CalPERS's $50 Billion Bet on Equities Pays Off?
The bet helped beat volatile equity markets in the 12-month state fiscal year that ended June 30, show interviews and pension system investment committee documents.Ben Meng is a very smart CIO. I had a lengthy discussion with him back in March and I can assure you he absolutely gets the challenges CalPERS faces across public and private markets.
The bet in the 12-month period between July 1 and June 30 involved moving around $54 billion from traditional passive cap-weighted equity strategies, which invest more in stocks with the biggest market capitalization, to a factor-based strategy, which picks stocks on attributes like long-term past performance or whether the stock is undervalued.
Eric Baggesen, a CalPERS managing investment director in charge of asset allocation, said that moving the cap-weighted equities to a factor strategy was key in CalPERS achieving a 6.7% return in the 2018-2019 fiscal year, shows a video stream of the pension system’s investment committee meeting on August 19.
Without the move of the investment money, CalPERS’s overall returns for its $360 billion plus portfolio would have been a much lower 6%, Baggesen told the investment committee.
“The factor-weighted segment of public equities over the fiscal year actually had a return of 13.4% that was over 800 basis points in excess of what the market capitalization return was,” he said.
CalPERS statistics show that the approximate $100 billion CalPERS keeps in passive cap-weighted strategies had a 5.4% return in the July 1, 2018, to June 30, 2019, fiscal year.
Overall, the equity asset class has a 6.1% return in the fiscal year ended June 30.
With a funding status of only 71%, CalPERS, the largest US pension plan, is short almost $140 billion in pension obligations it needs to pay long term. It needs to achieve or exceed its expected 7% rate of return each year, or come as close to it as possible, to avoid even bigger funding deficits.
The current deficits are particularly troubling for hundreds of municipalities whose employees are CalPERS members. The municipalities say if their contribution rates continue to rise, employee layoffs and even bankruptcy will be in their future.
Personnel in school districts and state employees are also part of CalPERS.
The major move into factor-based equity strategies in the 2018-2019 fiscal year was much broader than trying to achieve better equity returns. It has to do with the fear of an equity drawdown similar to what CalPERS experienced during the great financial crisis back in 2008 and 2009.
The value of CalPERS equity portfolio back then dropped by almost 30% and overall returns were down by around 25%.
Baggesen said that investment staff is “focused through the lens of trying to mitigate some of that equity drawdown potential.” He noted that CalPERS is well aware of the financial strain a drawdown could have on government entities that make contributions into the system for their employees.
He said factor investing can act as a buffer to mitigate some of the drawdown.
CalPERS, like most public pension plans in the US, has a large allocation to equities. In CalPERS’s case its around 50% of its portfolio.
“So what happens is the equity markets tend to drive what happens to the fund and that’s going to be the case as long as we have the proportion of equity investing that we do have,” Baggesen said. “And this is typical for virtually every public pension fund in the United States. And honestly, many of them around the world as well.”
Baggesen said a side benefit of factor investing was that in addition to offering some drawdown protection, factors portfolios tend to do better in volatile equity markets.
“Even though it took the entire year to complete that work (transfer of the money from cap-weighed to factor-weighted investments) , it did have a positive effect on the fund that added approximately two and a half billion dollars to the overall market value with a gain of 70 basis points,” said Baggesen at the August 19 meeting. “And that’s a pretty significant achievement.”
The presentation to the investment committee shows that as of June 30, the factor equity portfolio made up around 15% of CalPERS overall portfolio while cap-weighted equities made up around 35%.
Using a cap-weighted index to pick stocks is the most popular from of passive investing. In CalPERS’s case, around $100 billion is tied to the FTSE All World Index. The index includes 16,000 stocks ranked by market price and number of shares outstanding, Baggesen explained at the investment committee meeting.
Stocks with the highest market capitalization get the largest weighting in the index, so stocks like Apple, Microsoft, and Facebook are among the largest holdings of CalPERS and other large US institutional investors in their passive equity portfolios.
Factor-based investing is not entirely new to CalPERS and many other pension plans have used factor-based tilts to enhance index returns. Money management firms that specialize in factor-based investments like Dimensional Fund Advisors in Austin, Texas, have seen tremendous growth as institutional investors have piled into those strategies.
CalPERS has for more than a decade made smaller commitments to factor investing through internally managed portfolios, but commitments have never been in the tens of billions.
The pension plan has used factor strategies that use a company’s quality, which is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance, or a momentum strategy, which is based on the theory that outperforming stocks in the past will continue to show positive, strong returns going forward.
CalPERS has not disclosed what factors are used in the approximate $54 billion new factor strategy.
It is also unclear what influence CalPERS’s new Chief Investment Officer Ben Meng, who took office in January, had in the new factor investment allocation. What is clear is that the continued movement of money from cap-weighted equities to factor investing happened partially under his watch, since Baggesen said it took a full year to complete the transfer.
Meng at the August 19 meeting had a warning that factor investing also has its risks in up market cycles.
“Just a word of caution,” he said. “It does not perform this well in all market environments, but in the down market we needed to perform better than other asset classes, which it has done. But when the market rallies, most likely these segments will underperform.”
I like the way the article ends because Meng is right, factor investing is no panacea, it typically helps large pension funds weather down or volatile markets (typically, not always) but when markets rally, it underperforms and it has underperformed considerably over the last three years.
In January 2018, I discussed how the Dutch pension behemoth APG has been applying a factor-based approach to investing for two decades, with mixed results but mostly successfully over the long run.
APG's Head of Quantitative Equity, Gerben De Zwart, leads a sophisticated team which is continuously looking to innovate, using alternative data and combining quant and fundamental data:
APG’s choice of factor investing is not so much a philosophical one as it is a practical one. The pension fund’s factor investments amount to about 80 billion euros, or A$124 billion, and it would be difficult to invest such a large portfolio completely with active, fundamentally focused managers.APG also takes pride in its approach to governance and sustainability and it requires its external managers to meet the same requirements. According to De Zwart, much of the research into responsible investing is quantitative as well and they share their methodology with their external managers to measure things consistently.
A factor approach allows APG to produce above index returns, while at the same time ensuring liquidity.
But it also has a fundamentally driven program.
“A large part of the portfolio is also equipped with fundamental strategies that are highly concentrated. We have a portfolio with 5 to 10 per cent interests, where we also have active ownership, and where we know the company well, we know the board of directors well, but you also see that these portfolios are not liquid,” De Zwart says.
“So half is quantitatively invested and the other half is invested fundamentally and what we see is that the return flows diversify very well. In the year that factor investing is doing well, fundamental is lagging behind and vice versa, which means that the total return on shares is very stable.”
All this to say, CalPERS's isn't the only large global pension fund that has adopted factor investing.
In Canada, CPPIB does a lot of factor investing as do other large Canadian pensions. CPPIB's Senior Managing Director & Global Head of Capital Markets and Factor Investing is Poul Winslow. He runs the Capital Markets & Factor Investing (CMF) team which invests assets globally in public equities, fixed income securities, currencies, commodities and derivatives, as well as the engagement of investment managers and co-investments to invest in public market securities. CMF is also responsible for managing the fund’s collateral, financing and trading needs.
One thing is for sure, almost every major pension and sovereign wealth fund is hunkering down, bracing for a global downturn.
They don't have much of a choice, with plunging yields wreaking havoc on global pensions and negative rates looming in the US, I've been warning all my readers to brace for a bumpy ride ahead.
And with most US pension plans falling short of their projected returns this year, not just CalPERS, it's critically important to protect against downside risk, especially if they are already in an undesirable underfunded position.
In fact, this morning, I received an email from Tom O'Donnell, Principal and Managing Director of 3D Capital Management stating this:
I enjoyed your article about how America’s Pension Funds Fell Short in 2019—especially this part: “It's just stupid to think US public pensions can index all their investments and not worry about huge volatility which will impact the volatility of their contribution rate. And when stocks and bonds get whacked, a lot of pensions that avoided alternatives altogether are going to be in big trouble.”I must confess, I haven't had a chance to talk to Tom about what exactly he means by 'strategic hedging' but I would invite my readers to 3D Capital Management's website here and get informed.
I completely agree. Back when I was doing risk-mitigation for the Virginia Retirement System, there was one thought that kept me awake at night: you cannot pay beneficiaries with negative returns. Ten years after the global financial crisis, public pension plans are living my worst nightmare--they remain underfunded following one of the longest and strongest bull markets on record.
Now, as your article astutely reports, we’re looking at another downturn. The risk is right in front of us, and it’s going largely unaddressed.
I think the answer lies in selecting the right kind of alternative investment. To mitigate the risk of a falling stock market, pension fund fiduciaries currently spread the fund’s holdings into different asset classes. This is akin to spreading one’s eggs into multiple baskets—always a smart thing to do—but what’s missing in most pension plans is a protective lining inside of the stock market basket that cushions the eggs when the market inevitably falls.
The protective lining that at-risk pension plans are not using is an alternative called strategic hedging. A strategic hedge is not “one more investment basket that we hope won’t be affected when the crash comes.” Rather, it’s a lining inside the stock market basket that is designed to profit when the inevitable happens. The objective of a strategic hedge is to stand out of the way when the stock market is rising, and to step in and profit by shorting the market when it is falling.
At-risk plans aren’t using strategic hedging because they say it can’t be done. But I know it can be done because I’m invested in a strategy that has done it.
All I know is while some media outlets are making a big stink about "CalPERS's $50 billion bet on factor investing", I'm more impressed by how liability-driven investing portfolios are proving their worth in era of interest rate volatility.
And it's not just US corporate plans. Last week, I discussed how Denmark's ATP tallied a record 27% gain in first half of 2019, mostly owing to gains on government and mortgage bonds.
Following that comment, Jim Keohane, President & CEO of HOOPP, was kind enough to share this with me on ATP:
"I know they had a very high return which has to do with how they manage their liability hedge portfolio. Their liabilities are different than a regular pension plan. Every Danish working citizen makes an annual contribution. They take 80% of that contribution and hedge it forward in the interest rate swap market and based on the yield they get on the swap they promise a future cash flow stream. So on the asset side of the balance sheet their entire liability hedge portfolio is long term swaps. Based on the move to negative rates in Europe they would have a huge gain on the swaps - hence the high return, but the present value of the liabilities would also go up by a similar amount so there is probably no change in their funded ratio. The asset return is only half the picture."Jim added this: "I would also add that it is a good thing that they run a liability matched portfolio otherwise they would have gotten killed. It is a very well-run organization."
Another explanation for ATP's record performance was provided to me by Marc-André Soublière, Senior VP Fixed Income and Derivatives at Air Canada Pension Fund:
"Another explanation is 30 bps move they made on 30 yr swap spreads! 30 year swaps spreads not swaps. They could have bought 30 yr German bonds, or futures. The spread between both was over 50 bps in January. To tie this in with what Jim Keohane wrote. If they discount their liabilities with a swap rate then there is no mismatch. However, in Canada, most liabilities are discounted using AA corporate yield. Using swaps to get your duration creates a mismatch or a basis risk. I am not familiar with ATP's LDI strategy...."I thank both of them for sharing their wise insights with my readers but it's clear LDI strategies helped ATP better match its assets and liabilities and saved it from an otherwise terrible funding mismatch.
Again, I'm happy CalPERS has discovered the benefits of factor investing in down or volatile markets, and while I think it should continue this activity, I'm not as impressed as some of the media outlets.
I'm more interested in seeing what Ben Meng is going to do in private markets, especially now that US private debt funds are bracing for a downturn.
Below, Part 1 of the CalPERS's Investment Committee which took place on August 19th. Take the time to listen to Eric Baggessen, Senior Investment Officer, Global Equities at CalPERS, as well as Ben Meng, CalPERS’s CIO.
I also embedded Part 2 of CalPERS's Investment Committee as it has great information on asset allocation return projections which I believe are still too stubbornly high.
Third, GPIF's CIO Hiromichi Mizuno discussed GPIF with CalPERS's board at their August 20 Investment Committee Education Workshop. CalPERS's CIO Ben Meng introduces him at the beginning. This is a must watch as Mizuno goes over a lot of details on GPIF that many investors need to understand. Also, read my recent comment on GPIF here.
Fourth, Kate Moore, Blackrock chief equity strategist, and Josh Brown, Ritholtz Wealth Management, join "Fast Money Halftime Report" to discuss the stocks they're watching.
Fifth, Sarah Ketterer, CEO and portfolio manager at Causeway Capital Management, and Mohamed El-Erian, chief economic advisor at Allianz, join "Squawk Box" to discuss what they expect from the markets as September kicks off in the red.
Sixth, September is a huge month for some of the biggest central banks around the world. CNBC's Steve Liesman reports.
Lastly, Dino Kos, chief regulatory officer at CLS and a former New York Fed official, Joe Lavorgna, chief economist of the Americas at Natixis, and Mohamed El-Erian, chief economic advisor at Allianz, join "Squawk Box" to discuss the big month ahead for the Fed and the different kinds of pressures it's facing. Great discussion, listen carefully to it.
Comments
Post a Comment