Wednesday, December 20, 2017

CalPERS Rejigs its Asset Allocation?

Randy Diamond of Pensions & Investments reports, CalPERS adopts new asset allocation increasing equity exposure to 50%:
CalPERS' investment committee approved a new asset allocation plan on Monday that is fairly similar to the current allocation, with the equity allocation rising to 50% from 46%.

The new allocation, which goes into effect July 1, 2018, supports CalPERS' 7% annualized assumed rate of return. The investment committee was considering four options, including one that lowered the rate of return to 6.5% by slashing equity exposure and another that increased it to 7.25% by increasing the exposure to almost 60% of the portfolio.

A lower rate of return means more contributions from cities, towns and school districts to CalPERS. Those governmental units are already facing large contribution increases — and have complained loudly at CalPERS meetings — because a decision by the $345.1 billion pension fund's board in December 2016 to lower the rate of return over three years to 7% from 7.5% by July, 1, 2019.

Under the plan adopted Monday, the California Public Employees' Retirement System will have a 28% weighting to fixed income, up from 20%. However, the current 9% allocation to inflation assets, which is largely made up fixed-income instruments such as inflation-linked bonds, is being merged with the fixed-income asset class.

Real assets, which includes real estate, will keep its 13% allocation, while private equity remains at 8%. CalPERS' liquid portfolio, made up of cash and other short-term instruments, will fall to 1% from 4%.

There was one dissenting vote on the 13-member committee, J.J. Jelincic, who argued that CalPERS could take its equity level to almost 60% because it was a long-term investor that could weather ups and downs in the portfolio. By being more aggressive in its portfolio, CalPERS could earn a higher rate of return over the longer term, he said.

Under the more aggressive option favored by Mr. Jelincic, CalPERS staff estimates it could earn annualized rate of 7.25% over the next 60 years.

Other board members said increasing exposure expose was too dangerous given the Sacramento-based plan's 68% funding ratio, endangering the plan's viability in the event of an equity downturn.

Chief Investment Officer Theodore Eliopoulos said the plan adopted was a good balance.

While he said CalPERS would be taking away increased returns if equity bull markets continue, at the same it would be protecting assets in case of a downturn, though even at 50%, CalPERS still has heavy equity exposure.

Critics have pointed out that the new allocation is unrealistic because the pension fund's own estimate shows the portfolio that was adopted would have a 6.1% rate of return annualized over the next 10 years. If investment returns fall under 7% that would increase the system's $138 billion unfunded liability in the near term.

CalPERS officials justified the allocation because they say long term over the next 60 years, they estimate the system can make the annualized 7% rate of return.
Robin Respaut of Reuters also reports, CalPERS invests more in fixed-income to reduce portfolio risks:
Pension fund giant CalPERS said on Monday that it would increase its allocation of fixed income to 28 percent from 20 percent in order to reduce risks in its $346 billion portfolio.

Overall, the California Public Employees’ Retirement System Board opted to keep its asset allocation similar to its current investment portfolio. This decision will guide investment decisions over the next four years.

The fund’s expected rate of return will remain at 7 percent with an expected volatility of 11.4 percent, it said. The expected rate of investment return, or discount rate, was lowered in December 2016 to 7 percent over the next three years. That compares to the fund’s net rate of returns of 8.4 percent since 1988.

Most of CalPERS’ asset allocation will be similar to the portfolio’s current makeup: half the fund will remain invested in global equity, 13 percent in real assets, and 8 percent in private equity. Less money will be devoted to inflation-protection assets and kept in cash.

Henry Jones, chair of CalPERS Investment Committee, said in a statement on Monday that “this portfolio represents our best option for success while protecting our investments from unnecessary risk.”

Board member J.J. Jelincic, the one dissenting vote among the board, said he would have preferred a portfolio with a larger allocation of global equities, arguing that CalPERS had missed market gains after it sold off some equities a year ago.

“We need to be long-term investors,” said Jelincic at Monday’s meeting. “I just do not think that it makes sense to take the lower risk and accept a lower return.”
There's been a lot of discussion in the blogosphere about CalPERS' new asset allocation. Zero Hedge laments, CalPERS Goes All-In On Pension Accounting Scam; Boosts Stock Allocation To 50%.

Leave it up to Zero Hedge to make a big stink out of anything CalPERS or any US public pension decides to do. In a nutshell, the allocation to public equities was increased by 4% to 50% and the allocation to fixed income was raised 8% to 28%.

However, the current 9% allocation to inflation assets, which is largely made up fixed income assets such as inflation-linked bonds, is being merged with the fixed income asset class, so overall, the adjustments were minimal.

Board member J.J. Jelincic was the only dissenting vote but in my humble opinion, he is dead wrong to want to increase the allocation to equities to 60% at this time given CalPERS's underfunded status and the fact the rally in stocks might be nearing an end.

I would have liked to have seen CalPERS more than double its allocation to bonds, and have expressed my reasoning:
I have also repeatedly stated on my blog to load up on US long bonds (TLT) on any backup in yields because when the bubble economy bursts and the next deflation tsunami and financial crisis hit us, it will bring about the worst bear market ever.

Of course, central banks know all this which is why the Fed has signaled it's preparing for QE infinity, something which I fundamentally believe is a foregone conclusion, which can explain pockets of speculative activity in the stock market.

Anyway, back to CalPERS. It's right to reduce overall equity risk but increasing fixed income for a large pension when rates are at historic lows necessarily means it will have to decrease the assumed rate of return going forward (the discount rate) and increase the contribution rate, which will cause major panic among California's public-sector employees and cash-strapped cities.

In fact, CalPERS wants broke cities to deliver bad news to out-of-luck pensioners, namely, some workers will lose a share of their pensions because of their employers’ failure to keep up with bills (get ready for the Mother of all US pension bailouts).

Most of Canada's large public pensions have been  reducing their allocation to fixed income and increasing their allocation to private markets, especially infrastructure, over the last few years.

But CalPERS doesn't have a dedicated infrastructure group and deals are pricey these days. I actually emailed CalPERS's CIO, Ted Eliopoulos, to put him in touch with David Rogers and Stephen Dowd at CBRE Caledon Capital so they discuss a game plan in infrastructure, a must-have asset class which CalPERS and many other US pensions are under-allocated to.

Why do Canada's large pensions love infrastructure? Because it's a long-term asset class, even longer than real estate, which offers stable returns in between stocks and bonds.

It's also highly scalable and Canada's large pensions can put a lot of money to work fairly quickly and they do so by going direct in this asset class, which means no fees to funds like they pay in private equity
.

The only large Canadian pension which has no infrastructure exposure yet is HOOPP which ironically has the largest fixed income allocation and is super funded (120+% and it will increase its benefits to its members).

Why doesn't HOOPP invest in infrastructure? It hasn't found the right deal yet because deals are expensive in this asset class and thus far, it hasn't needed to. Interestingly, however, HOOPP is shifting some of its credit risk as it recently committed a big chunk to a new CLO risk retention vehicle.

I'm not sure CalPERS is ready to increase its infrastructure investments or do anything exotic in its credit portfolio so I would argue it's sensible to tactically shift more assets in bonds in anticipation of a major pullback or bear market which will clobber risk assets.

Alternatively, it can increase its allocation to Private Equity but that portfolio needs some work and Mark Wiseman and BlackRock's special attention.

Let me also state the following, while I applauded CalPERS nuking its hedge fund portfolio three years ago, I think now is the time to allocate a sizable amount to a select few large hedge funds across directional and non-directional strategies.

Of course, in order to do this properly, CalPERS needs to hire experts who know what they're doing and pay them properly, no easy feat (there's a reason why CPPIB and Ontario Teachers' are Canada's largest hedge fund investors).

But at a minimum, if I was Ted Eliopoulos, I would definitely sit down with Bridgewater, Balyasny, Citadel, Farallon, Two Sigma, Angelo Gordon, and many more top funds who focus on alpha.

CalPERS should be looking at all possibilities but it's easy for me to say they should do this and that, the reality is they can't because they don't have the governance to do everything Canada's large pensions are doing.

So, with all due respect to JJ Jelincic, I disagree with him that now is the time to increase risk in public or private markets. Maybe the right move is to hunker down, increase fixed income allocation, accept lower returns and lower volatility for the foreseeable future, and limit your downside risk.

Lastly, I highly recommend Ted Eliopoulos and CalPERS‘s board speak to my friend, Nicolas Papageorgiou, Vice President and Head of Research, Systematic Investment Strategies at Fiera Capital here in Montreal. There may be smarter ways to reduce overall risk and volatility while maintaining decent returns.
The sad fact is CalPERS is getting a lot of flack for doing the right thing, namely, lowering the assumed rate-of-return it can earn (the discount rate) to 7% which is still a lot higher than what Canada's large pensions are currently using (4.75% to 6.3%).

I feel like telling these people out in California who want CalPERS to increase its equity allocation and assumed rate-of-return: "Hey, wake up, you have an underfunded pension plan, the more stocks you buy now, the greater exposure you will have to material downside risk. Are ou willing to live with that given CalPERS's underfunded status?"

In pension parlance, these asset allocation decisions are path dependent, meaning if your starting point is 68% funded and stocks tumble 40% like they did back in 2008, CalPERS will risk going to below 50% funded status, which is then chronically underfunded status.

But wait because I can hear J.J. Jelincic grumbling, "come on Leo, stop with the scaremongering, pension liabilities go out 60+ years and we withstood 2008 and came back strong."

Yup, with a lot of help from global central banks and passive investing taking over, but I caution all of you even though stocks keep climbing to new record highs, the liquidity party won't last forever, and when the bottom falls, you need to prepare for the worst bear market ever.

Now, what if I'm wrong? What if we don't have deflation headed to the US, inflation expectations slowly rise, rates rise gradually and the best of all worlds for stocks continues unabated?

Great, under this scenario, CalPERS will see an increase in its assets but more importantly, a significant decrease in its liabilities (because of higher rates). So what if it misses a bit more upside by allocating more to global equities? It's funded status will improve, and that's what counts most.

But what if I'm right about deflation headed to the US, rates plunge to new secular lows, risk assets get clobbered across public and private markets and the funded status deteriorates to the point of no return? What happens then? Is J.J. going to still be around to say "don't worry, our liabilities go out over 60 years, we need to invest over the long run"?

I'm not picking on J.J. here because J.J. could be any other board member and at least he has the guts to dissent but I'm worried that too many people are focused on missing the upside gains with little to no appreciation of the downside risks that come with increasing the allocation to equities.

I will however concede this much to the reflationistas, I'm a market guy and track markets very closely. One thing that struck me this week isn't the selloff in US long bonds (TLT) which I feel is another big buying opportunitiy, but the weekly breakout in the S&P Metals and Mining ETF (XME):


You look at that chart and wonder maybe global growth has a lot more to go, things aren't that bad and cyclical stocks (energy, metals, banks, industrials) have a lot more upside.

Forgive me, I'm extremely skeptical here, still think once this tax plan is signed, traders will lock in gains and sell stocks and other risk assets.

So, if I had a choice to buy the breakout on  S&P Metals and Mining ETF (XME) or load up on more US long bonds (TLT) here on the selloff, I'd opt for the latter and sleep well at night:


But hey, that's just me, I'm very cautious trading these markets and I'm concerned the big, fat liquidity party is coming to an end, and when it does, the hangover will last for years.

Below, Jonathan Golub, Credit Suisse's chief US equity strategist and one of Wall Street's biggest bulls, tells CNBC's Courtney Reagan why he sees the market rally raging on in 2018. "JUST BUY MOAR STAWKS!" but be careful, especially if you're an underfunded pension.

Update: Malcolm Hamilton, a retired actuary sent me these great insights after reading this comment:
CalPERS assumes a 2.75% rate of inflation while most of the Canadian plans are using 2%. This means that the assumed real rate of return on investment for CalPERS will be down to 4.25% once the new basis is fully implemented, as compared to a Canadian range of 2.75% to 4.3%. So CalPERS is moving its funding target to the bottom of the Canadian range (high discount rates mean low funding targets) and this is a big improvement from years past. Unfortunately, the funding target is well above the funding level so it will take many years and/or surprisingly good investment performance for CalPERS to dig out of the hole in which it finds itself.

Still, as you point out, CalPERS is doing the right thing seemingly without support or encouragement.
I asked Malcolm why would CalPERS assume a 2.75% rate of inflation when 10-year inflation breakeven rate for the United States is 1.88%, which basically means the market is pricing in an average inflation rate of 1.88% over the next 10 years (read more on this here).

Malcolm replied:
I don't know why they do it but it is common in the US. Basically, the US plans ignore market interest rates, yield curves and the inflation expectations revealed by inflation-protected bond prices. They attach great importance to long-term averages of past interest and inflation rates. It's silly, but they are very stubborn - and they like what they see when they look back 25 to 50 years.

Pension plans like looking back 25 to 50 years because that's where they find high returns and high interest rates. It's not easy justifying a 4% real return target when, looking forward, long term interest rates tell you not to expect much more than 1% without taking risk and demographically, as populations age and pension plans mature, the plans are less able to bear the risks that they need to take to earn a 4% real return.
Very silly indeed, again read Brian Romanchuk's comment here. The market isn't pricing in over 2% inflation over the next 10 years so why are these US pensions so dead-set on using long-term averages?

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