CalPERS' board on Monday held an educational session that included the idea of embedding leverage in its asset allocation, in advance of its 2021 asset liability study.
The $396.9 billion California Public Employees' Retirement System, Sacramento, already is allowed to use up to 20% total fund leverage.
CIO Yu “Ben” Meng noted that it would likely take three to four years to lever up the portfolio to 20% and 10 years to fully benefit from the leverage.
However, a leverage element in its asset allocation would allow pension fund officials to create allocation targets totaling in excess of 100% of its assets.
Steve Foresti, CIO of Wilshire Consulting, explained that asset owners are struggling with the "collision" of their return objectives against market investment opportunities and any constraints imposed on the asset allocation process.
Skipping over changing return assumptions, he said market opportunities are asset classes not already in an investor's portfolio.
"So, probably a little bit of room to find some additional investments. But limited," Mr. Foresti said.
Turning to constraints, he said leverage is "an embedded constraint that most investors just in essence impose on the process without really, you know, thinking about it."
Mr. Foresti said modern portfolio theory puts together a combination of asset classes that adds up to 100%. "Embedded in that is a constraint not to borrow some money to go over 100%," he said. "Implicit would be through direct borrowing or just derivative markets; is there a way to invest more than 100% in asset classes?"
Mr. Foresti said Wilshire's suggested use of leverage is "a risk management tool as opposed to a return chase tool" in that investors can use the leverage to diversify their portfolios.
However, Thomas Toth, a managing director of Wilshire Consulting, who spoke next about leverage, said leveraging an asset allocation "can be scaled by leveraging to increase the expected return to get closer to that target return threshold without sacrificing diversification."
In response to a question from Betty T. Yee, a board member and California state controller, Mr. Foresti said Wilshire executives have discussed it with other clients and he expects some Wilshire clients might include it in light of expected lower returns.
"I think we're going to run into many, many difficult asset allocation conversations with clients," Mr. Foresti said. Clients will either stick to the status quo and "accept lower returns" or try to push back against the prospect of lower returns with more complex techniques using leverage to "hold the line on returns."
Wilshire spokeswoman Amanda Lake said in an email, “Wilshire clients occasionally use leverage.”
