CalPERS to Leverage Up its Portfolio?

Arleen Jacobius of Pensions & Investments reports that CalPERS officials might leverage the portfolio as part of a plan to help the pension fund weather an economic downturn:

The topic came up in a response by CIO Yu Ben Meng to a question from Lynn Paquin, California Controller Betty T. Yee's designee on the board, regarding what investment policy changes the staff could request so staff members could act more quickly in the event of a market drawdown.

"Yes, very good question. So, for example one of the undesirable outcomes during a drawdown is we don't have money to deploy to take advantage of a market dislocation," Mr. Meng said. "And one of the ways to generate additional liquidity is put on leverage on the total fund. So, we borrow money."

This would impact the total fund's leverage policy, Mr. Meng noted.

However, he added that the emerging plan is currently under development and the staff will return to the investment committee to seek an investment policy change if needed.

Mr. Meng declined to comment further on whether the staff plans to leverage the entire fund in preparation for or in the event of a market downturn.

We're having (and have had) discussions about the use of leverage in the asset allocation work for years, spokeswoman Megan White said in an email.

Officials for the $365.1 billion California Public Employees' Retirement System, Sacramento, can use some leverage on the portfolio already, Ms. White noted. CalPERS' treasury management policy references "borrowed liquidity," which is the short-term use of leverage to help maintain the pension fund's target risk profile. Borrowed liquidity requires CalPERS to have a plan to unwind the debt if the duration extends past 90 days. CalPERS' investment policy also allows the use of leverage within global fixed income, global equity and real assets.

"These asset class leverage capabilities have been in place since late 2008 when staff requested the board insert it into the global equity policy to allow us to run notional leverage via equity exposure, from derivatives being supported by assets other than cash," Ms. White said.

If CalPERS decides to leverage up its portfolio, it would be quite a change in policy. In July 2017, CalPERS was reviewing the use of leverage in strategic asset allocation and later that year, it said no to adding leverage:

In an asset liability management (ALM) workshop on November 13, CalPERS managing investment director, asset allocation and risk management, Eric Baggesen, told the board that “after a lot of discussion” the investment office decided not to proceed for two reasons.

“The first reason is the application of leverage, for one thing, certainly increases our market sensitivity,” Baggesen said. “It’s questionable as to whether we would really want to increase our market sensitivity when the majority of the segments of the investment opportunity set appear to be pretty highly valued at this point in time.”

Baggesen said the second, and “probably even more relevant” issue, from the perspective of strategic asset allocation, was that the application of leverage is not a set-and-forget exercise. He said the use and benefit of leverage depends on the spread between the cost of the leverage and the expected benefit of purchasing an asset using that leverage.

“That spread is not a constant, it expands and contracts,” he said. “That expansion and contraction, by definition, appears to recommend leverage as an active-management tool, in contrast to a strategic-management tool.”

Baggesen’s comments on leverage emerged during the CalPERS board’s asset liability workshop, an event held every four years to review, and if necessary revise, the fund’s long-term strategic asset allocation, and the demographic, actuarial, financial and economic assumptions that underpin them.

So why is CalPERS considering to add leverage now? Ben Meng, CalPERS's CIO, explains why above: "...one of the undesirable outcomes during a drawdown is we don't have money to deploy to take advantage of a market dislocation, and one of the ways to generate additional liquidity is put on leverage on the total fund. So, we borrow money."

Remember what happened to CalPERS during the 2008 crisis, it was unloading stocks in a falling market to make sure it has enough cash to meet its private equity and real estate obligations:

The pressures come as the California Public Employees' Retirement System has had to raise cash to fulfill commitments to private-equity firms and real-estate partners. The giant fund's predicament is another sign of how the market selloff is tightening the screws on pension funds nationwide. Many other pension funds have similar partnerships and could also confront liquidity strains.

Members of the board investment committee at Calpers held a closed-door session on Monday and discussed ways to raise more cash, according to people familiar with the matter. The issue was brought to the attention of the committee after members of the investment staff expressed concern, a person with knowledge of the matter said.

Typically, Calpers keeps less than 2% of its assets in cash, but the recent demands have forced it to raise that level.

"Calpers receives more than enough cash from employers and members to cover its monthly benefit obligations" to retirees and other beneficiaries, a Calpers spokeswoman said Friday.

Under normal conditions, pension funds count on some private-equity partners to distribute investment gains, while pensions owe some partners more capital. During the recent market selloff, however, distributions have dried up while capital calls continue. That's created a mismatch and a cash strain.

Since the credit markets have tightened up and real estate and alternative investments aren't very liquid, Calpers has been compelled to sell off stocks to raise large sums quickly. Those sales are turning paper losses into realized losses.

Calpers said it had $188.8 billion under management as of Wednesday, down 21% from the end of June. The fund, which said it had about 63% of its assets in global stocks at the end of August, has been punished severely by the stock-market selloff.

That was October 2018, a lesson for all mature pension plans that need liquidity when a crisis strikes.

If CalPERS was able to borrow back then, it would have made its capital calls to private equity partners without selling stocks at the bottom of the market.

This is what I call the intelligent use of leverage, a hot topic at pension funds these days. Most critics don't understand the use of leverage at a large pension fund like CalPERS which is why they're quick to criticize it.

CalPERS isn't the first US pension fund considering the use of leverage. In 2010, the State of Wisconsin Investment Board said it was considering leveraging its then $67.8 billion core fund to achieve an asset allocation equivalent to 120% of total assets over the next three years:

The groundbreaking move — believed to the first effort to adopt an approach that a number of pension funds are weighing — would enable the board to reduce its equity exposure and increase allocations to lower-returning and lower-risk assets that offer greater diversification benefits while seeking to meet the board's expected actuarial return.

SWIB officials discovered that, like many pension funds, Wisconsin's exposure to equity risk comprised 90% of the fund's volatility. The pioneering change also would position the fund to endure a period of high inflation and low economic growth, a scenario of growing concern for many investors.

Wisconsin's big public pension cheese basically adopted Bridgewater's all-weather approach which is one of the reasons why it's one of the few fully-funded US public pension plans.

The main reason Wisconsin's public pension is fully funded, however, is it adopted a shared-risk model like most of Canada's fully funded public pensions.

Canadian pensions have also pioneered the use of leverage and have the requisite sophistication to do this properly and intelligently using a broad array of instruments and strategies.

CalPERS might not be there yet but in my opinion, its CIO Ben Meng is smart enough to understand he doesn't want to get caught in another 2008 scenario where CalPERS is unable to meet capital calls without selling equities (at the bottom).

The main message I want to convey here is leverage isn't a bad thing, you need to use it wisely at the right time, so ignore CalPERS's critics who simply don't understand the use of leverage at pensions.

Below, I embedded Part 1 and 2 of the CalPERS's Investment Committee that took place earlier this week. Take the time to watch both clips but listen to the discussion of item 9 (beginning of the second clip) where Ben Meng discusses mitigating drawdowns and CalPERS's leverage policy.