California’s giant public pension fund has a giant problem: Its $400 billion portfolio isn’t profitable enough and won’t be without a major change in strategy. That’s what Chief Investment Officer Ben Meng is about to undertake.
At Monday’s meeting of the California Public Employees’ Retirement System, Meng will tell board members that the fund has to take greater risk, he said in an interview. He’ll explain that Calpers must increase its allocation to buyout funds, add private credit and, further departing from its past as a conservative holder of stocks and bonds, use leverage to enhance returns.
“We need unflinching honesty and a willingness to make decisions which are difficult when needed,” said Meng, who joined as CIO in January 2019.
The new approach contrasts with the emphasis on loss prevention under Meng’s predecessor and has potentially far-reaching implications. As the country’s largest pension plan, Calpers is a bellwether for other funds. And as steward for the retirement savings of some 2 million current and former California public servants, it draws plenty of political scrutiny.
Calpers in February invested $1 billion with Oak Hill Advisors, one of the biggest originators and managers of nonbank loans. Another $1 billion went in March to distressed-debt specialist Oaktree Capital. Some mandates Calpers had negotiated with distressed managers before the market’s recent correction were triggered, Meng said later at the meeting.
Meng has little choice but to make changes. To meet its future obligations, Calpers must generate a 7% annual return. Yet an in-house study in 2019 found that its chances of meeting that target over 10 years are just 39%. In a world of historically low yields, the fund would be hard-pressed to hit its goal with $8 of every $10 of assets in publicly traded equities and traditional income products.
Without any changes, the long-term return on Calpers’s portfolio is estimated at 6%, meaning the state eventually would need to make up the difference either by requiring public employees to contribute more of their salaries or by using taxpayer funds. The portfolio lost 4.1% in the nine months through March.
The solution, Meng said, involves raising the fund’s current 8% target allocation to private equity “by a few percentage points” and building a small position in private credit over the next three years. Calpers has preferential access to the best professional investors and needs to exercise that “structural advantage,” he said.
Meng’s research shows that private equity has the highest expected rate of return, at 8.3%, versus 6.8% for stocks and 2.8% for fixed income.
At the same time, Calpers is redoubling an effort to cut costs by concentrating its business with fewer outside managers and exiting underperforming strategies. Since Meng joined, he has brought $34 billion in-house, saving Calpers $115 million annually in fees.
“As the risk-free rate gets lower and lower, cost savings become more and more important,” he said. “There’s no volatility around a dollar of savings. That’s the highest-quality source of alpha we have.”
The choices Meng is making are difficult partly because they can result in unanticipated outcomes. One example was his decision in 2019 to end a tail-risk hedging program he considered neither cost-effective nor suitable for a fund Calpers’s size. When the coronavirus pandemic hit and stocks collapsed in March, Calpers missed out on a $1 billion payout because it had exited one of the hedges.
Implementing leverage has the most potential to backfire. While borrowing money can boost profits, it can also magnify losses and exacerbate return swings.
“We will have to live with the possibility of market drawdowns as the price for increasing the probability of achieving our ambitious target rate of return,” Meng said. “There is no alternative.”
Calpers has board approval to borrow $20 for every $100 of assets — nowhere near as much as the typical hedge fund — and Meng doesn’t plan to go that far. He said Calpers will add leverage via total-return swap agreements, taking equity and Treasury positions in futures and raising cash by lending out securities.
“We plan to deploy leverage regularly and prudently,” Meng said at the meeting.
There’s no certainty that Calpers will be capable of doing what Meng wants. Already, the fund has struggled to meet its current allocation target for private equity in part because doing so requires investing such large sums.
“We’ve been trying to ramp up exposure to private markets without compromising our underwriting standards,” he said. “We could ramp it up faster, but at a cost.”
Another item on Monday’s agenda is raising Calpers’s allocation to opportunistic strategies to 5% of assets from 3%.
Even if Meng succeeds in allocating more money to private assets and adding leverage, he said Calpers’s chances of hitting its 7% target return over a decade will still be less than 50-50.
“We’re not trying to get lucky, just identify what we’re good at, mitigate what we’re not good at and ignore all the short-term noise by being a patient long-term investor,” he said.
-With assistance from Michael McDonald.