CalPERS’ outperforming internal corporate governance investments program will be challenged by the fund’s new capital allocation model, according to a review of the program by consultant Wilshire.
As part of its regular review, Wilshire said the three main issues facing the program are the new capital allocation model, the alignment of interests between CalPERS and the program managers, and the outlook on where activist strategies can best add value.
The corporate governance investments program is highly concentrated with a high level of volatility, which would be challenged by the new capital allocation model which is focused on balancing the expected risks and returns of the total equity portfolio based on expectations about the nature of a given portfolio’s future returns.
In its current state, the capital allocation model cannot easily process the nature of the corporate governance investment program’s managers.
“The capital allocation model would choose to eliminate each of the corporate governance investment program’s managers, despite the significant value added by the program over the long term,” the report says.
Wilshire believes that staff should work to find a way to incorporate the corporate governance investments program into the capital allocation model and has suggested using the risk and return characteristics of the entire program as a solution, rather than manager by manager.
The second challenge to the current manager lineup is the focus on alignment of interests between the interests of the external managers and the fund.
Much of this work is around lowering asset-based fees and implementing fees for meeting or beating appropriate performance objectives, improving the liquidity of the investments (such as shortening or eliminating lockups), and ensuring that fees are paid on investment capital only rather than committed capital.
“This process is ongoing but could result in changes to the manager lineup as those firms that are unable or unwilling to meet CalPERS’ terms will likely be terminated. Clearly any new manager will have to agree to terms such as those that are being examined with existing managers.”
The third challenge is a response to evidence that indicates activism may be more effective in less efficient markets. While those markets, such as small-cap and less developed, may present opportunities, there may be fewer qualified managers operating in those markets.
In addition if, for example, the program were to transition to small-cap emerging markets only, the internally managed index fund would likely need to be underweight small-cap emerging markets or the overall equity portfolio would end up with an obvious bias, Wilshire says.
“Again this draws attention to the fact the current version of the capital allocation model cannot incorporate the corporate governance investments program in its analysis.”
As a result of these three issues, new investments, both with external managers and co-investments, are on hold.
The program has outperformed in the past 10 years, adding 5.2 per cent of value on an annualised basis versus the program’s benchmark, and 4.8 per cent of value versus the total global equity benchmark over the same period.
Wilshire’s score on this strategy was 73 per cent or 220 out of 300. This was slightly higher than last year’s score of 218, but the largest detractors remain turnover of senior level staff over the last few years, and the program’s inability to own equity in the program.