Exclusive: How a More than $50 Billion Bet Boosted CalPERS Returns

The California Public Employees’ Retirement System took a more than $50 billion bet with its $177 billion stock portfolio and won. 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.

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.

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“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.”

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Tags: CalPERS, Fiscal Returns, Pension, Stocks

Public sector and church pension plan sponsors can use an alternative approach to investing that suit their “unique but similar financial challenges” by seeking equal or greater investment returns with less funded status volatility than conventional investment strategies, according to a white paper from asset manager River and Mercantile.

The white paper, which was written by Rivera and Mercantile Managing Director Thomas Cassara, said that difficulties facing both public and church plans included funding ratios less than 100%; high levels of annual cash outflows (such as benefit payments that are often more than 5% of the plan’s market value); and a limited ability or interest to significantly vary cash contributions each year.

However, the paper also said public and church pension plans typically have financial flexibility in how they can manage their pension obligations because they are able to use a liability discount rate that reflects the long-term expected return on plan investments. This, it said, results in lower, more predictable reported liability values. They can also establish relatively long amortization periods to pay back any underfunded liabilities, which provides more contribution stability, and they can smooth out investment gains and losses over a longer number of years.

Cassara wrote that most plan sponsors and trustees diversify their asset holdings over several asset categories, and will look to blend the allocation to create an investment strategy to meet or exceed their return objective, while controlling investment risk. In rising markets this has worked well, he wrote.

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However, he said that because most plans have public and private equity holdings of well above 50% of assets, they are exposed to potentially big losses if a market correction or prolonged recession hits. Cassara cited a study by Wilshire that found that during the financial crisis, the level of funded status for state public plans went from an average of 92% funded in 2007 to 61% in 2009.

“Unfortunately, many of these plans had high benefit payments and expenses relative to contributions and investment income, creating a negative cash flow situation,” Cassara wrote. “These plans had to sell off assets during the crisis in order to raise cash to meet required benefit payments, and as a result, had fewer assets with which to participate in the subsequent market rebound.”

According to Cassara, an ideal investment strategy for these plans needs to address two key objectives. One is to improve the funded status of the plan while managing the ups and downs of the funded status volatility. The other is to avoid having the plan become underfunded to the point where it falls into a “death spiral” from which the only way to recover would be to significantly increase contributions and/or reduce future benefits.

Cassara writes that the objectives can be reached through a portfolio that has an underlying fixed income investment strategy made up of higher-yielding investment-grade securities, as well as equity derivatives, such as put options and call options, that provide contractual exposure to the equity markets, but in a way in which risk can be managed.

He said a combination of fixed income and synthetic equity derivatives can provide a higher likelihood of providing a plan a steady increase in funded status over time, meeting or exceeding the expected return assumption, net of fees and expenses, and mitigating the risk of a death spiral, especially during a market correction or recession.

“This portfolio stands in sharp contrast to other investment strategies that rely heavily on illiquid and ‘alternative’ asset classes, many of which have been in vogue since the Great Financial Crisis of 2008,” wrote Cassara. “With a goal of controlling volatility while still seeking to earn a sufficient investment return, typical mainstream investment strategies have struggled to meet plans’ objectives while tending to have a higher fee structure and less transparent investment management.”

Tags: Challenges, Church Pension, Pension, Plan Sponsors, River & Mercantile

Exclusive: How a More than $50 Billion Bet Boosted CalPERS Returns

Public, Church Pension Plans Face Similar Challenges

Alternative strategy seeks to increase returns, improve funded status, avoid ‘death spiral.’