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June 28, 2021 12:00 AM

CalPERS mulls tracking-error method change

New calculation would remove alternatives, citing problems with investible benchmarks

Arleen Jacobius
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    John Delaney
    Photo: Nicole Delaney
    John Delaney said that while it isn’t very difficult to find public equity benchmarks, determining benchmarks for alternatives comes with a host of issues.

    CalPERS' board is expected to decide in September whether to remove alternative investments from its tracking-error calculation used to control risk.

    Deciding to do so would make sense, consultants say. When it comes to alternative investments, tracking error doesn't work because these asset classes lack an investible benchmark.

    By comparison, it's "fairly easy to find benchmarks" for public equities, said John Delaney, Philadelphia-based portfolio manager for Willis Towers Watson PLC.

    Using tracking error for alternative investments means that investors are constraining "real life strategies" to a certain level of correlation or volatility relative to a proxy benchmark, he said.

    Many asset owners use a benchmark reflecting the opportunity cost, or the return over a public markets index for alternative investments. For example, CalPERS' private equity benchmark is Custom FTSE All World All Cap Equity, plus 150 basis points.

    For private assets, tracking error limits can limit investment in assets that "don't look like the benchmark," reducing the value of investing in alternative investments, Mr. Delaney said.

    The issue came up at the June 14 investment committee of the $469.8 billion California Public Employees' Retirement System, Sacramento. Staff would like to switch to what they call an "actionable tracking error" approach.

    According to proposed investment policy changes shared with the investment committee, CalPERS would remove a requirement that the asset allocation for its entire portfolio be managed within a target forecast annual tracking error compared to its benchmark of 0.75%. The asset allocation limit of 0.75% implies that during any one-year period, there will be less than a 5% probability that the active asset allocation return will fall less than 1.2%, the existing investment policy said.

    The asset allocation requirement in the existing investment policy captures the asset class deviations in CalPERS' total fund relative to its asset allocation targets, said CalPERS spokeswoman Megan White in an email.

    "Any underweights or overweights in any asset class relative to the policy benchmark create tracking error because our portfolio weighting differs from the policy weighting," she said.

    Arnold B. Phillips, interim deputy CIO, said in an email that the separate, annual asset allocation tracking-error limit of 0.75% wouldn't be needed because the actionable tracking-error calculation for the total portfolio would take that into account.

    "The asset allocation impact on tracking error comes from the deviations between the total fund portfolio and the policy benchmarks for the asset classes defined in the strategic asset allocation," Mr. Phillips said. "The asset allocation contribution is just one piece of the calculation of both total, and actionable tracking error."

    If adopted, the total fund would instead have an active risk target "consistent with forecast tracking error" of up to 1% relative to its benchmark. The proposed methodology would remove alternative investments from its calculation as well as eliminate annual tracking-error limits.

    Different definitions

    During its June 14 meeting, Mr. Phillips told the investment committee that other asset owners use actionable tracking error but define it differently by "ignoring the allocations within various asset classes." CalPERS would include those allocations, he said.

    CalPERS is not alone in considering how it measures risk and the value of tracking error across its portfolio.

    CalSTRS, for example, modified its approach in 2020. In March of that year, the board adopted a tracking-error approach for risk budgeting in its global equity portfolio.

    Its global equity portfolio is now managed within an annualized forecast active risk range of 10 to 50 basis points, according to the policy. The $299.8 billion California State Teachers' Retirement System, West Sacramento, had formerly had static targets for active and passive strategies, a report to the board at its March 2020 meeting said.

    Those targets were that 30% of CalSTRS' U.S. equity portfolio was to be actively managed, 50% of non-U.S. developed equity portfolio was to be actively managed and 100% of the emerging markets equity portfolio was to be actively managed.

    The board adopted the active risk budget to allow staff to move equity investments between passive and active management.

    In July, the CalSTRS board is expected to decide whether to adopt active risk budgets for its fixed income as well as its sustainable investment and stewardship strategies portfolio, said CalSTRS spokesman Thomas Lawrence in an email.

    The active risk budget gives staff more flexibility to invest in the "best opportunities across global markets, regardless of the region," the report to the CalSTRS board said.

    Closely related concepts

    During an educational session on tracking error in November, Michael Krimm, an investment director at CalPERS, explained that tracking error and risk budgeting are closely related concepts.

    The idea of risk budgeting is basically the question "of how you … budget or allocate risk," Mr. Krimm said. "That includes questions like, what should our tracking error limit be?"

    He added that the topic of risk budgets is "really a broader topic about plan investment strategy, more broadly."

    Rather than adopt a risk budget like CalSTRS, per se, when it comes to active strategies, staff has been given discretion by the CalPERS board to deviate from the policy portfolio, CalPERS' Ms. White said.

    "The question is how this discretion should be managed/allocated," she said. "We have a continuous CIO-level process of planning, assessment, allocating and monitoring of investment risk across the plan."

    It is more of an ongoing activity than risk budgeting, she said.

    "We are hesitant on the term 'budgeting' as allocating risk is a lot more nuanced than just allocating tracking error," Ms. White said.

    Some asset owners including CalPERS are reconsidering how they use tracking error in measuring risk.

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