With interest rates low enough to sometimes render bond investing all but futile, and questions as to whether the public equity markets can keep increasing at the same torrid pace seen in recent years, allocators are plagued with worry about meeting their investment targets.
At its mid-November meetings, the California Public Employees’ Retirement System revealed its plan to manage these changing market dynamics. The fund intends to change its strategic asset class allocation, funneling more money into private equity and adding a small amount of leverage to the portfolio.
But industry experts are mixed on whether or not these decisions will bolster the $495 billion fund’s portfolio.
“To me, this highlights the biggest challenge that institutional investors have, which is achieving a rate of return that will meet their investment goals,” said Michael Rosen, chief investment officer at Angeles Investment Advisors, a California-based investment manager. “I applaud CalPERS for moving in this direction.”
As a part of the larger strategic asset allocation plan approved in mid-November, CalPERS will be increasing its private equity portfolio from 8 percent to 13 percent of its total assets, or roughly $25 billion. CalPERS is selling some Treasuries and stocks to push further into privates.
One former member of CalPERS’s senior investment team, Ron Lagnado, is raising concerns about the plan. “That’s an enormous amount of money to be shoveling into private equity,” Lagnado said. “Everybody is trying to crowd into the space. If this is all the largest pension fund in the United States is going to come up with, I don’t think they’re thinking carefully about what they’re doing.”
CalPERS, however, said that the move will be measured and incremental. “It’s not that July 1 rolls around and we’re suddenly at 13 percent,” said Megan White, a spokesperson for the pension fund, via e-mail. She added that private equity has been the fund’s best-performing asset class over the most recent ten- and 20-year periods.
Lagnado left CalPERS in March 2020 to become a director at Universa Investments, the investment firm that was managing part of the tail-risk hedging strategy for CalPERS. Just before the markets cratered in March 2020, the pension fund ended the strategy, missing out on roughly $1 billion in gains. That event became a lightning rod for CalPERS and what it was doing to mitigate risks in its portfolio in the months that followed.
“I have no axe to grind,” Lagnado said in response to a question about his criticism of the CalPERS plan. “I voluntarily left.” But Lagnado is passionate about how public pensions will make good on their promises to investors and the limitations of traditional approaches to diversification, including the diminishing protection that comes from bonds during a drawdown. He previously argued in an II opinion piece that state pension funds are underfunded and that will only get worse when markets inevitably turn down “A considerable body of evidence shows these funding problems are connected with how most pension portfolios have been constructed for more than a decade. Without changing the approach, it seems unlikely that funded status can be improved in the coming decade through investment performance alone.”
Lagnado pointed to historically high valuations in the private market as a big cause for concern. Many investors share those worries, given how much the industry has raised in recent years and the increase in competition for deals.
Rosen pointed out that most asset classes are overheated these days. “Questions always come about high valuations in equities,” he said, “[but] I never get a question about high valuations in fixed income. And yet, by any measure, valuations are far more extreme in fixed income than in equities.” Rosen quipped, “bond prices are the highest they’ve been in 5,000 years.”
CalPERS isn’t alone in boosting its private-equity allocation — the move is one that most pension funds in the U.S. have made in recent years. However, adding leverage to the portfolio is not as common. That’s particularly true given that risk-parity strategies, which are an alternative diversification scheme that relies on leverage, have fallen out of favor among investors.
The pension fund plans to add up to 5 percent of leverage, borrowed money, to its portfolio. CalPERS argued in the recent presentation that leverage would improve diversification and reduce risk.
“By and large, with the use of leverage we can reduce the equity exposure just a smidge and increase the fixed-income exposure,” said James Sterling Gunn, CalPERS’s head of its trust level portfolio management program, during the mid-November meeting. “And the overall effect is [that] with a modest level of leverage, we have a modest decrease in the drawdown risk of the portfolios. So that really is the key takeaway message for the strategic allocation of the leverage.”
According to Rosen, the decision to add leverage has the potential to boost returns. “It’s important that you’re confident that you’ve got a program in place and a discipline and process associated with leverage,” he said.
Ludovic Phalippou, a French financial economist and researcher whose work has been highly critical of private equity, cautions about the use of leverage in a portfolio. “Most people think that adding leverage increases returns, and that is a mistake,” he said via e-mail. “Put as simply as possible: If you invest in AAA bonds, let’s say you receive 2 percent for sure. If you lever up an equity portfolio, [you may, let’s say,] have a 50 percent chance of receiving 20 percent and a 50 percent chance of losing 10 percent. The expected return is higher in this example, but you don’t receive the expected return, [and] this is where the mistake is: You either win a lot more or lose a lot more. If you are a pension fund and increase leverage, you are doing the latter — i.e. basically betting the house. You are taking the risk of losing a lot of money because you want to have a chance to become solvent.”
While headline-grabbing, however, CalPERS's addition of leverage to the portfolio may not be as large as it seems. “There's a ton of implicit leverage everywhere,” Rosen said. “Obviously, private investments are typically levered. It’s embedded in that space.”
This is something that the CalPERS board and investment team touched on during the November 15 meeting. According to interim CIO Dan Bienvenue, there is already about four percent active leverage in the portfolio. Even Ron Lagnado says that that figure isn’t a concern. “They’re adopting leverage, [and] the interpretation is that they’re leading the way and it’s a direction all funds must follow,” he said. “[But it’s] a minuscule amount of leverage.”
What CalPERS is doing is changing its asset-allocation strategy as it adds leverage to its portfolio. The pension fund is reducing its allocation to Treasuries and public equities while adding to private equity and investment-grade credit, among other asset classes. In effect, Lagnado said, this is a bet on the outperformance of private assets, and of credit relative to Treasuries. Risk mitigation via diversification relies on perfectly timed rebalancing to add value over a drawdown cycle – something CalPERS failed to do in 2008 and in 2020, he added.
In response to a follow-up question, Megan White clarified via e-mail that adding 5 percent leverage to the portfolio applies uniformly. “It is not tactical,” she said. “It’s part of the strategic asset allocation.”
CalPERS declined to make board or investment staff members available for interviews.