CalPERS made history last week after it became the first US pension fund that has took on a total portfolio approach (TPA). The change, approved by the board after months of internal deliberation, is another mark of chief investment officer Stephen Gilmore, who before joining CalPERS was the investment head at NZ Super – one of the most prominent TPA adopters alongside Canada’s CPP Investments and Australia’s Future Fund.
Yet some US public pension funds doubt if yet another acronym to label something they should already be doing is entirely necessary. Like Ben Cotton, chief investment officer of $80 billion Pennsylvania Public School Employees Retirement System, founded in 1917 and one of America’s oldest pension funds.
“It’s interesting that we need a new acronym to help us focus on what should be common sense,” Cotton tells Top1000funds.com in an interview from PSERS’ Harrisburg office. He joined the fund in 2023 from overseeing retirement benefits in the motor industry, recruited as a safe and experienced pair of hands to shore up internal controls and governance after PSERS had reported an inflated investment performance in 2021.
“A lot of allocators have made the mistake of being too siloed and segmented, whereby rather than make decisions in the context of what is best for the whole portfolio, they make decisions focusing more on each different allocation. I have tried to approach investments more holistically my whole career, and adding an acronym doesn’t make it a new strategy.”
Cotton views TPA as allocating in accordance with the opportunities in front of him, and says PSERS has allocation targets with embedded leeway that already allow a conscious decision to overweight or underweight. Moreover, the board have always delegated to the investment team on rebalancing decisions and asset allocation adjustments within the context of the strategic asset allocation.
“We [always] ask ourselves if we are making decisions that complement the whole portfolio or if we are making decisions that just maximise a silo in isolation. The former is the better way to go,” he says.
PSERS is close to its target asset allocation, apart from a slight overweight to cash and underweight to long-duration fixed income. Positioning away from the long-term strategic asset allocation requires high conviction and in today’s climate, he argues that conviction is thin on the ground. “You need a high conviction to stray off your long-term plan, so in the current environment we’ve got closer to our targets as a result.”
He points to the recent decision to axe PSERS’ remaining 5 per cent allocation to leverage as a typical example of the investment team’s ability to adjust to an ever-evolving market environment.
“When cash is close to zero and the cost of leverage is zero, over the long run the risk premium you pick up with a modest amount of leverage is additive. But once you hit the point where the cost of leverage is as high as the risk premium you pick up, it starts to introduce undue uncertainty, not only in return expectations, but also liquidity needs.”
The decision to drop the hedging strategy also shows Cotton’s holistic approach in action.
For the last 14 years, PSERS has hedged around 70 per cent of its FX exposure to developed markets in a “winning” trade that has both reduced volatility in the portfolio and enhanced returns. But the Trump administration’s reshoring policies have turned the tide on the strategy: a cheaper dollar, he explains, makes it easier to onshore assets and ensure goods made locally in the US are more competitive with those from abroad. “On balance, we decided we’d rather not have that currency hedge,” he reflects.
He adds that removing the currency hedge has not increased volatility in the equity portfolio and is a strategy other funds are now also adopting. “Most of our peers in the public space were not hedging to start with, and of the few who did, we know of one that recently went to zero just prior to us.”
The value of liquidity at the fund, which is only 64 per cent funded, has also informed his decision to axe the strategy.
Paying out on hedges and settling on derivative positions should the currency move the wrong way requires cash and creates transaction costs, he explains. “In a period when we are concerned about our liquidity profile, we want to keep surprises at bay.”
It leads him to reflect how the funded status informs other decision-making too – namely forcing a level of risk and a larger appetite and tolerance of uncertainty. A strong funded ratio gives investors more freedom in how they approach the market, but pension funds with large deficits are compelled to take a minimum level of risk.
“Our funded ratio limits our options and opportunity to de-risk in light of uncertainty because de-risking exposes us to inflation at the same time as we are paying out cash to meet our liabilities,” he explains.
Keeping private markets within target
Liquidity has also played into Cotton’s firm cap on PSERS’ 30 per cent allocation to private markets which he says would have ballooned overweight if historical pacing models had been maintained.
The allocation, comprising private equity, real estate and infrastructure, was 8 per cent overweight when he joined but moderating pacing, combined with a more selective manager approach and selling off older assets, has kept the allocation in check.
“If we had blindly followed our pacing model in private markets based on historical experience, we would be significantly overallocated,” he says, adding that the team also struck it lucky when it came to re-investing money garnered from selling private assets in the secondary market.
“We sold certain private assets into the secondary market on average close to par and at a good clearing price. It helped us beef up liquidity and freshen our private markets book. We were also able to reinvest the proceeds into the April drawdown, so when we put the money back in the market, it was a fortunate time to be deploying into equity markets.”
Although private markets account for an ever-increasing portion of the investable market, his outlook for alternatives remains cautious because of the cost of capital and stop-start distributions. “The cost of capital is much higher, so to make it work, investors want to buy private assets at a lower price. We are seeing things improve, but distributions are still challenged, and activity is a lot slower than historically.”
He is also mindful of fees – even though PSERS rarely pays 2:20. “Our fee load is closer to 1:11 across private markets. This is not just because we are strong negotiators but mostly because we take advantage of our scale and lean into relationships.”
Rebuilding the trust
Rebuilding the trust and connection between PSERS’ investment staff and the board has been a key focus since he joined.
His efforts have focused on increasing transparency and reporting, particularly around investment management fees, and improving the context in which the investment team provide information to the board. Cotton says that information in and of itself does not amount to transparency – information needs to be presented to the board in context.
“It’s about providing the information that helps answer [their] questions.”
In a benefit that now reverberates throughout the entire fund, trustees have begun to delegate decisions to the investment team, increasing efficiency.
“Up until recently, we had to bring approval for every GP commitment to the board, even when we were re-committing to long-term relationships. Now our policy provides for delegation approval for mandating certain existing relationships to the investment team, and it has started helping us be more efficient on investment decisions,” he says.
