CalPERS Adds Modest Leverage to its Portfolio

Arleen Jacobius of Pensions & Investments reports CalPERS adds 5% leverage to entire portfolio:

CalPERS on Monday adopted a new asset allocation that adds 5% leverage to the entire portfolio, boosts private equity by 5 percentage points to 13% and adds a 5% opportunistic allocation.

The asset allocation which goes into effect on July 1 also increases fixed income and real assets by 2 percentage points each to 30% and 15%, respectively. Reductions came from global equity, cut by 8 percentage points to 42% and liquidity down 1 percentage point to zero.

The leverage and opportunistic allocations are considered separate from the pension fund's target allocation.

Sterling Gunn, a managing investment director at the $495.3 billion California Public Employees' Retirement System, Sacramento, told the investment committee Monday that including leverage as a strategic allocation would "improve the diversification in the portfolio and to help reduce risk."

Mr. Gunn said the staff selected 5% as an upper limit of leverage for now, but that could be increased or reduced in the future.

CalPERS' staff already has the ability to take active leverage, which reflects the deviation of its portfolios to their benchmarks up to 20%, said Dan Bienvenue, acting CIO, in response to a question from outgoing board member Margaret Brown.

"What this (adding 5% leverage to its asset allocation) would do would be to add leverage in to the strategic asset allocation as a diversifier," Mr. Bienvenue said.

At the request of committee member and board President Henry Jones, the staff will bring back an option as part of its implementation plan for the new asset allocation to consider reducing the 20% active leverage to 15%, when the staff adds 5% strategic leverage to the entire portfolio.

Mr. Gunn said the staff reduced its cash allocation to zero in each of the candidate asset mixes presented to the board because "that is our level of confidence in our ability to now manage liquidity."

Mr. Gunn added, "We're always asking ourselves, do we have sufficient liquidity. And the answer is yes. We have lots," including investment in U.S. Treasury bonds.

"So we're fairly confident we don't need to explicitly allocate the cash and incur that drag," Mr. Gunn said.

The investment committee also decided to keep its expected rate of return at 6.8%. In July, CalPERS' 21.3% fiscal-year 2021 returns automatically triggered a reduction of its expected rate of return.

The staff is expected to have a plan to implement the new asset allocation in March.

Separately, following public comment at Monday's investment committee meeting, Theresa Taylor, committee chairwoman, asked the staff to return to the committee after the first of the year with a report on stranded energy assets in CalPERS' portfolio caused by worldwide transition away from fossil fuels as part of the Paris Agreement.

Investment committee member Lisa Middleton asked the staff for a list of all of the renewable energy projects in which CalPERS is invested. At the urging of investment committee member and California Controller Betty T. Yee, Ms. Taylor directed that both reports be made consistent with the Task Force on Climate-related Financial Disclosures framework. The TCFD was created by the Financial Stability Board to standardize reporting on the impacts of climate change.

The staff will also be reporting back to the board about an issue with private equity firm Apollo Global Management's investment in metallurgical coal producer Warrior Met Coal. During the public comment period, Philip Smith, director of communications and government affairs for the United Mine Workers of America said Warrior Met Coal was formed with the assets of another company, Walter Energy. Apollo was a creditor and the creditor group won concessions, including reductions in employee wages, elimination of health-care benefits and elimination of pension plan contributions, Mr. Smith said. The company, which went public in 2017, has paid millions in dividends to Apollo and other investors while refusing "to make up any of the sacrifices the workers made in 2016 that allowed it to come out of bankruptcy," Mr. Smith said.

Hence, the company workers have been on strike for eight months, he added.

So CalPERS decided to add 5% leverage to its total portfolio.

My first thoughts were "it's about time!".

Ben Meng, the former CIO, talked to me in June 2020 about adopting leverage and addressed the nonsense back then that CalPERS' was going to leverage $80 billion of its portfolio to invest in private equity.

As you can see, CalPERS rightly approved modest leverage (up to 5%) and I think they can easily go up to 10% leverage. 

What does leverage allow you to do? It allows you to pounce on opportunities as they arise without having to sell assets in public markets at rock bottom prices to meet capital calls from your private equity ad real estate partners.

That's exactly what happened in October 2008 when CalPERS sold stocks amid the rout during the great financial crisis to fulfill commitments to PE and real estate GPs.

Leverage also allows you to take advantage of opportunities when you're fully invested and don't want to sell.

Along with US Treasuries, leverage is part of liquidity risk management. 

I'm not sure exactly which form this leverage will take at CalPERS but I think it's a very wise decision.

Leverage has always factored into the long-term success of Canada's large and mighty pensions and I think more and more large US pensions will follow CalPERS (some already have adopted leverage).

In short, it makes perfect sense for long-term pensions to use modest leverage wisely and it is in the best interest of their members.

There have been numerous critics calling out CalPERS for adopting leverage, they have no clue whatsoever about what they are talking about. Period.

Below, I embedded the latest CalPERS board meeting (three clips covering three days). You can fast forward through some parts but it is definitely worth listening to others.

Update: David Long, former CIO of HOOPP and Managing Partner at Alignvest, had this to share on LinkedIn on using leverage at pensions:

For a given level of risk, one can own a portfolio of higher risk assets or one of leveraged lower risk assets. While the latter can frequently look more attractive than the former, one has to also consider that one’s risk estimates could prove too low for “low risk” assets. It could be that either strategy is the right one depending on circumstances.

Beyond the assets, the type of liabilities taken on also need careful consideration. How long is the guaranteed term of the liabilities? Are the assets reliably easy to re-finance? Is the liability limited to the value of an asset or theoretically unlimited? The answers indicate the liability related risks of using leverage.

Along the same lines, having access to additional cash to pursue an immediate investment opportunity will depend upon a leveraged investor’s ability to increase leverage and/or sell other assets quickly. Leveraged portfolios containing large amounts of government bonds or large cap equities are better suited for this than other such portfolios.

Leverage offers the potential of higher risk adjusted returns, but requires a holistic approach to managing risk.

I thank David for sharing his wise insights on leverage.