CalPERS considers new asset class classification

CalPERS is considering doing away with traditional asset class classifications in favour of classifying assets according to fundamental characteristics in a bid to provide a better understanding of portfolio risks and performance drivers and so move to a more effective portfolio construction and risk management framework. Amanda White reports.

In response to analysis of the CalPERS portfolio, which found that the big Californian public sector fund did not have a meaningful-enough exposure to assets that could have been a hedge in times of financial crisis and provide adequate liquidity to the fund, the staff and the board’s consultants – Wilshire and PCA – have developed an alternative classification of assets based on underlying fundamental characteristics.

CalPERS now uses five broad asset classes in its strategic asset allocation – public equity, private equity, fixed income, real estate, inflation-linked and cash – but the new classification system would expand this to six different categories based on return drivers and fundamental characteristics.

In a letter to the investment committee, PCA describes the new asset classifications as a “necessary evolution towards a more effective portfolio construction and risk management framework”.

The proposed new categorisations are: government bonds, income; growth, inflation-linked, market neutral and liquidity.

Under those broad categories, assets or ‘building blocks’ are allocated according to their objectives and risk drivers.

Within government bonds sits government nominal bonds and government inflation-linked bonds, which have the objective of diversifying growth assets, hedging liabilities, and providing liquidity.

In the income classification sits investment-grade spread sector, securities lending and credit enhancement, which are driven by yield and have the aim of diversification and liability hedging.

In growth sits public equities, private equity, real estate and high-yield bonds which aim to achieve high returns from economic growth subject to prudent risk.

Inflation-linked consists of infrastructure, forestland and commodities which aim to hedge inflation risk and risk of commodity price spikes and are driven by changes in inflation.

Market neutral includes absolute return, hedge funds and all strategies with low asset class beta, which aim to materially outperform cash and generate stable returns and are driven by manager decisions.

And within liquidity sits short-term high-quality fixed income securities which provide liquidity and are driven by central bank rates.

The new classifications aim to address the limitations of the current asset categorisation, and by considering fundamental factors that influence returns and risk, it attempts to transcend the limitations of the more statistics-based approach used now.

In a staff-prepared paper, to be presented to the investment committee this week, investment staff determined there were three main drivers of asset returns – economic growth, inflation and real yield.

And an analysis of the CalPERS portfolio shows that many of the assets are significantly related to economic growth. Nominal government bonds and government inflation-linked bonds – treasury inflation protected securities (TIPS) are the only asset classes that are relatively insensitive to the economic cycle.

Staff outline that the current asset class structure was shown to have a high degree of single-factor exposure, GDP growth, during the economic crisis, and it masks the underlying risk exposures, with different risk exposures mixed together in a single asset class.

Measures of standard deviation and correlation do not provide a full picture of the fundamental risk exposures of assets and their return drivers, the paper says.

According to the report this new classification would allow for a more clear understanding of, and anticipation of portfolio behaviour, and better manage risks under various economic scenarios.

It also provides a way for an increased focus on liability hedging, liquidity and income returns than currently exists.

The new classifications also introduce a separate asset class for absolute return strategies in recognition of its distinct return profile.

Under the new classifications, essentially along risk lines, asset boundaries will become blurred, with real estate in particular an asset that could fit into a number of the new categories.

In its letter to the investment committee, Wilshire outlined a few issues of disagreement between staff and the consultant about classification, in particular asking for guidance around real estate – with it recommending core real estate be classified as income and value-added and opportunistic real estate be classified as growth – and the role of high yield bonds.

This investment committee will discuss the new proposed framework for asset classification generally as well as review the proposed role for fixed income and real estate.

This discussion, about the role of asset classes in the strategic allocation, is the first step in a three-step process for the 2010 asset liability management review. Capital market assumptions and the ALM process and methodology will be discussed at subsequent investment committee meetings.