CalPERS’ search for a new asset allocation strategy

The year 2010 will go down in history as one of reformation for the $205 billion CalPERS. In this, consultant and enterprise risk management reviews seem small in comparison to the overhaul of the fund’s asset allocation. Amanda White spoke with chief investment officer Joe Dear about the pension giant’s year-long asset allocation study.

A Joe_Dear_nlCalPERS investment committee workshop in May, which reviewed its capital market assumptions, marked a turning point in the big Californian fund’s approach to asset allocation.

The fund has embarked on a year-long asset allocation review that is more like a total engine makeover, and arguably one of the most important activities the fund’s investment staff, in conjunction with its board, have undertaken.

Not only is the fund reviewing its allocations, but the very assumptions that drive investments, with the potential outcome not just a tweaking of allocation bands but an entirely new way of investing in assets. In addition, it’s being done in a fully transparent and open dialogue with the board and the public.

“To the maximum extent possible we want to be transparent so our beneficiaries and others can see into the methods, assumptions and processes we’re using to develop the asset allocation,” investments chief Joe Dear says.

“There is no enduring proprietary secret that would be protected by trying to do it all behind closed doors and a lot to be gained by engaging people as much as possible.”

In March the investment committee kicked off the analysis with a review of the role of asset classes, concluding that CalPERS’ current asset class structure was heavily influenced by GDP growth and masked underlying risk exposures.

The recent May workshop engaged the board with a discussion about the underlying capital market assumptions, in an attempt to better understand the drivers of investments, portfolio behaviour and risks.

“The purpose of the May workshop was to explore the issue and engage the board in a more comprehensive way. In the past the board was just given the consensus assumptions and not allowed or asked to weigh in with a view,”  Dear says.

The outcome of that process was an indicated set of return assumptions considerably lower than the current 7.75 per cent, at 7.29 per cent, a median of the work done by staff and consultants.

As a result of these first two steps, about a third of the way to setting new strategic targets, CalPERS is now running a parallel process with portfolio models built on the standard tools of mean variance portfolio optimisation, but also on an alternative factor model identified in March.

“One’s the fail safe, the classic method. The factor model is to try and do something to improve upon the asset allocation toolset,” Dear says.

“The factor modelling is to try and get a better grip on risk and account for some of the more extreme events that are possible.”

In this model, the CalPERS investment team identified six factors and about 11 security types or building blocks.

In this alternative asset classification the factors are government bonds (which includes government nominal and inflation-linked bonds as the building blocks), income (investment-grade debt, securities lending and credit enhancement), growth (public equity, private equity, real estate and high-yield bonds), inflation-linked (infrastructure, forestland, commodities), market neutral (absolute return), and liquidity (short-term fixed income).

“It is clear from recent experience that having a portfolio of equities and corporate bonds turns out to provide little by way of diversification if there is a major slowdown in economic growth, so economic growth is a risk factor,” Dear says. “We are trying to understand more generally the difference between real diversification and apparent diversification.