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June 29, 2020 12:00 AM

For CalPERS CIO, revolution is now

Meng centralizes management, adds leverage and changes governance

Arleen Jacobius
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    Ben Meng
    Photo: Emory Ensign
    Yu ‘Ben’ Meng’s addition of leverage is meant as a way to bring oversight of all asset classes under centralized control.

    CalPERS CIO Yu "Ben" Meng has been conducting a slow-moving campaign to boost the $386.9 billion pension plan's returns by centralizing management and making comparatively revolutionary changes to the fund's governance along the way, adding the ability to leverage the entire fund up to 20%.

    Use of leverage has attracted a lot of attention for the California Public Employees' Retirement System, Sacramento, after its investment committee signed off on that in September. The new leverage limit is another step in CalPERS' move since the financial crisis to govern the plan as a whole, rather than each asset class operating independently with its own leverage limit and leverage definition.

    Currently, the Sacramento-based pension plan has 4% to 5% leverage, Mr. Meng said. In September, the plan had less than 10% leverage.

    "We don't plan to leverage to 20%," Mr. Meng said in an interview. "We will deploy leverage gradually, prudently and opportunistically."

    He called the 20% limit "moderate" leverage that is needed to offset lower return expectations; CalPERS currently has a 7% expected rate of return.

    Before the 20% total fund limit was set, the leverage allowed in each asset class totaled about 23%.

    However, not all leverage is counted as such. Leverage in both capital commitments and direct debt are considered as contingent liabilities, according to CalPERS' investment policy. And leverage in currency derivatives used for hedging or risk management purposes likewise isn't counted as leverage.

    The 20% total fund leverage limit applies to the total leverage in which staff exercises direct control of the exposure. Direct control means leverage where staff has authority over a manager or limited partnership's use of leverage or staff applies debt to in-house portfolios.

    "If you can't control it, you can't manage it," said Eric Baggesen, CalPERS managing investment director, trust level portfolio management, in a separate interview.

    Staff using leverage

    Staff members' ability to leverage the pension plan is just one of the changes made during Mr. Meng's nearly 18-month tenure as chief investment officer. Earlier this month, the board increased the percentage of the plan invested in opportunistic strategies, a bucket that is not part of its asset allocation, and skewed those strategies toward credit investments. At the same time, the board changed its total plan benchmark methodology to help it avoid the denominator effect of a down market on alternative investments.

    Over the past year, Mr. Meng has continued to centralize management — taking a total fund approach not only to leverage, but also liquidity, drawdown capacity and the risk budget.

    The board has also given staff more room to operate with less oversight, reducing some reporting to the investment committee and increasing investment discretion. For example, in December, the investment committee transferred the private equity and real assets leverage limits to its policy-related procedures from its investment policy, meaning leverage limits violations are reported to senior staff instead of the committee. Leverage will allow CalPERS to borrow money at low interest rates and use the capital to invest in assets that could offer higher returns. Mr. Meng said this is part of his strategy to acquire "more assets" using leverage as well as increase exposure to alternative investments, which he called "better assets." He said he plans to increase alternative investments with or without borrowing money to do it.

    This strategy is not risk free, Mr. Meng said. Leverage can exacerbate a market drawdown by increasing short-term volatility. "We're not able to hide from risk exposures," he said.

    "Leverage is a double-edged sword," Mr. Meng said.

    During the most recent market sell-off, CalPERS did not have to sell assets to meet liquidity requirements and had enough capital to invest in market dislocations, he said.

    But not all risks are "created equal," and CalPERS may use leverage to gain more risk exposure, he added.

    CalPERS is taking advantage of its size by centralizing risk management across the entire portfolio rather than by each asset class. The pension fund is continuing to manage the risk in-house, he said.

    Leveraging the plan will also enable CalPERS to increase exposure to investments with expected higher returns such as private equity and private credit.

    CalPERS had $27.2 billion in private equity and $44.7 billion in real assets as of March 31.

    Staff expects alternative investments to outperform public asset classes, which will help CalPERS attain its 7% expected rate of return, he said.

    CalPERS officials have not only centralized the governance structure, but staff also conducted total plan liquidity testing and implemented a "liquidity on demand" plan, he said.

    "Too much liquidity in a low-yield environment is costly and too little is deadly," Mr. Meng said, repeating a phrase he has said often in meetings.

    Borrowing for liquidity

    A key feature of liquidity on demand is that CalPERS can borrow when it needs liquidity from very reliable counterparties, he said.

    While uncommon among U.S. public pension plans, leverage is more often used in U.S. corporate defined benefit plans and European pension schemes, said John Delaney, Philadelphia-based senior director for investments and a portfolio manager at Willis Towers Watson PLC.

    Still, it's not for every asset owner. Only larger funds are able to add total fund leverage because only they would have resources to manage all the risks, he said.

    Leverage can be added in different ways, like using futures for equity exposure and other hedging strategies for bond and Treasury exposure, Mr. Delaney said.

    Asset owners also need to set up a single collateral pool to put 10% initial margin to cover exposure for the equities and Treasury side, he said. The idea behind the single collateral pool containing both equity and Treasuries is that those assets usually tend to work in opposite ways, with Treasuries losing money when equities are roaring, he said.

    One of the risks of total fund leverage is that stocks and bonds don't always operate as expected, he said. At the end of March, for example, equities and Treasuries dropped at the same time.

    The real risk is an asset owner will have to sell physical equities and bonds in its portfolio to cover margin calls to replenish the collateral pool if both equities and Treasuries are selling off at the same time, Mr. Delaney said. Most of his clients typically only leverage Treasuries rather than both equities and bonds to avoid this risk, he said.

    Leverage when properly managed can provide higher risk-adjusted returns for asset owners wanting to tie up only 10% of capital for physical bonds and equities and use the other 90% for higher-returning assets such as private equity, credit and real assets, Mr. Delaney said. Asset owners need to use the borrowed money to invest in assets that will earn enough premium over the borrowing rate to increase its total fund returns, he added.

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