10 per cent of our entire spend, so I think that’s material,” he says.
A large component of those savings have been in hedge funds, through renegotiation of fees and better terms on new funds, as part of the three pillars initiative which saw a restructuring of the portfolio in 2009.
“In hedge funds the idea of better alignment of terms, greater transparency and flexibility to move our funds was something they understood. We don’t begrudge a manager making a lot of money, as long as we do too at the same time.”
Now he says there is more that can be done in private equity. Private equity and infrastructure are two investment areas where CalPERS will focus in the future.
“I hope to grow the size of the infrastructure team, but that will be another budget,” Dear says.
The fund manages 70 per cent of its global equities and 95 per cent of its fixed income assets in-house, with the remainder being externally managed.
“We won’t be developing in-house standalone private equity or real estate functions, but we are building up our capacity for co-investment and direct investment in infrastructure, and co-investment in private equity, so we’re trying to strengthen our capacity in those areas.”
The fund recently announced it would take a 12.7 per cent stake in London Gatwick Airport. The $155 million investment is the first direct-style investment in its infrastructure portfolio, which makes up about 1.5 per cent of the total fund.
Dear believes the asset allocation is only part of the equation to good pension fund investment management, and the art of investing, through processes and judgment, needs attention in a world without an exact science.
“This is one of the arguments for a highly visible process so that there’s lots of debate among staff, and with staff and the board, to try and get these issues out, so we do the art along with the science,” he says.
The fund has also revised its pay policy, so the board has some discretion to eliminate incentive payments in years of negative performance by the fund. Dear says this will help create greater incentive to collaborate between staff and the board.
In July the board will hold an offsite with outside experts presenting new approaches to asset allocation practices, then conduct an asset/liability workshop in November. It is expected the investment committee will review and finalise new strategic asset allocation targets and ranges in December.
|CalPERS’ investment portfolio as at April 30, 2010
|target allocation (June 2009)
|Global fixed income