Asked how he is managing through the Covid-19 crisis, Ben Meng, chief investment officer of Calpers, is unequivocal. “We have a plan,” he says, “and we are sticking to it.” On the basis of a root-and-branch investment strategy review initiated last year the near-$400bn Californian public sector workers pension fund has been restructuring the portfolio better to reflect its structural advantages. The chief ones are sheer size and the ability of a perpetual fund to take a very long-term view.
This has led to a three-year strategy based on what Mr Meng calls “more and better assets”. The better assets are in private equity and private debt, where Calpers aims to capture the bigger-risk premium (or surplus return) available in illiquid markets relative to public markets. Size means that the fund has access to top managers in a market where performance is widely dispersed. It also ensures the clout to negotiate non-usurious management fees and a greater degree of control than is normal in private equity.
More assets means incorporating leverage, whether through borrowing or the use of derivatives. This is backed by the belief that because economies and markets always recover from downturns in the end, leverage can amplify returns over the long run to help meet Calpers’ challenging 7 per cent return target. The move does not have the unanimous support on the Calpers board and will almost certainly spark controversy in the wider pension industry.
Mr Meng does not play down the risks in this portfolio overhaul. The lack of liquidity in private assets can, he acknowledges, lead to balance sheet strain because of the uncertain timing of demands on the fund from, inter alia, capital calls and margin calls. It is also difficult to increase the private equity portfolio percentage, currently 7.7 per cent, to the fund’s 10 per cent target, in a crowded market place. There is also a question about how readily Calpers can bring private equity managers into alignment with its beliefs on sustainability and responsible investment.
The problem with leverage is that it magnifies losses in a downturn as well as multiplying gains in an upturn. The danger is that lack of liquidity or investor panic causes unrealised declines to turn into permanent capital losses.
Mr Meng has been attacked by Nassim Nicholas Taleb, the mathematician, writer and former trader, for a failure of risk management in the March market slide because he abandoned a hedging strategy for tail risk, the risk of low probability but highly costly events. Mr Taleb is an adviser to tail hedge manager Aversa, one of more than 30 external fund managers sidelined by Mr Meng, while bringing more management in-house.
Mr Meng counters that Calpers has developed a balance sheet liquidity management framework which ensures the most important uses of liquidity, such as paying benefits and meeting margin calls, are covered by reliable sources including borrowing capacity via repo markets.
The portfolio has also been de-risked by tilting the fixed interest portfolio towards longer-dated US Treasuries and moving more money into factor weighted equities.
Mr Meng told the Financial Times that this strategy protected the fund from losses of $11bn in the market slide, outweighing the $1bn profit forgone on tail risk hedging. The message: why would a fund with a 100 year-plus investment horizon need to smooth short-term performance at the cost of worsening long-term returns?
His philosophy, he says, is that “too little liquidity can be deadly but too much is costly”. So Calpers only raises and starts paying for liquidity when it needs it. And its risk management approach has also been opportunistic. In 2019 Calpers executed large “trigger” mandates with distressed credit managers that took effect during the market slide in March.
A crucial risk in the overall strategy is that a fund manager can come under immense pressure to abandon the long-term plan when markets plunge. Mr Meng likens this to Homer’s tale of Odysseus and the Sirens’ song, where Odysseus’s men tied him to the mast of the ship to prevent him from being lured to his death. That, he says, highlights the importance of having the will and commitment not to squander the long-term horizon.
Last week’s renewed market tumble is a reminder of the ever-present nature of this risk.
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