CalPERS manages outsized equity risk

California Public Employees’ Retirement System investment staff are concerned with the level of equity risk in the portfolio. This week, they warned it was greatly exposed to equity downturns and said they would be closely monitoring and managing the active risk for the first time.

At the CalPERS investment committee meeting this week,outgoing chief investment officer Ted Eliopoulos said attribution analysis of the fund’s fiscal-year return of 8.6 per cent revealed the need to review the level of active risk throughout the portfolio.

He said the investment office had developed total fund data and governance architecture and the focus for the next two years would be decomposing the level of active risk taken within the various asset classes.

“We will be measuring active risk and coming to some conclusions about whether we are being rewarded for the active risk we are taking, and make some shifts within the portfolio to pursue programs and efforts where we are being rewarded for active risk taking and avoid those where we are not,” Eliopoulos said. “We can now isolate more specifically the investment decisions that are made in a given year, and it’s quite complex and complicated to do that.

With all the work we have done on the data and governance side, we are quite confident we can review the allocation decisions and sub-factor decisions that are made.”

Chief operating investment officer of the $335 billion CalPERS, Elisabeth Bourqui, said the next step in the active risk assessment would be to “construct agile decision-making” and to develop the ability to compare the different levels of active risk.

“Another great step is to construct a data strategy to be quite agile about our own understanding and overview,” Bourqui said. “This goes with different notions of risk that are being taken. One notion is the return and asset risk, but another part is to understand what this looks like from a funding ratio perspective and what active risks are contributing to that. We will put the active risks together with the funding ratio and come up with a way to measure the levels of active risks and how the funding ratio will evolve over time with that. Then, if needed, we can implement some measures on the active-risk side that would affect the downside of the funding ratio.”

CalPERS board president Priya Mathur espoused the move to review the active risk.

“I’m very glad we are going to be doing an active review of risk taking across the asset classes,” Mathur said.

Exposed to global equities

An assessment of CalPERS’ portfolio shows that the biggest risk for the fund is a severe drawdown in global equity markets. The average weight to public equities over the last five years has been 52 per cent, the allocation now sits at 48.4 per cent, and the fund also has a 7.7 per cent allocation to private equity.

The fund has a 55 per cent capital allocation to growth assets, placed in public and private equity, managing investment director, asset allocation/risk management, Eric Baggesen, said the risk contribution from those two asset classes represents almost 85 per cent.

The investment committee heard how exposed the portfolio was to drawdowns in global equity markets.

“With our current asset allocation, if the events of the early 2000s – the tech crash or the financial crisis – were replayed, we would be seeing drawdowns of $80 billion-100 billion,” Baggesen said. “There would be a fairly significant effect on the funding ratio if those events replayed themselves. The portfolio is exposed.”

It was estimated such a loss would leave the fund 50 per cent funded, down from its current position of 71 per cent.

Not only is equity risk the biggest for CalPERS, but also the fund’s equities exposure hasn’t added any value – actually detracting 19 basis points from the total portfolio in the year to June 30.

Not surprisingly, given the fund’s asset allocation, Baggesen showed that the portfolio is driven by growth assets and the fund’s performance is closely tied to the equity market.

The key return drivers of the portfolio over the year to June 2018 have been real assets, allocation management and fixed income. In the last year, both public and private equity have decreased returns, accounting for -19 basis points and -17 basis points, respectively.

Similarly, over five years, private equity has detracted 25 basis points from returns; with the drivers of return over this period being fixed income (13 basis points) and public equity (3 basis points).

While Bourqui said the portfolio’s underperformance of the benchmark by 6 basis points was acceptable, it was disappointing.

The loss was due to country positioning in emerging markets and an overweight position to value-tilted strategies in global equities.

“This meant, in the US, we were underweight the mega-cap tech stocks such as Facebook, Amazon, Netflix and Google.”

CalPERS manages its global equities portfolio using factor-based strategies, and Mathur said that while this approach to equities affected the portfolio in the short term, these strategies should be judged by measuring them over the long term.

“A factor-based approach to equities impacted the portfolio,” Mathur said. “But this is an approach we need to measure over the long term, and we don’t want to over-learn the one-year message. We don’t want to retract from our factor-based approach, which we think will serve us over a long period of time.”

Bourqui said the factor approach also allowed the fund to navigate the market and look at particular concentrations that it might want to avoid.

“The factor-based approach to diversify against market concentration is useful,” she said.

Asset allocation implications

Despite the concentration of risk in equities, and the fact the allocation hasn’t added value where it should, there doesn’t seem to be any discussion about changing the fund’s weighting to growth assets.

Baggesen said managing the risk of the portfolio centred on maintaining the equities exposure.

“In large measure, the management of the risk is to make sure we administer the fund in a way that allows us to try to maintain the large growth bet in any environment,” he said. “In 2008-09, we couldn’t continue the same risk profile of the fund.”

Eliopolous told the committee the return was within an acceptable range.

“The overall message is that this is appropriate risk and an acceptable result from a relative standpoint, but disappointing in terms of [being] below the benchmark, even if marginally,” he said. “What’s around the corner we don’t know, both macroeconomics and the markets are a domain of randomness and we don’t have a crystal ball for the future.”

CalPERS asset allocation   June 30, 2018