Monday, November 13, 2017

CalPERS Doubling its Bond Allocation?

John Gittelsohn of Bloomberg reports, Calpers Considers More Than Doubling Bond Allocation to 44%:
The California Public Employees’ Retirement System, the largest U.S. pension fund, is considering more than doubling its bond allocation to reduce risk and volatility as the stock bull market approaches nine years.

Calpers is looking at a menu of options for its fixed-income target ranging from the current 19 percent to as much as 44 percent, according to a presentation for a board workshop in Sacramento coming up Monday. Equities could be cut to as little as 34 percent from 50 percent. Stocks were the best-performing asset class in fiscal 2017, returning almost 20 percent.

“The markets have had a pretty good run and it’s possible Calpers staff is thinking this might be a good time to lock in some of the gains,” Keith Brainard, research director for the National Association of State Retirement Administrators, said in a phone interview.

Calpers oversaw $343.6 billion in assets as of Nov. 8, up about 13 percent this calendar year on a combination of returns and contributions from employees and taxpayers. The fund lost money in past bear markets, including about 25 percent in the 12 months through June 2009 and 7 percent in fiscal 2001.

Bond yields remain at low levels because of persistent weak inflation, central bank easy money policies and global investors chasing income. Raising the allocation would reduce the fund’s discount rate, or average expected return, to 6.5 percent from the 7 percent annual target adopted last year. A lower target would probably require bigger contributions from taxpayers and public agencies to cover pension obligations, a shift that board member JJ Jelincic said he would oppose.

Screaming Employers

“We’ve cut the return expectation to the point that employers are screaming, ‘We can’t afford it. We can’t afford it,’ ” Jelincic said. “I personally would be willing to take on a little more risk.”

The average allocation for public pensions is about 23 percent to fixed income and 49 percent to stocks, according to Nasra data.

The Calpers board is scheduled to vote on the allocation in December. Almost all of the fixed-income and stock holdings are managed in-house while more complex assets, such as private equity and real estate, are overseen by outside consultants. Allocations to private equity and real assets would stay at 8 percent and 13 percent, respectively, under all scenarios under consideration.

The allocation revisions occur every four years. Calpers is working to provide for a growing wave of longer-living retirees.
I recently discussed big bonuses at CalPERS and CalSTRS and stated part of the difference in returns in FY 2017 can be explained in the private equity returns and that the latter took on more global equity risk and more risk in general while the former was hunkering down.

Now we learn that on Monday, CalPERS's board will discuss several items, including a significant increase in its bond allocation. You can see the Investment Committee agenda and items by clicking here.

So, what do I think? Well, you know my market views. I'm openly worried about deflation hitting the US and my most recent market comments tell you that I think it's wise to take some risk off the table:
Moreover, I don't foresee a big reversal in inflation, and openly worry many market participants still don't get the "baffling" mystery of inflation-deflation.

I have also repeatedly stated on my blog to load up on US long bonds (TLT) on any backup in yields because when the bubble economy bursts and the next deflation tsunami and financial crisis hit us, it will bring about the worst bear market ever.

Of course, central banks know all this which is why the Fed has signaled it's preparing for QE infinity, something which I fundamentally believe is a foregone conclusion, which can explain pockets of speculative activity in the stock market.

Anyway, back to CalPERS. It's right to reduce overall equity risk but increasing fixed income for a large pension when rates are at historic lows necessarily means it will have to decrease the assumed rate of return going forward (the discount rate) and increase the contribution rate, which will cause major panic among California's public-sector employees and cash-strapped cities.

In fact, CalPERS wants broke cities to deliver bad news to out-of-luck pensioners, namely, some workers will lose a share of their pensions because of their employers’ failure to keep up with bills (get ready for the Mother of all US pension bailouts).

Most of Canada's large public pensions have been  reducing their allocation to fixed income and increasing their allocation to private markets, especially infrastructure, over the last few years.

But CalPERS doesn't have a dedicated infrastructure group and deals are pricey these days. I actually emailed CalPERS's CIO, Ted Eliopoulos, to put him in touch with David Rogers and Stephen Dowd at CBRE Caledon Capital so they discuss a game plan in infrastructure, a must-have asset class which CalPERS and many other US pensions are under-allocated to.

Why do Canada's large pensions love infrastructure? Because it's a long-term asset class, even longer than real estate, which offers stable returns in between stocks and bonds.

It's also highly scalable and Canada's large pensions can put a lot of money to work fairly quickly and they do so by going direct in this asset class, which means no fees to funds like they pay in private equity.

The only large Canadian pension which has no infrastructure exposure yet is HOOPP which ironically has the largest fixed income allocation and is super funded (120+% and it will increase its benefits to its members).

Why doesn't HOOPP invest in infrastructure? It hasn't found the right deal yet because deals are expensive in this asset class and thus far, it hasn't needed to. Interestingly, however, HOOPP is shifting some of its credit risk as it recently committed a big chunk to a new CLO risk retention vehicle.

I'm not sure CalPERS is ready to increase its infrastructure investments or do anything exotic in its credit portfolio so I would argue it's sensible to tactically shift more assets in bonds in anticipation of a major pullback or bear market which will clobber risk assets.

Alternatively, it can increase its allocation to Private Equity but that portfolio needs some work and Mark Wiseman and BlackRock's special attention.

Let me also state the following, while I applauded CalPERS nuking its hedge fund portfolio three years ago, I think now is the time to allocate a sizable amount to a select few large hedge funds across directional and non-directional strategies.

Of course, in order to do this properly, CalPERS needs to hire experts who know what they're doing and pay them properly, no easy feat (there's a reason why CPPIB and Ontario Teachers' are Canada's largest hedge fund investors).

But at a minimum, if I was Ted Eliopoulos, I would definitely sit down with Bridgewater, Balyasny, Citadel, Farallon, Two Sigma, Angelo Gordon, and many more top funds who focus on alpha.

CalPERS should be looking at all possibilities but it's easy for me to say they should do this and that, the reality is they can't because they don't have the governance to do everything Canada's large pensions are doing.

So, with all due respect to JJ Jelincic, I disagree with him that now is the time to increase risk in public or private markets. Maybe the right move is to hunker down, increase fixed income allocation, accept lower returns and lower volatility for the foreseeable future, and limit your downside risk.

Lastly, I highly recommend Ted Eliopoulos and CalPERS‘s board speak to my friend, Nicolas Papageorgiou, Vice President and Head of Research, Systematic Investment Strategies at Fiera Capital here in Montreal. There may be smarter ways to reduce overall risk and volatility while maintaining decent returns.

Update: Below, part 1 and 2 of CalPERS's November 13th Investment Committee (see agenda here). These board meetings are long and tedious but for pension investment junkies like me, they are worth watching. Take the time to watch both parts below which are also available here.


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