CalPERS’s Journey into Smart Beta Has Boosted Equity Returns

Since 2006 the biggest U.S. public pension fund has built its smart beta business with external and in-house strategies and products.


The California Public Employees’ Retirement System became a leading institutional investor in smart beta by following a philosophy that has evolved over the past decade. The biggest U.S. public pension fund defines the smart beta exposure it wants to add to its equity portfolio and finds the best way to get there at the lowest cost. That could mean sourcing the strategy and the product externally, or creating one or both in-house.

Smart beta rejects index or portfolio weighting by market capitalization in favor of a rules-based approach designed to outperform passive investments in traditional market-cap indexes. Although such strategies are typically viewed as passive, CalPERS — which prefers the term “alternative beta” — treats them as active investments.

The Sacramento-based pension fund had $28 billion allocated to alternative beta at the end of 2014. Its targeted exposures can be fundamental company factors such as book value, earnings, revenue, sales, dividends and total number of employees, or share price pattern factors like low volatility or momentum, explains Dan Bienvenue, senior investment officer for global equity. CalPERS then looks to index developers and model designers to see if they can capture the exposure it seeks.

“If we think we can hire a model provider at a competitive price and use our internal resources for other things, then we’ll do that,” Bienvenue says. “However, if all the products and providers just really weren’t designed and tailored to exactly what we want to achieve, that’s one we build for ourselves.”

The move into smart beta at $296 billion CalPERS and other institutions is partly driven by current market conditions, says Fabio Cecutto, senior investment consultant at Towers Watson Investment Services in New York: “With bond yields at all-time historical lows and equity markets being very high, hence yields very low, there is a compelling need to do something better with your portfolio.”

This has led investment officers to adopt smart beta strategies that can help their passive equity or bond allocations provide better risk-adjusted returns. At the same time, institutional investors are looking to reduce fees. “That really opens that door for smart beta,” Cecutto says. In a recent Towers Watson survey of 300-plus institutional investors, respondents said they allocated a combined $8 billion to smart beta last year, pushing their total to $40 billion, double the tally for 2012.

CalPERS, which has a ten-person team of portfolio managers and traders for equity strategies, achieves its goals of excess returns and lower management costs by running alternative beta in-house. “When your equity portfolio is over $150 billion, the economies of scale are such that we can create a management capability here and it’s a pretty compelling value proposition,” Bienvenue says.

CalPERS moved into alternative beta in 2006 by setting up its own version of the FTSE RAFI US 1000 Index. The idea grew out of conversations between Bienvenue and smart beta pioneer Rob Arnott, co-founder, chairman and CEO of Newport Beach, California–based Research Affiliates, that grew to include index provider FTSE in London. It was a logical move for CalPERS, which was already a major investor in FTSE’s traditional passive indexes. “Our perspective was that we have the internal management capability and FTSE’s got that index calculation methodology capability, so why not have everybody do where their expertise is?” recalls Bienvenue.

CalPERS runs five FTSE RAFI index strategies, including two FTSE Diversification Based Investing Index Series strategies developed by FTSE with New York–based QS Investors. Its $4.88 billion version of the FTSE RAFI US 1000 gained an average of 16.63 percent annually for the five years ended last December, the pension fund reports, an excess return of 104 basis points. The FTSE RAFI Developed World Index strategy, which manages $3.37 billion, returned 7.73 percent over the same period, beating its benchmark by 92 basis points. The $1.21 billion FTSE RAFI Emerging World Index strategy has matched its benchmark on average for the past five years.

More recently, CalPERS has ventured into newer alternative beta approaches such as low-volatility, momentum and risk-adjusted strategies, and further expanded its in-house capabilities. In the case of volatility, the fund couldn’t find what it wanted elsewhere, so it built its own model, Bienvenue says. A little over a year old, the $2.54 billion low-volatility strategy returned 14.03 percent in 2014, according to CalPERS, 134 basis points above its benchmark.

A proliferation of investment product offerings further complicates due diligence for newcomers to smart beta. Investors must be sure that a potential strategy makes sense, is well constructed and captures the risk premium it’s designed to achieve effectively without too many transaction costs, Towers Watson’s Cecutto says. “We prefer smart beta strategies that are not black boxes,” he adds. “There has to be a high level of transparency in what you get.”