A rigorous debate between staff, consultant and investment committee has resulted in the $224-billion CalPERS deciding to fund an allocation to hedge funds from its global equities allocation, using futures to neutralise the policy allocation, rather than have a separate strategic asset class. But the strategy is on watch, and will be reviewed mid-next year.Absolute return strategies (ARS) make up about 2.5 per cent of the fund, or about $5.3 billion, but were not included in the policy portfolio under CalPERS’ new strategic asset allocation. Staff and the fund’s consultant are at odds about how they should be funded.
Investment staff at CalPERS presented three options to the investment committee for how ARS could be funded, but ambiguity remains about the role of hedge funds as risk reducer or return enhancer.
The discussion is necessary because ARS no longer form part of the policy portfolio.
Before the fund’s extensive 2010 strategic asset allocation review ARS were included in global equities, but following the review it was not designated as a strategic asset class.
“Staff has debated over the last year-and-a-half as to whether it is an active strategy or an asset class. And we’ve held the view that it’s an active strategy,” says senior investment officer, Farouki Majeed.
The crux of the latest debate is the most basic of all discussions: what is the role of hedge funds in the portfolio – to enhance return, or reduce risk?
In its explanation to the investment committee, CalPERS’ staff have a particular view on this.
“If the primary purpose of the ARS program is to reduce volatility of the policy portfolio, staff is not convinced that absolute return strategies are the most efficient way to achieve that goal. Other asset classes and/or strategies might serve the same purpose with less cost and complexity,” they say.
CalPERS’ staff and the fund’s consultant, Wilshire, debated three possible capital allocation scenarios. The scenarios differ on whether there is an allocation in the policy portfolio, and whether there is an equitisation process through the use of futures.
It is staff’s recommendation that ARS not be included in the policy portfolio, but be funded by a global equities allocation, with an equitisation of about 2 per cent of the total fund to bring the global equities allocation back to the benchmark weight.
“Staff is recommending option B for the reason it stays true to the committee-approved policy portfolio that we currently have. And ARS then becomes an active strategy to enhance returns at the total fund,” Majeed says.
Wilshire, on the other hand, recommends that the total fund benchmark be changed to include a 2.5 per cent allocation to hedge funds.
“This is consistent with the prior action by the investment committee to add the ARS benchmark to the total fund policy via the global equity asset class, and also maintains the historic role of ARS as a risk-reducing investment,” says the managing director and principal of Wilshire, Michael Schlachter.
Schlachter says the difference between the two recommendations boils down to whether the investment committee wants ARS to remain an absolute-return program, or for it to become a portable-alpha program.
According to Wilshire, the fact the staff recommendation involves buying equity market index futures to restore the global equities allocation to its intended weight in the policy portfolio means that ARS will change from being an absolute-return program to being a portable-alpha program.
The board decided to choose the investment staff’s recommendation, with a requirement they return to the board by the end of June 30, 2012 with a detailed and comprehensive review of the program.
Investment committee member Priya Mathur says the review should include an evaluation of the actual performance of ARS in its role as a volatility reducer and its performance overall, the appropriate benchmark, and implications for the total fund.
And another member, JJ Jelincic, adds that the analysis should include the extent to which the enhanced return comes from leverage, and what happens if the return is significantly lower than the assumed cash plus 3.5 per cent.
The analysis will also include what the return and volatilities look like in different economic environments.
Two committee members voted against the motion.
The CalPERS’ ARS program was launched in April 2002 and went through a number of restructures before the spin-out of global equities in July this year. Since inception it has outperformed cash by 3.5 per cent.
Meanwhile the asset allocation ranges of the global equity portfolio have been adjusted following the removal of ARS from its gamut.
Global equities has three sub-asset classes: passive; enhanced and active; and alternatives.
Alternatives includes corporate governance and emerging manager, and is where the risk-managed ARS program used to sit. The anticipated ranges for this sub-asset class have been changed from between 5 and 21 per cent to between 3 and 13 per cent.