How CPP Investments uses leverage: Lessons for CalPERS

The CIO of Canada Pension Plan Investments, Edwin Cass, shares insights on the benefits of leverage, the impact on liquidity and the governance structures for success.

As CalPERS adopts a new asset allocation that adds 5 per cent  leverage to the entire portfolio, board members gathered key insights on how the strategy will work including the lessons from Canada Pension Plan Investments which currently applies 22 per cent leverage to the portfolio.

Edwin Cass, chief investment officer of Canada Pension Plan Investments (CPPI Investments) shared the experience of the C$541.5 billion Canadian fund where a seasoned leverage strategy adds diversification and maximises returns without increasing risk.

Cass explained to CalPERS’ board members that many people associate the use of leverage with increased risk. Although leverage can be used to increase risk, CPP Investments’s use of leverage leaves its risk tolerance unchanged.

The Canadian fund invests based on a mandate to maximise returns without undue risk or loss and has an above average 85 per cent equity risk target – more than a standard 60:40 portfolio due to the fund’s long-term investment horizon and funding ratio.

Leverage is used to maximise return at its current level of risk – increasing the overall fund performance on a risk adjusted basis – by increasing diversification. Diversification, Cass told CalPERS board members, “is the one free lunch in investment.”

CPPI borrows money and adds leverage to the portfolio to get access to less risky assets. Increasing the fixed income allocation this way helps mute tail outcomes, namely correlation which Cass said is capable of “sinking a portfolio.”

“The portfolio has a higher risk-adjusted return and is a bit more robust. The important part is not to increase risk but decrease bad outcomes,” he said.

There are different measures of leverage. Top of house at CPP Investments is a total financing leverage – the amount of money the fund borrows physically or synthetically to increase exposure to its balance sheet. Today it is applying 22 per cent leverage to the portfolio below a limit of 40 per cent set by the board.

Sources of leverage

CPP Investments uses different sources of secured and unsecured leverage over the long and short term. The sources of leverage have expanded over time – as you diversify your asset mix, so you diversify your sources of finance, he said.

Today, sources include commercial paper issued in the domestic, US and UK markets for terms out to 30 years. Elsewhere, it borrows in the repo market while around one third of its exposure comes through derivatives, short selling derivative contracts.

A team of around 25 people follow the market, analysing the cheapest way to borrow and where to find staggered maturities. Cass told CalPERS’ board members that it costs more to borrow over longer maturities, however on the flipside borrowing longer-dated means there is less maturity risk and CPP Investments doesn’t have to go into the market and rollover debt, a dangerous exercise when liquidity is scarce like in March 2020.

According to the fund’s data, financing costs were $1,217 million in fiscal 2021, a decrease of almost 50 per cent compared to $2,429 million for the previous year, attributable to lower effective market interest rates.

Cass explained that alongside important board approvals, it also looks to rating agencies to help it set a comfortable level of leverage that helps ensure it can maintain its AAA status and comfortably meet liabilities.

“Rating agencies are another check on risk management,” he said. Other lenses through which to view leverage include peer analysis. CPP Investment’s peers in Canada follow a similar model.

“We are at the low end compared to Canadian peers regarding the amount of leverage we use. We get comfort from looking at our peer organisations.”

He added that from a strategic perspective, the fund’s use of leverage is not dynamic. However, on a day- to-day basis it can fluctuate depending on where it sees opportunities in the market.

Liquidity

Next the conversation turned to governance and reporting leverage, particularly its impact on liquidity ratios. At CPP Investments, the board has insight of the total financing leverage program with a particular eye on liquidity levels.

The pension fund has floors to its liquidity coverage ratios, below which the organisation is put at risk.

Cass said his priority is to target a level of liquidity that does more than simply allow the fund to meet its liabilities. For example, he wants money on hand through cycles to re-up with private equity funds. Elsewhere, the variation margin in derivative contracts requires capital on hand.

He said that inflation doesn’t hold much of a risk for the fund’s leverage strategy. Sure, inflation increases borrowing costs, but the fund always ensures its financing costs are adequately compensated with expected returns.

Cass warned that taking on too much leverage would put the portfolio in harm’s way. He said that leverage and liquidity are linked, and March 2020 illustrated the importance of keeping enough liquidity on hand to help platform companies in the investor’s large private equity allocation.

At the large Canadian fund a special committee came into play to control capital going out the door and ensure liquidity levels through the 2020 crisis. It was stood down nine months later.

Cass concluded with a note on the importance of board oversight of a leverage strategy. He said investors should understand why they use leverage, ensure transparency, and anticipate how the portfolio will behave in times of stress.

He advised on a “crawl, walk, run” approach and reassured CalPERS’ board members that watching how the portfolio reacts to leverage will imbue confidence in the strategy.