CalPERS CIO Orders Active Risk Review

Ted Eliopoulos, the chief investment officer of the California Public Employees’ Retirement System (CalPERS), says he is “disappointed” that the pension plan’s 8.6% rate of return for the fiscal year ending June 30 fell six basis points below its custom benchmark and has ordered a review of the system’s active investment risk-taking.

Eliopoulos told the CalPERS Investment Committee Monday that the two-year review will “decompose” the amount of active risk being taken in each of the $352.8 billion retirement system’s asset classes to “come to some conclusions about whether or not we’re being rewarded for the active risk that we’re taking.”

The CIO described the system’s active risk as “moderate” and said the review would help CalPERS decide if it needs to restructure its asset allocation: “perhaps making shifts within the portfolio to pursue programs and efforts that we are being rewarded for active risk taking and perhaps avoid some of the areas that we’re not.”

CalPERS’s largest asset class, global equities with around $171 billion in assets under management, had an 11.5% return for the fiscal year ending June 30, 42 basis points below the custom benchmark for that asset class. The review is expected to include examining the system’s large focus on using factor-based investing to help select stocks.

The factor-based approach used by CalPERS aims to enhance passive stock index picking by adding factors such as a value tilt towards securities selection. It also avoids a cap-weighted approach, in which the largest valued companies make up the largest percentage of an index. In such a scenario, large price moves in the largest stocks in the index can have a large impact on the index’s value.

Elizabeth Bourqui, CalPERS chief operating investment officer, told the investment committee that a key reason for CalPERS’s equity underperformance was that the pension system was underweight in so-called FANG stocks like Facebook. Apple, Netflix, and Google in the June 30 fiscal year. She said that was because of the pension system’s factor-based equity investment approach.

Bourqui said CalPERS does not concentrate or over-concentrate a portfolio on large stocks that make up large positions in an index.

CalPERS has now underperformed its custom benchmark for two fiscal years in a row. In the fiscal year ending June 20, 2017, it had an overall net return of 11.2% but that was still 15 basis points below the custom benchmark.

Around one-third of CalPERS portfolio is managed by external managers in active investment strategies, while the rest is internally managed in mostly passive investment strategies. Certainly, the review could push CalPERS, the nation’s largest system, to a more passive investment approach.

But it’s not as simple as that. For example, CalPERS’s factor-based equity strategies in the US, which total around $70 billion, are index strategies, but contain active tilts such as a value stock tilt. So, it might be hard to classify them as passive or active strategies. Some investors classify the strategies as smart beta.

As CalPERS analyzes its active risk, it must deal with the largeness of the system’s assets under management, says Jeff Schwartz, president at investment technology and analytics provider Markov Processes International.

CalPERS is the only US public pension plan with more than $300 billion in assets under management.

“In general, one might expect that the size of CalPERS’ portfolio will make it harder to generate excess returns in almost any asset class as they are actually moving markets,” Schwartz told CIO.  “As such, they really need to pick their battles when it comes to identifying areas to pursue excess returns, especially on a risk-adjusted basis, given that less-efficient market segments tend to hold more risks.”

Schwartz commended CalPERS for conducting the active risk review and said such deep dives were increasingly being conducted by institutional investors around the world.

“It’s fair to say they aren’t alone in pursuing a deeper comprehension of the risks and rewards that their internal and external managers, across asset classes and strategy segments, are taking,” he said.

Eliopoulos told the investment committee that the investment decisions made within a given year can be “quite complex,” but said the system over the last five years has built the infrastructure, including more detailed data collection, to be able to analyze those decisions.

The review comes as CalPERS is under increasing pressure to meet return expectations. While its funding ratio went up three percentage points in the last year, its funding ratio is only at 71%. Eliopoulos told the investment committee that the pension system is still being affected by the great financial crisis.

In the fiscal year ending June 30, 2009, CalPERS saw a more than 20% investment loss. Eliopoulos said that when that loss is figured in, the pension system’s rate of return averages around 5.6% over the 10-year period ending June 30. It is below the 7% assumed rate of return CalPERS is attempting to earn each year.