Fixed Income

CalPERS prepares for market dislocation

California Public Employees’ Retirement System’s CIO Ben Meng is preparing for a market dislocation by ensuring the $354 billion pension fund has enough dry powder on hand to take advantage of a drawdown.

Speaking during the fund’s June board meeting, Meng stressed the importance of sufficient liquidity ahead of the “probability of a large drawdown” in a session that included expert commentary on the importance of the pension fund’s 28 per cent fixed income allocation.

In the second of a new series of education sessions for CalPERS 13-strong board that includes three new members, the CFA Institute’s Jeffrey Bailey explained bonds’ low risk, liquidity and counter-deflationary benefits in a detailed analysis that served to highlight the predicament facing America’s largest pension fund.

Despite bonds’ solutions to today’s challenging markets, grindingly low yields (set to go lower still following the Federal Reserve recent signalling of cuts later in the year) mean buying them won’t close the fund’s 71 per cent funded gap or meet its 7 per cent hurdle rate.

In the absence of high interest rates, buying bonds isn’t an option,” said Meng.

Drawdown around the corner

Drawdowns typically follow in the wake of recessions and come every ten years in a pattern characterised by six or seven “good” years followed by “two or three” bad years, said Meng who was deputy CIO at China’s $3.2 trillion State Administration of Foreign Exchange before returning to CalPERS as CIO in January where he served seven years from 2008. That tenure turned into a front-row seat to the financial crisis sending the fund plunging 24 per cent.

“Most people are implying that the next drawdown is near; it’s coming,” he said.

Meng said his priorities are making sure CalPERS can pay all its bills – the pension fund paid out $22.9 billion FY2017-18 in pension benefit payments – and ensuring it has the dry powder on hand to take advantage of opportunities via a “proactive and comprehensive” liquidity management action plan, something Meng turned his hand to on “the first day” he started back at CalPERS.

The investment team have also set up a “real time scenario analysis” and plan to update CalPERS’ investment policies and guidelines to facilitate a response.

“The policies and guidelines are for normal times, not for times of crisis,” said Meng.

Low for long

Low bond yields have forced pension funds to hunt for higher risk assets outside bonds, particularly private equity, said Bailey, an allocation CalPERS is aiming to develop in an expanded strategy.

“The yields are just too low. If you went back to the 1990s, the standard asset mix was 60/40, everybody would talk about 60/40. And today no one talks about 60/40. It just doesn’t generate the expected return that people like to plug into their calculations.”

Low fixed income returns aside, in a prospect vice chair of CalPERS board Theresa Taylor referred to as “scary” for the fund’s 1.9m beneficiaries, Meng said that based on capital market assumptions (CMAs) for the next 10 years the pension fund is expected to return 6.1 per cent on average, below its 7 per cent target.

According to the pension fund’s new strategic asset allocation adopted in July last year, assets are split between global equity (50 per cent) fixed income (28 per cent) real assets (13 per cent) private equity (8 per cent) liquidity (1 per cent)

Bailey also warned the board about fixed income benchmarks, stressing the importance of monitoring the appropriateness of the benchmark for any individual investment manager given that managers, assigned a particular niche of the market to operate in, tend to gravitate towards more risk inside their investment mandates.

Over the long run, higher yielding assets hopefully produce higher returns, however that doesn’t necessarily mean the benchmark is appropriate for that particular manager, he cautioned.

“If you had taken more risk than the benchmark, should you be scored in a positive way? One of the big questions that I think staff have when they deal with investment managers is how they keep an eye on the investment guidelines associated with that manager. Not always easy.”

For CalPERS board member Margaret Brown, setting the right benchmarks for internal staff to avoid “riskier bets” is also a concern.

“We have benchmarks for our investment staff and they earn bonuses based on surpassing benchmarks. I want to make sure that when we set those benchmarks, we’re taking risk into account,” she said.

Dry powder

Bailey also referred to the deflationary hedge benefits of high-quality bonds.

“If there ever was deflation, fixed income would be the place to be,” he said, noting that after a decade of economic growth the prospect of deflation has faded to the back of investors’ minds, yet the risk is evident in the negative government bond yields in Japan and some European economies.

Liquidity management is another key reason to own fixed income, he said. High quality bonds can be bought and sold at almost no cost making it a low-cost way to manage liquidity and its fungibility makes it easy to sell if needed to rebalance equity positions.

“If there was a significant equity market drawdown it would be easy to sell high quality fixed income and invest back into equities.”

Taking lower risk is always going to result in lower returns. But taking higher risk doesn’t necessarily mean higher returns, he said, concluding with a warning that the next downturn will reveal where higher risk strategies have worked.

“I think the ramifications of taking higher risks are only going to be clear on the next major downturn. At that point, we’ll find out how those strategies have worked.”



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