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After a year that saw public pensions derided as legacies of quasi-socialism, for being unable to meet their target investment return, and for being bastions of unsophisticated management, reality set in midsummer: Public funds, lo and behold, had impressive investment returns in fiscal 2011. To celebrate this achievement, aiCIO sought out two of the most influential chief investment officers in America: Chris Ailman of the California State Teachers’ Retirement System (CalSTRS) and Joe Dear of the California Public Employees’ Retirement System (CalPERS). Despite their offices only being separated by the Sacramento River, their schedules rarely see them in California’s capital simultaneously—so, aiCIO conducted numerous interviews over a series of July weeks on the topics of asset allocation, tail risk hedging, public fund structure and, humbly, their stellar annual returns.

Dear: Honestly, and not taking anything away from the team here, our 20.7% returns in fiscal 2011 were largely the result of market beta. Public equities are about half our $234 billion portfolio, and it is no secret that public equities significantly increased in value over the past year.

Ailman: Last year, the key to investment returns was definitely the beta. Historically, it’s always the beta exposure that’s key. In all large institutional portfolios, the beta exposure is large, and is driven largely by asset-allocation decisions. Breaking it down, the driver was first and foremost global equities. Some managers added value; some did not add value, as always. Last year, our U.S. active managers added a fair amount of value. However, for once, so did our non-U.S. developed equity managers.

D: We also saw strong returns with our private equity program. About 14% of our assets are in private equity, and we beat our program benchmark by about 500 basis points. In terms of inflation-linked assets—including infrastructure, commodities, forestland, inflation-linked bonds—the only detractor was real estate, which was 970 basis points under its benchmark. It still earned 10%, however. We maintain a slight overweight in equities, underweight in real estate, so that helped.

A: I’ve been quoted as saying diversification failed in 2008—it didn’t fail, but it didn’t work perfectly well either. In 2001/2002, and in 2008, all correlations pushed toward one, and diversification did not work as a risk reduction tool. So, as opposed to the short-term gains and losses seen in years like these, long-term results come from how you structure your portfolio, and your fund in general. With portfolio construction: We have +/-3% bands around most buckets, with a +/-6% band around global equities. This is lower than most funds—but then again, we are not a jet ski. We’re a giant cruise ship. So it comes down to asset allocation.

D: The takeaway from this year is twofold. One is that we benefited from what we didn’t do. For example, we didn’t do a major reduction in risk assets after the financial crisis. The second is a note of caution: A lot of the equity performance is due to governmental action. In the near term, monetary policy is relatively straightforward, but fiscal policy is very concerning. So, while we are pleased with 20% returns, we don’t want to inflate their significance.

A: For fiscal year 2010/2011, we’re obviously happy with it, but it’s only one year. Looking forward, we need to continue to innovate—something we try to do with our Innovation and Risk unit. Right now, the Board is interested in commodities. They’ve been interested before, but they’re looking at them closely now. In 2009, we needed an inflation hedge. What drives inflation? It’s varied, but we wanted to look into that. TIPS are the most obvious, with infrastructure and real estate also often helping. However, with commodities, there are lots of questions, and some [people] can be uncomfortable with them. Being a public fund, sometimes commodities can be viewed as speculation, like betting on pork belly futures.