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August 22, 2008 01:00 AM

CalPERS ready to go opportunistic in fixed income

New portfolio - up to $2 billion - to use student loans, auto receivables, credit cards as alpha generator

Raquel Pichardo
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    CalPERS’ staff is itching to take advantage of wide credit spreads and other fixed-income market conditions that could be short-lived through a new internal derivatives-based enhanced equity portfolio.

    The life of the portfolio may be only around three years but in the meantime will add modest returns above the pension fund’s equity benchmark, according to Eric Baggesen, senior investment officer of global equities at the $232.5 billion California Public Employees’ Retirement System, Sacramento.

    The new portfolio will likely total some $2 billion and will exploit current dislocations in the fixed-income markets, Mr. Baggesen told the investment committee at an Aug. 18 committee meeting. Funding will come from reducing an internal domestic equity index fund that totaled $44.7 billion as of March 30.

    If approved by the investment committee, the program will use short-term, high-quality, asset-backed securities, like credit cards, student loans and auto-receivables, as the alpha engine and a futures overlay designed to replicate the Wilshire 2500 as the beta driver. The fixed-income portion would be very similar to an internal high-quality LIBOR portfolio run by CalPERS’ global fixed-income staff.

    Officials at CalPERS plan to bring a formal pitch for the new program to the investment committee at its Sept. 15 meeting.

    The new internal portfolio will be similar to the $1.6 billion in fixed-income driven enhanced indexing strategies that was run by external managers until January when the assets were brought in-house.

    “This is a (simpler) version of what they were doing,” Mr. Baggesen said.

    As of Dec. 31, CalPERS had at least three managers that ran similar, fixed-income driven, enhanced equity strategies. Western Asset Management Co., Pasadena, Calif. and Smith Breeden Associates Inc., Durham, N.C., managed $600 million each while Atlantic Asset Management LLC, Stamford, Conn., managed $400 million.

    At the time, staff had discussed bringing some of the external enhanced equity index portfolios in-house since the pension fund’s internal, stocks-based program was outperforming the external one.

    CalPERS’ currently runs a $4.6 billion internal enhanced indexing portfolio that uses stocks as the alpha engine, instead of fixed-income securities.

    In an equities-based portfolio, an investor will hold an index fund and overweight or underweight stocks modestly within that fund, whereas with a derivatives-based strategy, an investor gains exposure to the index through futures, explained Neil Rue, managing director at consulting firm Pension Consulting Alliance Inc., Portland, Ore. Both strategies are equally common.

    No worries about default risk

    The new derivatives-based enhanced portfolio is expected to return 50 basis points above the Wilshire 2500, while the existing stocks-based one returns “two to three times that,” Mr. Baggesen said.

    A typical derivatives-based enhanced indexing portfolio brings in about 100 basis points of returns above a benchmark, said Greg DeForrest, head of the global manager research group at Callan Associates Inc., San Francisco.

    “The returns depend on your guidelines,” he said. “If collateral is managed conservatively, then your return expectation is going to be lower,” Mr. DeForrest said.

    Investment grade paper backed by student loans, for example, is trading at a positive spread to the London Interbank Offered Rate of 70 basis points when historically spreads have been at a discount of two basis points, according to a staff write-up of the proposed policy presented at the Aug. 18 investment committee meeting.

    Staff believes these securities are relatively cheap because of liquidity issues in the market and not the poor credit quality of the borrower.

    “There is a danger that the spread level is caused by a greater default risk, but we don’t think that’s the case,” Mr. Baggesen told the committee.

    Regardless, some risks exist.

    On the fixed income side, the portfolio expects to add alpha by taking on duration risk, wrote Andrew Junkin, managing director at Wilshire Associates Inc., Santa Monica, Calif., the pension fund’s general consultant, in a memo to Anne Stausboll, interim chief investment officer. Staff is also taking on additional credit risk.

    And even though credit spreads are wide, even cheap assets can continue to fall in price, he wrote. However, if staff can identify securities with returns above LIBOR and that have no defaults, “the irrationality of the market would be washed away by the maturity of the securities at par,” Mr. Junkin wrote. The consultant supports the new portfolio.

    Contact Raquel Pichardo at [email protected]

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