Implementing CalPERS new asset allocation

Setting a new asset allocation is one thing, implementing it is another thing altogether. CalPERS expects to have its new asset allocation implementation policies completed by the beginning of July, so head of asset allocation, Farouki Majeed, discusses the challenge.

Senior investment officer, asset allocation at CalPERS, Farouki Majeed, is optimistic – tired but optimistic. For the past few years his team has been responsible for the research, presentation, decision-making and now implementation of the fund’s new risk-based asset allocation targets.

The alternative asset classification introduces the concept of two hedging portfolios to protect against extreme market risks (liquidity), and rising inflation; and allocates according to how those assets function in high- or low-growth markets, and the prevailing inflation environment.

This year it is unlikely to result in any major changes in actual asset allocation, but the framework for assessing the portfolio in its entirety, with a particular emphasis on risk management, is now in place.

A desire to hedge the portfolio against extreme market risks and rising inflation was one of the underlying drivers of the change, and Majeed says setting a minimum allocation for the inflation and liquidity buckets, the two hedging portfolios, was a necessity.

“You could run an unconstrained optimisation but then you wouldn’t get the allocations because you wouldn’t like the risk/return. We are saying you need a minimum allocation to these buckets because we expect them to address tail risk,” he says.

“The rest of the portfolio is a combination of growth oriented assets – dependent on favourable economic conditions – public and private equity, and real assets.”

Inflation and liquidity have been set targets of 4 per cent each, and Majeed says those targets will be reached “soon”, with the fixed-income group being recalibrated to manage the liquidity and inflation portfolios.

July 1 is the target date for the new asset allocation implementation policies for the three-year plan, this will detail issues such as the ranges for sub-portfolios within the broader categories.

The new asset allocation targets (see table below) will be achieved over a longer time frame, and Majeed says are some assets that need work to reach their targets.

Commodities is at its target but the 3 per cent infrastructure target is a long way off.

“Real allocations depend on the opportunity,” he says.

In addition to these investment-specific challenges, there are also some implementation issues the fund is working on.

“We need to sharpen our tools and modelling in terms of risk and assessment models, and we are upgrading our risk system as we speak,” Majeed says.

The fund uses Barra which it is upgrading in the fourth quarter of this year.

“We are also trying to improve our internal governance and decision-making processes to be able to make this happen.”

Like its institutional peers, CalPERS conducts a major strategic asset allocation review every three years, it now also wants to incorporate an annual review of risk and return expectations to validate those assumptions.

The next step in the new asset allocation implementation is for each asset class to develop a strategic plan and portfolio construction expectations.

One of the more empowering results of this process, according to Majeed, is that the senior investment officers of each asset class have a “fair amount of authority and flexibility relative to their targets and risk”.

“The board delegates authority to the senior investment officer of each asset class which is adequate for them to implement,” he says.

The SIOs and CIO will meet regularly to tweak investment allocations and discuss the portfolio in broad terms of risk and return. In this way the new framework will provide investment staff with the ability to work more holistically.

It enables staff to manage assets in terms of how they perform in varying conditions – inflationary, deflationary and cash-constrained environments – and a framework for assessing investments and adjusting them according to market trends.

“It is our intention to make adjustments, particularly in light of uncertain conditions. I can’t say we will make huge moves but we are thinking through it and we have authority within the ranges.

“We will be looking for private assets to provide some alpha and the hedge fund program is potentially a source of alpha for us.”

There is still a focus, but more work to be done, on the attribution of excess return.

Majeed says the interaction between the investment staff and the board in terms of coming to the best decision around asset allocation has been an important part of the process.

“One lesson, particularly because the board makes the asset allocation decision, is the process is very important. It was important to start early and conduct the necessary education and information sessions with the board to bring them along the process. We brought outside experts to present their views. It takes time educating the board and bringing them to a good position.”

He says internally there are still some issues in terms of the impact on the way asset classes will be managed and they will be addressed “along the way”.

“We will be sure to get buy-in from internal staff members,” he says. “This is just the beginning.”

 

 

 

CalPERS alternative asset classification 2010

Income        Fixed income                           16.0%

Growth       Public equity                           49.0

Private equity                          14.0

Real            Real estate                     10.0

Infrastructure & forestland      3.0

Inflation      Inflation linked bonds             3.0

Commodities                           1.0

Liquidity     Treasuries                      4.0

 

 

 

CalPERS historical asset allocation policies

Classification		1993	1995	1997	2000		2002	2004		2008	2009
Cash		2%	2%	1%	0%		0%	0%		0%	2%
Fixed income	domestic	37	24	24	24		–	–		–	–
	international	4	4	4	4	global	26	26		19	22
Total fixed income		41	28	28	28		26	26		19	22
Equities	domestic	33	38	41	39		39	40		–	–
	international	12	20	20	19		19	20	global	56	49
	AIM	4	5	4	6		7	6		10	14
Total equities		49	63	65	64		65	66		10	10
Real estate		8	7	6	8		9	8		10	10
Inflation-linked assets		–	–	–	–		–	–		5	5
Total		100	100	100	100		100	100		100	100