A consistently low allocation to private markets, too little exposure to growth and a damaging decision to jettison a home bias in favour of poorly performing international equity have been some of the key contributors to CalPERS weak historical performance relative to peers. Speaking during the latest board meeting in an especially carved-out agenda item, new CIO Nicole Musicco put her stamp on the giant pension fund, laying out errors of the past and her plan for the future.
A hypothetical benchmark composed from peer funds’ performance over the last ten years sheds light on where CalPERS has persistently underperformed. Between July 2014 and July 2018, America’s biggest pension fund lagged peer funds in the index by 2 per cent with most achieving hypothetical annualised returns of 7.6 per cent compared to CalPERS 5.6 per cent.
The reason, she said, was the fund’s over-prioritisation of downside risk. “We constructed a portfolio to limit the downside and with that missed out on a big chunk of growth,” she said. “This is a hypothetical portfolio of peer funds, but the messaging is consistent.” With assets of $439.6 billion, down $30 billion compared to June 2021 and having just posted the lowest fiscal return since 2009 at -6.1 per cent, Musicco stressed it was time to act.
Private markets PAIN
CalPERS consistent failure to allocate more to private markets is the biggest single cause of the poor performance relative to peers. “The private markets programme is the problem,” she said. CalPERS failure to consistently pace capital deployment in private equity – and private markets more broadly – between 2009 and 2018 resulted in the portfolio missing out on between $11-$18 billion in a lost decade.
Still, Musicco insisted the future is bright and that CalPERS can make up for lost time. Many asset owners are currently overallocated to illiquids, but CalPERS, late to the game, has room to invest more. “It’s an excellent time to go into private markets,” she told board members.
This could manifest in an opportunity to backfill and pick up secondary buys. The current environment will also play to CalPERS strength in value investments given today’s focus on traditional corporate metrics like cashflows and margin. CalPERS in-house private equity team is thoughtful, agile, well governed and increasingly sought-after for its ESG expertise. She pointed to a list of excellent partners and CalPERS own, growing reputation as a decisive partner, quick to “give a yes or a no” that will help build out the co-investment programme. “We are in a position to become the first call and invest in needle-moving opportunities from a scale perspective.”
Musicco’s historical analysis highlighted another painful mistake: abandoning the home bias. Some years ago, in a bid for diversification, CalPERS ploughed into international public equity. Relative to peers who maintained a home bias, that decision backfired. A source of consternation for board member Theresa Taylor who recalled questioning the decision at the time. “I asked, ‘how come we are overweight international’ and I was brushed off,” she said. “We stayed that way, even though we returned poorly.”
Elsewhere, CalPERS’ factor-weighted segment, added to the strategic asset allocation in 2018, has proved problematic. Designed to reduce the beta exposure in public equities and avoid excess volatility, it has come at the expense of important upside growth. “For an extended period of time, the active strategies have not been working,” she said.
CalPERS historical over-emphasis on downside risk has coupled with the fund not getting paid enough for the risk it did take. Turning the conversation to risk return, Musicco said CalPERS’ frustrating sharp ratio proves the fund has not got the return on risk it should have.
For example, CalPERS wasn’t sufficiently rewarded for its riskier real estate investments. The portfolio is portioned between core, opportunistic and value add, but the latter, riskiest allocation, didn’t always result in expected higher compensation. In recent years CalPERS has transitioned the portfolio back to core whereby the opportunistic and value add allocation (a combined 10 per cent of the portfolio) is dominated by legacy investments.
She said it was still too early in her analysis to clarify for sure if CalPERS had taken on more or less (unrewarded) risk than peers since this would depend on asset class analysis. Still, she said “in general” the fund had taken less risk overall and been paid less for the risk it had taken.
Going forward, Mussico will devote much of her attention to ensuring CalPERS gets sufficiently rewarded for the risk it does take and leans into active risk to fully grasp the value creation inherent in an active programme.
Rebooting active management will involve reviewing the risk budget, deciding what the pension fund needs most from its active programmes. At its heart it requires a cultural shift whereby the investment team are held accountable, but also empowered to take risk, backstopped by innovation and resilience.
“My hope is that we are going to get more focused and accountable regarding active risk,” she explained. “The next chapter of my first year will go on developing the right tools and culture for risk taking. I don’t want us to fear risk taking; if you’re punished every time you won’t be motivated or incentivised, but we also need to get the appropriate level of return.”
She is not just rebooting CalPERS approach to alpha in the equity book. Active risk budgeting will span the whole portfolio, targeting every opportunity to generate value-add dollars. “When we transition to the next phase I want to look at how we apply our entire risk budget across different strategies; how we set metrics, if we are being paid and held accountable. Our behaviour and culture are not focused in this way. Rather than beating the benchmark I want to look at where we are adding dollars to pay benefits.”
Musicco also stressed the importance of consistency in the investment process. Pulling out of the private markets programme hurt CalPERS dearly, she said. “It doesn’t serve us to come in and out of programmes.” It’s why she will particularly focus on governance and decision making, avoiding stop-start decision making and ensuring the board thoroughly vet the consequences of both investing but also frequent changes in strategy.
This, combined with a philosophy that goes beyond just setting a SAA and pressing the button. She also espoused the importance of a sufficiently robust governance to allow agile decision making that is visible to all investment partners “We need the tools in place to act, rather than just wait it out,” she concluded.