CalPERS using leverage, alts to hit return target

CalPERS reached a new milestone on the road to fulfilling its last CIO's vision of leveraging the $495.3 billion pension plan and investing the capital in alternative investments.

The board of the California Public Employees' Retirement System, Sacramento, has been making a series of small changes that culminated in a new asset allocation on Nov. 15 that embeds 5% of leverage into its asset allocation and shifts nearly $60 billion in assets into alternative investments by creating a new 5% private debt allocation, boosting private equity by 5 percentage points to 13% and increasing real assets by 2 percentage points to 15%.

The new asset allocation goes into effect on July 1, 2022. Staff is expected to return with an implementation strategy at the investment committee's next meeting in March. CalPERS investment staff declined to be interviewed.

CalPERS officials plan to use leverage to increase the portfolio's exposure to lower risk investments, like fixed income, by leveraging assets such as global equities to help increase the portfolio's diversification, said CalPERS spokeswoman Megan White in an email response to questions.

Under its new asset allocation, CalPERS also cut global equities by 8 percentage points to 42% and liquidity to zero, and increased fixed income by 2 percentage points to 30%.

"The new asset allocation is 105% because leverage is like whip cream on top of pie that is sliced global equity (42%), fixed income (30%), real assets (15%), private equity (13%), private debt (5%)," she said.

"Adding whip cream doesn't change how the pie was sliced," Ms. White said.

The 5% leverage is "a good starting point," but that could be increased or reduced in the future, James Sterling Gunn, managing investment director of CalPERS' trust level portfolio management program, told the investment committee Nov. 15 before it selected the new asset allocation. And staff may want to increase the leverage in the future.

Staff said leveraging the portfolio adds diversity and lowers risk. What's more, the portfolio already has some leverage.

CalPERS staff currently has the ability to take active leverage, which reflects the deviation of its portfolios to their benchmarks up to 20%, said Dan Bienvenue, interim CIO.

The difference is that the new 5% leverage allocation adds leverage to CalPERS' strategic allocation "as a diversifier," Mr. Bienvenue explained. Active leverage is "not intended to … diversify risk whereas adding leverage to the strategic asset allocation ... would act as a diversifier and a ... risk reducer," he said.

The investment team will use a combination of physical and derivative securities to build the desired strategic asset allocation including the new leverage when it goes into effect, Ms. White said.

CalPERS Board President Henry Jones asked staff to include in its asset allocation execution strategy an option to reduce the 20% active leverage to 15% to keep the total leverage in the portfolio, including the new strategic allocation, to 20%.

CalPERS did much of this work without a permanent chief investment officer. It's former CIO, Yu "Ben" Meng, resigned in August 2020 after questions arose about his personal investments and Mr. Bienvenue, CalPERS' deputy CIO, was appointed interim CIO. CalPERS is currently in the midst of its second search process. Finalists interviews are expected in December.

Under the last timeline provided to the board over the summer, a new CIO is not expected to join CalPERS until March, the same month that staff plans to provide the investment committee with its asset allocation implementation strategy. Under this timeline, the new CIO would have no input into the leveraged asset allocation nor how it will be implemented.

The road map CalPERS has been following appears to be one set by Mr. Meng, who set pension fund officials on the course to lever the pension plan to add more alternatives including a new private debt allocation to increase the portfolio's returns.

Mr. Meng was still at the helm in June 2020 when the board started easing more assets into private credit by increasing the percentage of the plan assets invested in opportunistic strategies, a bucket limited to 5% of plan assets 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.

The topic of increased leverage was raised in June 2019 by Mr. Meng, who said leveraging the portfolio could give staff members cash to take advantage of market dislocations in a market drawdown. In September 2019, the investment committee added aggregate leverage of up to 20% when the staff directly controls the exposure. Staff control is defined as when the staff applies debt to in-house portfolios or when the staff has authority over a money manager or a limited partnership that uses debt.

Mr. Meng said at the time 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 add the leverage to its asset allocation right away.

Currently, the pension plan has 4% of active leverage, Mr. Bienvenue said.

The leverage is "aimed at fixed, not private assets," Ms. White said in an email. So, cap-weighted global equities that would have been 34% in an unlevered portfolio designed to achieve a 6.8% return are 30% in CalPERS' new levered portfolio that is expected to earn the same return, she said.

That 4-percentage-point difference is added to the 5% leverage in the new asset allocation to equal a total of 9% leverage, she explained.

Mr. Gunn said using leverage as part of CalPERS' asset allocation allows plan officials to "reduce the equity exposure just a smidge and increase the fixed-income exposure and the overall effect is with a modest level of leverage, we have a modest decrease in the drawdown risk of portfolios."

Mr. Gunn also said the staff is very comfortable leveraging the portfolio because of its monitoring tools.

"So that really is the key takeaway message for the strategic allocation of the leverage. In terms of 5%, the intent here, we feel quite comfortable doing this, we have a dashboard for liquidity and leverage that we monitor regularly," Mr. Gunn said.

The dashboard was another innovation added by Mr. Meng during his short tenure at CalPERS.

CalPERS' general investment consultant, Wilshire Advisors LLC, agreed with leveraging the portfolio in part due to the monitoring tools shepherded by Mr. Meng. In 2019, CalPERS centralized its liquidity management and developed a comprehensive, real-time liquidity management framework and dashboard to allow staff to track the portfolio's liquidity. In addition, CalPERS stress tests the portfolio over three-, seven- and 30-day periods, Mr. Gunn noted at the Nov. 15 meeting.

"While a leverage target does increase the complexity of the portfolio, Wilshire feels the organization is well positioned to handle implementation and has sufficient tools in place to monitor the amount of leverage and the liquidity requirements necessary to support such an approach during challenging market environments," the consultant said in a letter provided to the investment committee for the meeting.

In general, leverage offers large investors a number of benefits and opportunities as well as risks, said John Delaney, Philadelphia-based senior director, investments, and portfolio manager at Willis Towers Watson PLC, in an email, noting he was not commenting specifically about CalPERS' plan.

Some of the benefits are that leverage allows investors to be "more efficient with their capital in terms of allowing portfolios to gain or increase exposures without dedicating physical dollars to get those exposures."

Willis Towers Watson recommends that asset owners add leverage to make their portfolios more efficient from a return and risk management perspective, he said.

"Most of our client base uses leverage within their Treasury overlay programs," he said. "Those that have not used it historically continue to consider it."

Adding leverage in a Treasury overlay program or within an asset allocation can have the same effect, Mr. Delaney said. Leverage also has the benefit of making investors more flexible in how they manage their portfolios, he said.

Leverage also allows investors to quickly increase or decrease equity beta or duration of the portfolio without having to wait for a physical equity or bond settlement.

The risks include added volatility because the portfolio's notional value is higher than its dollar value, which could make the portfolio lose more money in a downturn than it might without the leverage. And added leverage makes keeping an eye on liquidity "crucial for managing risk and maintaining exposure," to ensure the portfolio has enough liquidity to replenish collateral should the assets being levered decrease in value, Mr. Delaney said.

"Largely, investors just need to be aware of how volatile the interest rate environment has been and is likely to continue to be, given the uncertainty around inflation expectations" and conduct stress tests to ensure their portfolios can withstand potential movement in interest rates, Mr. Delaney said.

CalPERS' new asset allocation is designed to achieve its 6.8% expected rate of return. The current asset allocation is only expected to produce a return of 6.2%.

In addition to increasing alternative investments, the new target allocation also decreased cap-weighted public equity by 5 percentage points to 30%, reduced factor-weighted public equity by 3 points to 12%, cut Treasury bonds by 5 points to 5%, decreased mortgage-backed securities by 3 points to 5%, increased investment-grade corporate bonds by 4 points to 10%, retained its 4% allocation to high yield, increased emerging market sovereign bonds by 4 points to 5%, and eliminated its 1% liquidity allocation.

The leverage in the new asset mix is in investment-grade corporate bonds and high yield, Ms. White said.