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Joel Posters, the head of ESG at Australia’s A$150 billion ($120 billion) Future Fund, is set to have his remit expanded as the sovereign wealth fund turns its attention to insulating the portfolio from technological risks.

This month marks three years since Posters was recruited from his previous role as global head of sustainability for the Rabobank Group, based in the Netherlands, to move to Melbourne and join the Future Fund as its head of ESG.

Over the past three years Posters has led a program to embed responsibility for managing environmental, social, and governance (ESG) risks with every single member of the Future Fund’s 50-person in-house investment team.

Future Fund chief investment officer Raphael Arndt told conexust1f.flywheelstaging.com that he is now looking at how to expand Poster’s role to include responsibility for helping the fund navigate emerging technological risks.

“Joel’s current job is to look at how the Future Fund is managing ESG risks,” Arndt said, “and that is not a world away from looking at the possible disruptions coming from technological change, which we get to see a lot of through our venture capital portfolio.”

He believes the lessons learned from embedding ESG risk management processes into the Future Fund’s portfolio can be readily applied to helping the fund improve its risk management for technological change.

“And there is no shortage of technological disruption on the horizon,” Arndt said.

The Future Fund needs to ensure its investment portfolio is resilient to big technology trends such as the rising influence of robotics and artificial intelligence.

“When you think about something like driverless cars,” he said, “that’s a technological trend that’s going to have an impact not just on car manufacturers but also delivery businesses, taxis, ride-sharing, parking stations and shopping centres.

“We need to ensure our managers are all thinking about these sorts of issues and investing appropriately.”

ESG embedded through the chain

The Future Fund manages roughly $150 billion across five separate funds, including Australia’s $130 billion sovereign wealth fund. This money is managed by a combination of internal teams and external managers.

The Future Fund describes its approach to ESG risk management as commercially driven and in line with its mandate to maximise returns over the long term without taking excessive risk. The mandate does not provide specific direction on how to approach these ESG issues. However, it does require the fund to show regard to international best practice for institutional investment in determining its approach to corporate governance principles.

“The wealth disparity which has widened since the global financial crisis, and the corresponding rise in support for populist policies around the world, mean investors must be concerned that companies they invest in maintain their social licence to operate,” Arndt said.

“Companies must be mindful of the operating environment and society’s expectations – and where they aren’t, governments are increasingly prepared to step in and regulate or impose other sanctions.”

He said that as a long-term investor the Future Fund incorporates ESG issues into consideration of all new investment proposals and investment manager appointments.

Rather than this being siloed in a separate department, Posters and his team act as “knowledge champions” or coaches to help asset class heads, their portfolio manager and analysts improve their ESG monitoring skills.

“This integrated approach is, in our view, fundamental to being an effective long-term investor,” Arndt said.

“For us, ESG issues don’t sit separately from our investment function but are integrated into it.

“Considering these issues is a key risk mitigation tool in an era where volatility is on the rise and regulatory and policy risks are elevated.”

Arndt said that as long-term investors ESG was like any other risk the Future Fund seeks to understand when assessing what price it should pay when making new investments or allocating capital.

“Where there is uncertainty over future cash flow – whether due to ESG risk or any other risk – or where there is risk that future cash flow might be impaired, we are inclined to pay less,” Arndt said.

Engagement over exclusion

As a general rule, the Future Fund favours engagement over exclusion, with a couple of notable exceptions.

“Our approach is commercially focused, and as a general rule we don’t believe in exclusions,” Arndt said.

“We believe limiting our investment universe is inconsistent with the mandate given to us by government to maximise risk-adjusted returns.

“Having said this, a small number of exclusions apply to activities that contravene an international treaty that Australia is party to – in practice this means companies involved in cluster munitions and landmines.

“Furthermore, the board has made a decision to exclude companies directly involved in the manufacture of complete tobacco products.”

Beyond those exceptions, where an ESG issue is identified, the Future Fund prefers to work with its managers and the end companies they invest in to help them improve their performance.

“The decision to appoint new managers includes consideration of environmental, social and governance issues,” Arndt said.

“Inputs from our ESG team help define the due diligence to be undertaken for each opportunity – and we have rejected investment opportunities on ESG and reputational grounds.

“All of this activity occurs to provide the most rigorous and complete assessment of the risk/reward equation for these investments over the long run.”

Over the past two years the Future Fund has assessed 38 of its investment managers on their ESG approach, has reviewed new managers and done refreshing work on existing managers.

“This process involves face-to-face meetings or phone contact, and is not just an exercise in filling in questionnaires,” Arndt said.

“For instance, in the case of an infrastructure manager, it might involve discussing with them how they incorporate thinking around carbon risk and the future path of energy prices into their assessment of investments.

“Or in the case of a distressed debt investment manager, it might involve a discussion on how they’d behave if a mining company they lent to went into administration and the approach they would take to voting our interests to ensure that the company meets any environmental clean-up and site remediation obligations.”

He said this work is delivering results and that he had been particularly pleased to see improvements made by one emerging market manager that had previously been lagging.

“We worked with them and following proactive engagement from us they now more fully incorporate ESG considerations into their investment process,” he said.

“Indeed, they’re proudly highlighting their new skills in their market with other investors.”

The whales were out in numbers off the California coast when the board of administration of the $330 billion California Public Employees’ Retirement System (CalPERS) met to discuss a range of emerging investment and governance issues.

“We couldn’t ask for much better weather,” board president Rob Feckner said from the meeting, inside the Monterey Tides, a beachfront boutique hotel on Monterey Bay.

“I know you need to focus on the panels and the people but we’ll be looking for those wandering eyes out there. Lots of whales were out there playing yesterday so hopefully at break-time they’ll come back and play again.”

It was a light-hearted opening but this summer offsite covered some heavy topics, ranging from the use of leverage in strategic asset allocation to private equity business models and a new enterprise reporting process.

As usual, the CalPERS offsite was open to members of the public and their comments were actively canvassed.

“We appreciate your active involvement,” Feckner said. “You’re important partners to us and we welcome your feedback.”

The sessions were recorded (or “videotaped” as Feckner somewhat quaintly put it) and available to view online within hours of ending. The full discussions, questions and answers, and the interrogation of CalPERS staff by the board are now out there for the world to see. Anyone who wants to know how CalPERS arrives at its decision on, for example, whether leverage should or should not be used (and if so, how) can watch and find out.

At the time of writing, the online version of the leverage session had been viewed just more than 150 times. It’s insignificant in the context of CalPERS’ more than 1.8 million members, but is indicative of a commitment to transparency and public accountability.

“As we advocate for those board qualities in the companies we invest in, I’m proud that we can serve as a best-practice leader in the way we conduct our own business,” Feckner said.

New in-house reporting system

The nature of the meetings and the interaction among directors, staff and the public “give us the chance to learn and strategise, and also encourage open and candid dialogue, which helps broaden our perspectives”, Feckner said.

Diverse perspectives help enrich the quality of information gathering and decision-making, and “diversity of thought leads to creative and innovative collaboration and, even better, it’s good for our bottom line”, he explained.

A commitment to transparency and accountability extended into a two-and-a-half hour discussion of a new business reporting system that CalPERS is rolling out across the organisation.

The chief executive of CalPERS, Marcie Frost, said key performance indicators already in the fund’s customer-facing programs would be extended across the entire organisation. The aim, she said, is to provide complete transparency on how the fund is tracking relative to those measurements, and to identify quickly any issues that need to be taken to the board.

“This board delegates work to the team at CalPERS, so with this management system, you’ll have transparency on how that delegation is functioning, and I think that’s very important,” Frost said. “It also gives you an overall view of the organisation’s performance, whether that’s [in relation to] a strategic initiative or in operational work that [affects] our customers or our team members…It also provides great visibility to our stakeholders, who have a great interest in what we do, and [creates] a level of accountability within CalPERS.”

Red – or yellow – alert

Frost said that to ensure full transparency and accountability – and that problems are identified quickly – a reporting system must focus on “ ‘what’, not ‘who’ ”.

“That’s something within the culture we’ll be working on,” she said. “What we’ll be proposing to you today, as a part of our ongoing review of performance, is this: We come to you each quarter and review with you any performance indicator or strategic measure that is in yellow or red status. [Indicators will be marked] yellow or red, depending on severity, to tell you when performance is off the targets we’ve established.”

This discussion with the board would identify the performance issue, assign a cause, and put forward concrete, specific actions to address it.

That could lead to some awkward questions being put to staff by the board. Knowing that the conversation could also be immortalised on YouTube might be an additional incentive to make sure things don’t go wrong in the first place.

A study of the organisational behaviour of large asset owners by the Future Fund and Willis Towers Watson gives unique insight into how leading asset owners have tackled the challenges of organisational growth, staff retention, remuneration, and effective decision-making in the context of long-horizon investing.

The study, which compared practices across 15 leading funds globally, helps validate the high standards these funds target and also highlights some opportunities for sharing ideas. The funds, with a combined $4 trillion in assets, were chosen for their strong governance, significant size and thoughtful international perspectives.

The study produced a number of ideas to follow in support of international best practice. These included: improved cognitive diversity, better sustainability, improved board-executive engagement, strengthened risk management through better understanding of the ecosystem, and better balance in the mix of internal and external intellectual property.

“We think [these funds] are creating followership opportunities in which other funds can develop sound practices consistent with these leadership exemplars,” the report states.

The study revealed the challenges and opportunities of the funds, including their investment and organisational challenges.

The funds are struggling with tensions created from staying in a flat and integrated structure, the natural shift to multiple specialist teams, and pressures to keep to one integrated strategy at the total fund level (one-portfolio thinking). Also, discussion of strategy at many of the funds still begins with asset classes, even though more of the thinking is now about allocations to risk factors and return drivers.

Some study participants have developed more engaged partnerships with outside firms and have seen clear benefits of this collaboration; the study identified the benefits to come from such collaborations in the future as well. This analysis extended to the question of how to optimise the value chain of outside providers and internal professionals and the sharing of intellectual property across internal and external asset management, along with extending strategic relationships beyond asset-management firms.

The study also looked at the importance of diversity.

“Research is uncovering biases that are present in investment decision-making settings. These are more numerous and deeply embedded than investors readily recognise,” the study states. “There are opportunities in using diversity effectively to reduce the impact of biases.”

Despite these funds having self-awareness around diversity, however, only 20 per cent had a female chief executive, and none of them had a female chief investment officer.

In the areas of sustainability and long-horizon investing, the study found that funds were too shallow and opportunities were being missed.

The study also found that boards are “having trouble being strategic”, and it highlighted the importance of risk management, particularly scenario analysis.

In culture and people management, the study examined compensation schemes and how to deal with organisational growth, making a case for considering “soft costs”.

“At the scale of most of the participant funds, the marginal hard cost of adding an additional staff member is close to zero,” the authors wrote. “The soft cost – in terms of impact on factors such as culture, clarity of decision rights and organisational momentum – might be considerably greater. Considerable care should be applied to weigh the benefits of additional staff relative to the hard and soft costs involved.”

Snapshot – Of the 15 funds in the survey:

9 have a chief investment risk officer/chief risk officer

11 have a chief compliance officer/general counsel

6 have a chief technology officer

13 have dedicated staff for environmental, social, governance investing/sustainability

10 have specific sustainability investment beliefs

3 have increased their allocation to sustainable investment over the last year

5 plan to increase their allocation to sustainable investment over the next 5 years.

Pensioenfonds Metaal en Techniek, the €70 billion ($81 billion) Dutch pension fund for metal and technical workers, will introduce its own bespoke developed market equity benchmark at the end of this year.

The goal of the new benchmark for PMT isn’t necessarily to improve risk/return, although chief investment officer Inge van den Doel acknowledges this would, of course, be a welcome benefit. It is a requirement of the index that risk/return not deteriorate but the primary aim is to better integrate ESG considerations, particularly climate risk, and select companies with operations and activities that fit PMT’s long-term investment principles.

The developed market equity allocation is already passive and the fund is not increasing the allocation. Also, Van den Doel estimates that possibly half of the companies in the current standard benchmarks will fall out of the new index, which is now in the final days of construction by the fund’s in-house team, based at PMT’s fiduciary manager, MN.

“We think we are doing something innovative and are really excited about it,” she says in an interview from the fund’s headquarters close to The Hague. “It has taken us two years to get to this stage and we are almost there. After this, we might look at other categories, like emerging market equities.”

Aligning investments with beliefs

PMT’s push to develop its own benchmark is driven by a desire to better match investment beliefs and objectives with the fund’s listed equity investments. About $17 billion in equities will track the new index. It amounts to a distinctive view of what passive investment entails, in what van den Doel says is as an enhanced passive strategy.

“For us, passive doesn’t mean just following standard benchmarks bought off the shelf,” she explains. “Standard benchmarks follow certain rule sets that are unlikely to reflect our requirements and values. We are large enough to make a benchmark that fits our beliefs and objectives.”

It is a top-down process, explains van den Doel, who joined PMT five years ago from the Dutch central bank, where her roles included head of investments for the bank’s €20 billion portfolio.

“We started by looking at the companies in the standard benchmarks in our portfolio and asking what we think of their activities and operations,” she explains. “We want to select companies with activities and operations that fit our values. On that basis, certain companies may fall off the table.”

Full-scale review

The decision to custom-build an index is just one of the results of PMT’s full-scale review of its investment framework two years ago, a process that specified the fund’s beliefs regarding investment, policy and risk frameworks. They’re all pillars that feed into a central investment objective that targets long-term excess returns of 1.5 per cent a year above the change in the value of the fund’s liabilities.

“This really was new, and a number we reached after an eight-month analysis of our ambition and risk appetite,” van den Doel says. “PMT consciously chose a relative performance target that is innovative in two ways: most funds have absolute return targets and hardly any fund explicitly states a specific number. The chosen excess return target strongly influences the portfolio construction.

“We wanted to make our investment policy easier to explain to our members and show them this is how PMT invests their money. We also wanted to make more use of our beliefs and principles in our investment strategy, rather than just using quantitative models. The investment framework also helps us build a bridge between the two different worlds of trustees and investment professionals, and make it clear to the asset managers what it is we are looking for, so they understand how we want them to invest, and that it is not just a matter of allocation.”

Return folio and matching portfolio

The portfolio is divided into a return and matching portfolio. The return allocation is structured around three asset clusters of equity, high yield and real estate – not to be confused with asset categories, which lie within the clusters. The equity cluster includes private equity, developed market equity and emerging market equity; high yield comprises classic high yield but also others classes, like emerging market debt; real estate comprises a domestic allocation to homes, offices and retail and a foreign allocation to direct real estate funds and listed real estate.

“The asset clusters help us get a grip on complexity,” van den Doel explains. “Each cluster has its own objective in the portfolio and well-defined strategic characteristics so we know what kind of risk is allowed and what kind of return we want.”

It also allows easy evaluation of any new investment products.

“We can see whether they fit with the clusters and if they provide added value compared with the existing investments of a cluster. If they don’t provide any added value, we aren’t interested. Right now, we are not looking for new products in the return portfolio.”

Equity makes up roughly 60 per cent of the return portfolio. At the end of 2016, PMT had a 34 per cent allocation to all equities, for a total equity portfolio worth €23.2 billion ($27.1 billion).

In the matching portfolio, finding the right asset mix while interest rates languish at historic lows is more of a struggle and something she acknowledges could keep her up at night. It is a balancing act that involves measuring interest rate and credit risk. The latter is a particular problem because PMT, like other pension funds, is forced to move up the credit curve for non-negative yields.

“The longer the duration of an investment product, the lower the spread should be,” she says. “Having a 30-year bond that has a high spread above our liabilities is a big risk, because the duration means that if interest rates change, our loss will be much higher.”

Van den Doel won’t contemplate more risk in the return portfolio, despite PMT having an enviable funded ratio at just above 100 per cent.

“Our funded ratio has come up from 75 per cent a couple of years ago but it remains very fragile,” she says. “It is still below the level set by the Dutch central bank of a minimum funding ratio of just above 104 per cent, and it is well below our long-term target ratio of 120 per cent. We see other funds taking on more risk, but we don’t think this is the right thing to do for PMT.”

Fees slashed

The fund has also made huge progress in slashing fees, which are down by half the 2011 levels, through a process that works via her favoured top-down approach.

“We looked at all our asset categories and asked ourselves, ‘Do we want to invest in this and is it worth the fee?’ ”

This led the fund to shelve its hedge fund allocation, which was revealed as both expensive and not providing the required diversification. In contrast, private equity has proven its worth, with a 3 percentage point net return above public equity.

“In private equity, a 3 percentage point outperformance is worth the costs,” van den Doel says. “But that doesn’t mean we don’t look very sharply at private equity costs.”

A second phase of fee analysis involves looking at implementation. One way the fund has saved money is by switching to more passive strategies, particularly in the emerging market allocation, which used to be completely active but is now split between active and passive. In 2016, total management costs fell to €259 million (0.392 per cent), down from €273 million (0.445 per cent) in 2015.

“We thought we needed active implementation to get a return, but we now believe emerging markets are becoming much more efficient because liquidity has grown.”

She adds that she can envisage wholly passive management in emerging market equities two to three years hence. Emerging market debt is still actively managed she is looking at using more buy-and-maintain strategies there, to save transaction costs.

“We look at costs in all ways, not just fees,” she says.

A third step to keeping a lid on fees has been selecting only managers prepared to accept lower fees.

“Our fiduciary manager, MN, sharply negotiated with our asset managers on fees in 2012 and we divested from those that were not willing to move or accept a lower fee,” van den Doel says.

Against a backdrop of rising equity markets and falling bond yields, portfolios dominated by equities and bonds have produced exceptional returns over the last eight years. In addition, investors have enjoyed a long period in which equity and bond returns have been negatively correlated, providing a powerful diversification effect. Looking forward, however, investors need to be prepared for an environment of lower returns from equities and bonds, along with the possibility that the diversification effect will disappear as equity and bond returns become positively correlated.

The negative correlation equity and bond markets have exhibited for most of the period since the early 2000s reflects, in part, the risk-on/risk-off behaviour of markets in which economic disappointment has bred a flight to safety (with bond yields falling), while economic improvement has been positive for risk assets. This diversification effect is not a permanent feature of markets, however, and a much longer-term analysis shows that there have been long periods of time in which the correlation between equities and bonds has been positive (indeed, the long-term average is about +0.1).

A potential catalyst for a return to positive correlations could be a shift towards a more inflationary environment, in which tighter monetary policy and rising bond yields lead to equities and bonds falling at the same time. While higher levels of inflation are far from inevitable, the shift in policy discussions towards fiscal stimulus (evident in Canada, Japan, the US, and to a lesser extent the UK and Europe) at a time of synchronised global growth raises the likelihood of inflationary pressures emerging over the medium term.

This raises two important questions:

What impact would a simultaneous sell-off in equities and bonds have on an investor’s financial position? This might be particularly important for investors making use of leverage.
What actions can investors take to improve the robustness of their portfolios in an environment that poses significant challenges to both equities and bonds?

Know thyself

Before considering what portfolio changes might be appropriate, investors need to have a clear idea of the economic/market outcomes they are least able to tolerate. For example, investors who are sensitive to mark-to-market volatility, or who are cashflow negative, may be most concerned about large market moves and a dramatic reduction in liquidity over a short period of time. In contrast, long-horizon investors may be most concerned about the erosion of their purchasing power due to an extended period of higher than expected inflation.

The following questions will help investors narrow the range of scenarios that are likely to be of most relevance to them when reviewing investment strategy.

What time horizon matters most? Will it shorten during a period of market distress?
What are the key characteristics of the liabilities (for example, real vs. nominal, the shape of the cashflow profile, and any flexibility in adjusting cashflow levels in difficult times)?
What external support might be available, if required, in an unfavourable market outcome? Under what conditions is that external support most likely to be compromised?

Identifying the scenarios of most concern to an investor and then testing the portfolio’s most likely response to plausible future outcomes is a critical step in risk management.

Seek robustness

Building on the discussion above (which will necessarily be investor-specific), we suggest investors consider potential action at three levels:

Explicit hedges: Adopt defensive exposures designed to provide explicit protection against one or more market outcomes. This category would include government bonds (nominal and inflation-linked), synthetic hedges (such as option strategies and swaps) and tail-risk hedging strategies. Nominal government bonds still have a role to play in defending against weakening economic conditions and deflationary environments (especially for investors sensitive to those outcomes). Inflation-linked bonds (where they are issued) will offer some exposure to rising inflation alongside their interest rate exposure, and synthetic hedges can be tailored to meet individual needs.
Defensive tilts: Recognising the return drag typically associated with explicit hedges, investors should also consider tilts (whether in the growth or defensive portfolio) that might improve robustness in scenarios to which the investor is sensitive and potentially exposed. This could include allocations away from equity or nominal bonds, in favour of defensive hedge funds, senior private debt or real assets with contractual income streams. Low-volatility equity and sub-investment grade credit might be more defensive than broad equity market exposures, but both would probably be highly correlated with equities in a crisis.
Additional flexibility: Cash may have a role to play in reducing the risk of having to crystallise losses to meet cash output requirements or collateral calls in stressed conditions, while also acting as dry powder, offering the ability to re-deploy assets at more attractive levels. The latter activity will be available only to investors with a strong governance process and a willingness to act in a dynamic fashion. Investors wishing to delegate this dynamic asset allocation activity might consider idiosyncratic multi-asset strategies or multi-strategy hedge funds.

Investors face a market environment offering the prospect of lower returns and fatter tails. Portfolios dominated by broad market equity and bond exposures are likely to face significant headwinds, not just in terms of the level of returns achievable, but also given the potential for a shift in equity-bond correlations.

In short, sovereign bonds proved helpful during the financial crisis but investors can no longer rely on bonds bailing them out in the next market meltdown.

Phil Edwards is global director of strategic research at Mercer.

The $323 billion California Public Employees Retirement System (CalPERS) has embarked on a detailed analysis of the use of leverage in its investment portfolios, as it grapples with meeting return objectives and seeks to lift its 68 per cent liability-funding ratio.

The chief investment officer for CalPERS, Ted Eliopoulos, said an examination of leverage in the system’s asset allocation process is “really one of the core components in our ALM [asset-liability management] process this year”.

Eliopoulos said there are pros and cons to using leverage at the total fund level, with greater risk to consider as well as potentially enhanced returns.

“But the board and your investment staff was very keen to look at this topic, again under the rubric of kicking every tyre, looking at every possible tool in the toolkit as we face the various pressures [of having to] deliver a portfolio construction that will meet our various objectives,” he said.

However, the CalPERS board of administration has been told that leverage will have at best a marginal impact on its ability to improve investment returns, while leaving its underlying portfolios’ risk profiles unchanged. It was told there is currently no way to tell the total amount of explicit and embedded leverage already in CalPERS’ portfolios.

Managing investment director Eric Baggesen said there is “no agreement on what is the definition of leverage”.

“So a piece of the work that [CalPERS investment director] Ron [Lagnado] and I will be laying out is really trying to [present] a set of definitions, and then build a set of reporting [mechanisms],” Baggesen said to the board. “But [inherent in] all that is really establishing” what we’re talking about.

A road map in the works

Lagnado said the CalPERS investment office is developing a “road map initiative”, which he said is designed to create a more effective and centralised governance and operating model “if potentially we want to move forward with using leverage in a more explicit way”.

At the board’s offsite held on July 17 in Monterey, California, chief executive Marcie Frost said investment returns had improved CalPERS’ funding ratio by 3 percentage points, to 68 per cent.

On July 14, the system reported an 11.2 per cent return for the 12 months ended June 30, 2017, following strong performances from its public equity program (19.7 per cent) private equity (a preliminary return of 13.9 per cent) and real estate (a preliminary return of 7.6 per cent).

“We really are at a critical juncture for the fund,” Frost said. “We are maturing as a system. The membership is getting older. We are in a negative cashflow position, which you all have been hearing many discussions about, and we are currently 68 per cent funded – so we’re up three points on that with the latest returns [and] the discount rate change that came in December, [which] is bringing in new contributions.

“That 68 per cent is the lens that our leadership team at CalPERS is looking through as we are managing the organisation, and it also informs our efforts around reducing risk, cost and complexity.”

Eliopoulos added: “We’re looking at every possible tool in the tool kit either to increase the potential for return or moderate or reduce the amount of leverage in our portfolio construction.”

Leverage an oft-discussed tool

Baggesen said leverage comes up regularly in discussions about asset allocation. He explained that about 18 months ago, the CalPERS’ board authorised a borrowed liquidity allocation and the intention was to “bring this topic of leverage back up into the discussion and insert it into the dialogue we’re having around our asset-liability management exercise”.

He said CalPERS is often “pinned” between prevailing market conditions, the rates of return that it needs, and the level of risk the plan is able to take. Leverage may be able to help the fund achieve its target returns while also managing risk.

“It is important to recognise that leverage…like most of the other tools we’ve been speaking about…should probably be thought of only as providing some kind of marginal change,” Baggesen said. “This is not a step-function change or a huge sea-change. Even if the desire of this board were to apply a tremendous amount of leverage, that would probably not be achievable given the size of CalPERS.

“The greatest opportunity around this is a marginal opportunity; we think it can have an influence, but it is not ultimately going to be a panacea for some of the challenges that are out in front of this organisation.”

He acknowledged that leverage is not a free lunch and brings risks with it. He added that those risks come from both the sources and applications of borrowed capital.

The managing director of Pension Consulting Alliance, and one of the fund’s consultants, Allan Emkin, told the board leverage must be managed at the total-fund level, which is not how institutional investors traditionally look at it.

“They’ve looked at leverage on an asset-class basis, or an individual asset basis, but not systemically,” Emkin said.

He said there are three critical aspects to an effective policy on leverage: who sets the policy, who implements the policy, and how large the range and when is it imposed? A policy that works for one system may not work for CalPERS.

“You have a unique board, you have a unique liability stream, you have unique staffing, and all of those things have to be incorporated into decision-making on the use of leverage,” he explained. “There are far more moving parts in your investment portfolio when there’s leverage, and it takes a level of knowledge, sophisticated analytics and oversight to make sure you’re getting what you want out of leverage.”

Emkin said leverage calculations and examples often quote average expected returns. But the challenge in using leverage, he explained, is to consider what happens when those averages prove to be overly optimistic, and “you’re on the left-hand side of the distribution” of returns.

The effect of leverage is to increase the potential return from an asset, but also the variability or volatility of returns.

“You as policymakers are probably much more concerned about the left-hand side of that distribution than the right-hand side,” Emkin told the board.

Leverage is tempting

The professor of finance at EDHEC Business School and director of EDHEC Risk Institute, Lionel Martellini, who also presented to the board, said investors such as CalPERS must “define a strategic leverage target at the total-fund level, including both directly controlled and embedded leverage, and explicitly measure and manage the associated risks, as opposed to having an uncontrolled amount of leverage opportunistically defined at the level of internal and external program managers”.

Martellini said the best way for asset owners to consider leverage is from the perspective of the impact it will have on the payoff from an investment.

“One’s ability as an institution to modify the payoff and make it more consistent with the needs of the institution is a key component of what financial engineering and asset-allocation decisions can bring in terms of potential benefits eventually to the beneficiaries,” he said.

He said increased access to upside using a leveraged strategy requires a lower level of performance from the underlying portfolio to achieve a given performance target at the fund level.

Conceptually – and notwithstanding the discount rate applied to the system’s liabilities over time – if a pension system is 68 per cent funded, it has to increase its funding ratio by 47 per cent to become 100 per cent funded.

Martellini continued: “I’m thinking about the funding ratio, and not pure asset value, so it’s relative to the liability performance, which is itself – given liabilities are mark-to-market – a function of the discount rate, which indeed is not constant over time.”

Using leverage to alter the payoff of an investment strategy is, therefore, tempting.

That’s on the upside, or the right-hand end, of return distributions. Looking at the left-hand end, Martellini said, “You come to the opposite conclusion, or a similar conclusion, in a way: it takes only a small or mild negative performance, a mild decrease in asset value in your underlying portfolio, [and] that’s going to translate into a decrease in the value of the levered portfolio.”

He said leverage is a tool to help investors reach a return target without increasing the risk of the underlying portfolio. Leverage increases risk, he said, but the increase in risk attributable to leverage is less than the risk that arises from trying to meet the return target without leverage and by increasing risk in the underlying portfolio.

“The bottom line is, there’s a trade-off,” he said. “Whenever you want to increase expected return, you always need to increase risk. But we have two choices: one with leverage and another one without leverage.”

The managing director of Wilshire Consulting, Patrick Lighaam, told the board that for many asset owners, and possibly for CalPERS specifically, leverage is underused, “especially if you think about how powerfully and how broadly it can be applied to your current portfolio”.

Lighaam said leverage is thought of as “one of these funky, weird and misunderstood tools…because it comes in so many shapes and forms. Maybe one of the reasons leverage is being frowned upon a little bit is because it’s not so easily defined. There might be a misperception…that leverage is much more risky than it actually is.

“That old view that introducing leverage is increasing the risk is very much linked to the way we were applying leverage in the old days.”