CalPERS Asset Liability Management Workshop Segment 2

Uploaded by CalPERSNetwork on 18.11.2010

>>As we've said several times
one of the new tools and
perspectives we're trying to
bring to bear on asset allocation
is to understand how portfolios
will perform under different
economic conditions.
And Farouki's going to
introduce Lorne Johnson who is
a part of the Asset Allocation
staff to describe exactly how
we intend to do that.
>>Yes uh, without further adieu
I shall do that.
This work was part of the
background analysis that was
conducted prior to uh, uh,
recommending this new, this
new asset allocation so it
informs that framework and that
So with that I'd like to turn this
over to Lorne Johnson who is
our Portfolio Manager in the
Asset Allocation Unit.
>>Thank you Farouki.
As Farouki mentioned this
presentation is a review of
material that has been
previously presented.
There's an extension of some
of that uh, and that material
specifically is considering the
investment performance of
different, different asset classes
under different economic
scenarios; growth and inflation
And the findings of this analysis
I believe provide the basis for
the alternative asset allocation
in that we can categorize asset
classes by primary economic
drivers, better understand the
risk to the portfolio under some
economic scenario that we
can't possible know but that if
we knew that economic
scenario we could perhaps
know a little better what the
performance of our asset
classes was going to be.
So moving into slide 1 here
asset returns vary substantially
depending on economic
conditions and in this case
thinking just about growth and
inflation when we have weak
periods of forward looking
economic growth real returns to
risky assets are on average
negative and during periods of
high inflation real returns on
most assets perform poorly.
The exceptions historically are
inflation protected securities,
TIPS, and commodities.
Starting with growth.
The expected performance of
many CalPERS asset classes
is conditional on the prevailing
economic growth regime.
And what do I mean by
I don't mean that uh, it's a
forecast on what we think the
scenario's going to be.
It's if I told you if the economy
is slowing down what kind of
returns do we expect?
If the economy is growing what
kind of returns can we expect?
Now we can divide that uh, with
a methodology I'm going to
present here and we see that
the outcomes are quite
For public equity/private equity
real estate and high yield based
on the historical data real
performance is on average
negative if leading economic
indicators are pointing
Forward looking financial
markets move ahead of actual
But are coincident or slightly
behind leading economic
indicators and that's why this
metric is used here.
We get GDP quarterly.
With a lag there's a richer
information set in this monthly
leading indicator series that
better lines up with the
outcomes of financial markets
than if we use quarterly GDP
which is lagging.
Typically markets move ahead.
We didn't see markets down,
turn down, before recessions
are announced and we see
markets recover before
recessions end.
I also want to note here with
respect to growth government
bonds in the historical data are
a unique asset class given
historical relative insensitivity of
their performance over the
business cycle.
Going to too much detail here
with this methodology to
breakup the leading indicator
time series simply to partition
between periods where we see
the leading indicators growing
and where we see them falling.
And what does that look like
relative to recessions to the
extent that you could see,
probably see it better in the
book than on the screen here.
Uh the leading indicator series
there are several points here
where the model measures a
contraction regime and that's
where you see the spike up in
the, the outlined areas not the
gray bars which are actual NDR
recessions and I think it'll be
pretty clear here that the
leading indicators pick up a
contraction regime before we
see GDP go down and as such
it's a more useful metric for
thinking about how financial
markets perform relative to
these LEI regimes than just
GDP growth.
This is a chart; total return
series of the S & P 500, I'm
sorry the MSCI World total
return index and the Barclays
Government Bond aggregate
and what you should be able to
pick out here is that in the
areas where you see the gray
bars which are the contraction
regimes is often a period where
you see a big move down in the
equity returns; the bond series
it's less volatile so you don't
see as big of moves up or down
but if you kind of focus in on
where you have the downturns
it generally holds its own and
more recently actually as Allan
alluded to bonds outperformed
in the recent economic
Now let's look at over decades
just equity returns in this case
and what the behavior was of
this LEI regime over the decade
generally and what the
subsequent return was on
equity returns.
So the percent of months here
that you see in the column
where for the whole period it's
23% that's the percent of
months where the model
measured LEI was slowing
It doesn't mean we were in a
It means that the economy was
slowing down and for different
decades we have different
The 70s was a period where we
had quite a bit of economic
The model picked up a lot of
periods where the economy
was slowing down.
The compound annualized real
return in the 70s was negative.
And then we had the 80s a
period where inflation was
falling, growth was picking up,
we had very good real return in
equities; the 90s even better.
And then the period of the last
decade which has already been
talked about some was a very
poor period for equity returns.
Not surprisingly it was also a
period where we had a fairly
elevated number of months
where there was a slowdown in
the economy.
Now looking at a number of
asset classes specifically
beyond just government bonds
and equities there's a very clear
relationship here between risk
assets and economic growth or
at least the economic growth
picked up by the leading
economic indicators.
For the full sample everything is
Actually we'll see some other
information like this.
The return is fairly tightly
bunched in real terms.
In the regime of growth growing
economic indicators risky
assets do the best on down the
scale where at the other end
we have government bonds
and TIPS still doing positive but
much less better than the
riskier assets.
If we had a regime of
contracting leading economic
indicators everything flips over
and the only things that are
positive are the higher quality,
well, the less risk fixed income
categories and then TIPS here.
Now with TIPS we have a
limited data series from 97 so
there is a modeled version that
lets us match up the data
series here going back.
It's a function of nominal
interest rates and expected
inflation but it ties very well in
sample so we have some
confidence it's a reasonable
picture of what would happen in
a period where we don't have
the actual fixed data.
Now for some of the data it's a
little harder to work with than
monthly and where we have
less history but the story is still
quite clear here.
This is for uh, CalPERS real
estate AIM where we have the
The actual quarterly data and
then we also have a real estate
index here that's similar to a
core real estate index.
The story is similar; periods of
growth the returns are quite
positive and in periods of
contracting LEI it's the opposite
with the AIM portfolio showing
the biggest divergence in
growth much like we saw with
public equity.
Now a little bit on inflation.
No surprise here we haven't
had a lot of inflation to worry
about in the last 20 years.
In fact the talk now is
potentially we'd be worrying
about deflation.
Inflation regimes are highly
It tends to build in and the
expectations build in and we
have long periods of high
inflation like we did as the
graph shows here in the 70s til
the yearly 80s and then the Fed
was successful in choking off
inflation expectations and we've
had a fairly long period of
moderate inflation.
This is measured inflation year
over year.
It's been in a fairly tight range
around 2%.
What do expectations in the
market look like now?
Well they're pretty subdued.
There's data through the end of
These have ticked up a little bit
but not materially for purposes
of the time series here that
we're looking at.
Expectations are low for
inflation and we see that in
what the market is pricing.
Here there are two different
metrics which basically map
each other.
One is the difference between
the real TIPS yield and the
nominal yield measured in the
10 year treasury and then the
other is a CPI swap which is a
bet on the actual outcome in
the CPI.
They're quite similar and they're
quite low.
The expectation is that we're
going to have pretty low
inflation and there's a huge
range of uncertainty around
Again it's talk of deflation.
The Fed is concerned about
There's a large cap on the
other side that believes all of
this monetary stimulus is
creating a sure case for much
higher inflation going forward.
And we're going to talk a little
bit about what that might mean
for our capital market
expectations in a couple of
Similar analysis by inflation;
now as we saw in that chart a
couple slides back the high
inflation is concentrated in a
period in the 70s and early 80s.
So that's where the sample is
drawn from that you're looking
at here.
So low and moderate inflation is
all the rest of the sample from
the 70s til now and then there's
a period of high inflation in the
70s and early 80s.
So using that data though we
see that when we have high
inflation it's very bad for risk
It's actually bad for uh, even
non-risky assets like nominal
The only things that'll hold their
own in the historical sample are
commodities and inflation
protected securities which
makes sense.
You lock in just the real yield
with the TIPS and then you're
going to get compensated for
the inflation.
Commodities I've heard
discussion a lot of levels why
they're part of uh, why they
look like inflation, why they're
part of the inflation index.
Historically they tend to lead
You have run up in oil prices
that's captured in commodities
and that runs ahead of actual
inflation as all prices in the
economy rise.
Okay, this chart might not be
easy to read on the screen uh,
but in your booklets on page 12
I'll just very quickly uh, discuss
what's going on here.
This is a series of portfolios set
up to identify these major risk
They're not CalPERS portfolios.
They are simulated port, well
they're historical portfolios
based on public market data,
S & P 500, the Bar Cap
Government aggregate; that's
(indiscernible), that would be
investing just in treasuries and
then I've created an inflation
hedging portfolio which is a mix
of commodities and TIPS.
Again, some of the TIPS data
is simulated because we only
have it back to 1997.
We looked at this data through
the decades just for equities.
Here it is for bonds and for this
inflation hedging portfolio for
You were able to get a positive
return except for in the 70s
when inflation really hurt your
real returns.
And then we have these
blended portfolios here.
One thing that might be notable
in the real return space as we
saw in the graph, the difference
in the returns for this sample
they are not huge right?
So the equity premium 1.7%
over the Bar Cap Government
again is a period where we had
falling inflation, falling yield so
it was particularly good for
bonds for the full sample.
This inflation hedging portfolio
held its own in the 70s and
that's because inflation was
high and you were
compensated for the inflation
And then we have the blend,
60/40, 60% equities, 40%
bonds; 40/60 is the opposite,
and then 40/30, 30 is 40 equity,
30 bond and 30 inflation
And, yes?
>>In your blend of portfolios for
the 40% bonds you're using the
Bar Cap I assume?
>>Bar Cap Government
Aggregate correct.
>>Okay and then the equities?
>>Is S & P 500 yes total return
>>And what are using for the
>>GSCI, a good question and
one could be critical of that in
that it's basically a oil index.
That's our CalPERS
There are other indices that
could be more diversifying and
maybe would have done better
for you in the most recent
Uh, underneath that uh, the
bottom table are the volatilities
uh, shouldn't be too surprising
in that second moments are
more stable uh, historically than
first moments.
Uh, you know the equity
volatility is a very tight range
A little more in some of these
other portfolios but much more
stable than the returns.
Volatilities are much easier to
forecast over long periods than
the returns.
On page 13 is a simple return
to risk profile of each of these
The lowest being for equity
The highest and that's
attributable again over the full
sample period when bonds did
very well uh, is the highest
there, and then for the blended
portfolios it's, it's higher than if
you were just in equities.
And then on page 14 is a look
at these specific portfolios
during periods of recent
financial stress.
So starting with the 87 stock
market crash which was clearly
an equity market event, bonds
would have given you a
substantial hedge.
The inflation portfolio would
have had a positive return
during that period.
Um, I'm not going to go through
all these but you know the
relationship, the one period that
was more bond specific 94
interest rates (indiscernible)
fixed income returns.
The most recent period which
would be the most fresh in the
memory huge equity market
You held your own in
government bonds.
Your inflation hedging did
terrible because commodities
got absolutely slammed
in 2008.
So what are reasonable capital
market assumptions under
different economic scenarios
which are forward looking which
we don't know?
We can guess.
We can say, "Well it seems like
we're in a slow growth
environment maybe we're going
to have some deflation." Or
you could be on the camp that,
"Gosh are the Feds crazy?
We're going to have a raging
inflation in 3 years." Very
different scenarios.
The other thing is what about
initial conditions?
Well those are things we can
observe and we'll talk a little bit
about that and how that informs
the capital market assumptions
looking forward.
Now what I have here,
scenario 1, is base case.
These are the capital market
assumptions that were
presented in June and revised
in September.
They are base on the input of
the staff team, the consultants,
and an eventual coming
together of the minds
discussing the pros and cons of
each of those inputs.
Uh, what scenario these
anticipate you know I, I would
say something like the history
of what we've seen.
In fact, I was looking at this just
a little while ago.
That 4.38% real is something
like a 50/50 portfolio.
So it's in between the 60/40
and the 40/60 portfolio that,
that was presented a couple
pages back.
There's an equity premium here
of 4%.
As mentioned earlier the fixed
income assumption was
brought down which made that
equity premium bigger because
we have such low yields.
The 10 year yield's about 2.5%
this morning.
We have a 3% inflation
assumption which it'll be
something else as all these
forecasts will be.
It could be lower, it could be
Right now we have 1% year
over year CPI.
So to get to 3 in 10 we actually
have to get some pretty decent
inflation in the out years.
Now I mentioned initial
conditions and how they can
inform our forecast or our
expected returns.
Well starting with probably the
easiest case and I'm not saying
this is easy but historically the
correlation between yield to
maturity on the 10 year yield,
the 10 year treasury which is
what I'm looking at here and
subsequent 10 year returns is
correlation of .92; pretty high.
So I think we're quite
reasonable in how we're
approaching our forecast on
fixed income and the 3.75 is
roughly reflective of the yield to
maturity on the fixed income
portfolio at the time we
presented it.
How about earnings yield?
Well, it's not as good but it's
pretty good.
It's informative.
If you have a very low earnings
yield that's going to be a
smaller input of your expected
return than if it was higher.
You'll see a couple of examples
of that historically.
And another truth is that over
time valuations go to the mean.
This is the Schiller PE; it's a
rolling, it's looking at price
versus rolling 10 year earnings
and the midpoint in this is 16.
We're a little above that right
Nothings like the extremes we
had in 2000 when we were at
43 or in 1980 when we were
much lower.
There's a chart with that in just
a moment.
So initial conditions are
They inform the decision
looking forward.
So let's think of the case 1980.
Ten year Treasury bond yield
11%; the dividend yield on
stocks was 5% so as a starting
point we could have expected
at least 5% just from dividends.
The earning yield much high
than that.
The Schiller PE I mentioned the
long term average was 16; we
were at 9.
So from valuation adjustment
we should have expected some
positive return for that.
So taking those different pieces
on what I'll loosely call an
income growth valuation model
uh, we're going to get 5% from
We'll say 2% real per capita
economic growth and 6% from
a valuation adjustment just to
the mean.
With that model we would have
expected a return on equities of
13% for the decade.
We got 10.5%.
How about 2000?
Well the treasury bond was
6.5%, dividend yield 1.1%, not
much there; earnings yield 2%,
PE 43 so putting all those
inputs in in the same way we
would have expected a
negative return 5.5%.
Well we got -3 so we actually
did alright compared to what
the model suggested.
How about 2010 where we're at
right now?
Well we already mentioned the
very low bond yield.
That's not part of this equity
return estimation but it's
referenced in terms of where
yields are.
Dividend yield is pretty low
1.8%, earnings yield a little
better, the Schiller PE is a little
above average so putting all
those inputs in maybe a real
return of about 4% which is
about where our capital market
assumptions are right now.
But who knows what's going to
happen in terms of economics
and there's inflation
A huge divergence there in
So let's take this basic
framework and think about
some different scenarios and
what could happen.
We have our base case which
is the best opinion of a wide
group on their best assessment
of what's going to happen.
What if we deviate from those?
So in the first case I take an
optimistic scenario.
Let's say inflation is low, is
actually lower than what we
expect but stable, no deflation
and growth is great.
Now this is not a consensus
I wouldn't put a probability on
this it's just for example
Look, if we do that we get a uh,
equity return 10.5%.
Only a little deflation on that we
get a real return of better than 7.
That's almost 3% better than
the base case.
Again these inputs are based
on a very simple model so for
the, the fixed income portfolio
we actually don't see a big
acceleration in inflation so
that's, that's good for the fixed
income portfolio.
The growth helps your, your
public equities and everything
Now we talked a lot earlier
about potential deflation
So what if we see something
like a Japan scenario?
The economy just kind of
muddles along, we're working
at you know 1.5, 2% growth,
kind of what we're seeing in the
second half of this year and the
inflation thing just never kicks in
and I'm saying 1, 1% inflation.
In Japan we've had negative
rates of inflation, deflation for
getting close to 20 years now
so it's something that can last.
What are the returns like?
Well for fixed income it's
actually not the worst thing.
There's no move up anomaly
you'll see; from where we're at
right now this would actually
suggest further appreciation,
capital appreciation, based on
the yields going lower.
And then for equities very poor
growth is an input so we can't
expect much there.
There's negative equity
premium and that passes
through into the other risky
Now on the other side; and for
real returns well it's a fairly
subdued 3.
That, that might be a little
optimistic if we really shifted
into a deflation scenario.
But that would kind of be a
scenario where we don't get
any traction from where
we're at.
We just keep muddling along
like we're going.
Now under a 70s like inflation
well the nominal returns don't
look that terrible but in real
terms you're getting almost
nothing and from the 70s we
saw for equities we can get
negative and these again are
maybe reasonably optimistic
what we could expect if we
really moved into an
environment of, of much higher
So here I have 5%.
That's taking us from 1% now
we'd have to be getting close to
8, 9, 10% inflation somewhere
in the out years to get a 5%
number for the full period
assuming there's, it's a gradual
That we don't wake up
tomorrow and just have 5%
inflation for the next 9, 10
So in conclusion hope to
convey here that investment
returns are very dependent on
initial conditions and the
prevailing economic
Periods of low growth and high
inflation present risks to the
current CalPERS portfolio.
We don't know those are going
to happen, in what form; there
will be some rate of growth,
inflation that's different than our
capital market assumptions and
that a more flexible asset
allocation structure with the
abilities to directly hedge
growth and inflation risks is a
more robust framework to
respond to changing economic
And I believe that we are
bringing that to the table today
with the alternative
We are specifically identifying a
new bucket to consider growth
risk, growth hedging, and doing
a more precise job in setting up
and inflation hedging portfolio.
Now, I'll be happy to take any
>>I have a marco question but I
- during these times of planning
as you did today and I
understand the example that
people tend to want to compare
and look at the deflation and
the flat growth in Japan.
Is that really a realistic view of
what can happen in the United
One thing the Japanese don't
have, will never have, is a large
base of natural resources and if
you are converting other
peoples' resources and the
products to the world you can
get into that cycle but do you
really see that that is a
probability in the United States
with such a large base?
Even though we may not
consider ourself to be a large oil
base natural resources but with
our agricultural bases, mining
and so on, do you see a
differential there?
>>I think the differences
between the U S and Japan are
I would also say that I would
not, here, assign a probability
to any of these things
happening one way or the
They're for illustration.
I think the example done here
was a U S version of the Japan
style in that we didn't go to
deflation and returns weren't
quite as bad.
It's just more of a lethargic
outcome than what perhaps the
base case is suggesting that
we get to some more moderate
traditional rate of growth.
But I agree that the differences
between the U S and Japan are
The way the Central Bank is
reacting as they perceive as the
risk of deflation is very different
and the pace at which Japan
reacted to that and yeah the
demographics are very
different, the economies are
very different so agreed and the
examples here were not
forecasts nor were there
probabilities suggested; just to
give an example what could
plausibly happen.
>>Just uh illustrative
(indiscernible) we would uh, uh
you know I, I would probably
assign a low probability to that
but you know coming out of the
crisis there were many people
who really thought hat that's
really the scenario for the U S.
primarily because of the fact
that, that economies that are
impacted by both, not only a
stock market crisis but also a
real estate crisis and there are
a number of cases that, where
this has occurred together and
those tend to be uh, those tend
to impact the economy really
badly and we are seeing some
of that because the growth
coming out of the recession in
the U S is much lower than
average of all prior recessions
in recent history.
This is because the impact on
the economy is so severe that
you now issues of
unemployment, growth and all
that is, is ... so there were
times when people were
thinking that perhaps that kind
of scenario is fairly probable in
the U.S. but now as, as time
goes on and the aggressive
actions that our Fed has taken
we, it's probably a lower
Uh the dip, the double dip
scenario is also a probability
now, a much lower probability.
A couple of months ago there
was a, a fair amount of
speculation with regard to you
know a double dip scenario.
So uh, but this case we just do
illustrate that if we would have
had uh, that kind of a scenario
what might be the impact on
the returns so it's just
I think you had a question.
>>Thank you uh, have you put
any , I'm sure you have but,
what thought have you put into
potential federal economic
policy around very aggressive
debt reduction if the Feds were,
if the administration were to
really pursue that or a
significant decrease in uh,
stimulus funding and support
type uh, funding at the
Federal level?
Would that, do you expect that
that would have a positive
effect on the economic growth
or a negative effect on
economic growth, if you know
anything about that?
>>I think the best answer I
could give on that is that we in
the asset allocation group are
active in following developments,
in trying to provide
informative input to staff
on what is going on, and
to, as conditions change, to,
to think about how that could
affect the portfolio.
I don't believe that something
that we're talking about today,
and that our horizon is different
in that, that more dynamic
framework that I think you
now going...
>>I know we, I know we just
had an election.
>>...for the long run and maybe
Farouki is better to.
>>I, I think uh, just to add
another point; I think the very
aggressive action taken by the
Fed on QE2 is really
unprecedented indicator, you
almost have to go to 30 to have
that kind of action.
I think it, that they're
desperately trying to forestall
you know, those kinds of bad
uh uh, scenarios and the point
that you mentioned about the
stimulus being sort of
withdrawn I think uh, so the
monetary policy uh, rather the
fiscal policy is almost now in
gridlock and you would not
expect any of that to happen so
I think that's why the Fed's
taken this approach to make
sure that they provide ample
liquidity and low interest rate
and (indiscernible) to continue
to uh, not only lift up asset
prices but also the, the growth.
>>I mean I know, I know that
we just had the election last
week but I, I guess I'm
concerned about sort of a
change in the prevailing winds
around some of these major
economic policies and what
that, how that could impact the
U S economy over the next few
>>I mean we would almost rule
out any further stimulus
obviously but within the, on the,
on the fiscal side uh,
withdrawing anything further I'm
not, I'm not sure about this.
>>I don't know either.
>>But the Fed seems to be
pretty uh, consistent on, on the
way they're approaching it.
>>There's no history to allow us
to forecast based on prior
experience with conditions like
we have now so it's a judgment
question and I go back to the
animal spirits.
One argument in favor of
significant contraction is to
restore faith in the financial
integrity of the U.S. and the
certainty of the its ability to
meet its financial obligations
with all that debt in which case
if people believe that's going to
happen and they make
investments the economy will
The counter argument is with
this much contraction in
Federal stimulus effectively you
know no new stimulus at all that
the economy will contract and
that jobs will fall and that the
psychology of people will
become more negative, they
won't invest and it will spur
The only actor in the system
now that's relatively free to
move is the Federal Reserve
and they're taking steps to
forestall deflation.
Presumably the market priced
in the election result because it
really didn't change that much
post the election so you could
see it coming ahead and so
that forecasting ability to
It goes back to this discussion
we had about dynamic
allocation and what do we see
in a 2 to 3 year timeframe in
terms of expected economic
outcomes but there's no model
that Dr. Johnson's going to be
able to bring to the table and
guide us uh, in terms of how to
view what the policy, the
economic effects of the policy
choices are going to be made.
>>One reason why if
(indiscernible) we conduct a
sort of an annual review of uh,
the you know what we see as
the economic environment
that's unfolding and if uh,
expectations for asset returns
have changed and so on so I
think you know in a more
uncertain environment you'll
probably want to look at this
more frequently rather than
assume a normal path over a
long period of time.
>>We look back at slide #5.
This doesn't seem to make a
very good case for uh, equity
I mean we're starting, I maybe
set those two indices at the
same place but in any event so
they start in the same place
and they end up at the same
place an what you have with
the red line uh, SCI World
Index there uh, sort of looks
like bubbles and then it seems
to be drawn back to the bond
Now, if you, and furthermore
since the - whenever the red
line is above the black line, I
mean you work from the red
line up to the current place; any
place the red line is higher
return is lower over that period
so if you unfortunately jump on
in one of those peaks; so uh,
so why did you pick this graph?
>>It's simply to show the
I, I take your point that yeah
after this period, a period that in
the end was uh, saw a huge
drawdown in equities with the
endpoint is where it is and I'm
not making the case for ...
>>...investing anything it's
more, 'hey this is the sensitivity
to this time series that we
looked at and clearly one of the
series is more reactive
than the other.
>> Is it, could it be a starting
I mean if you were in January
of 75 instead that would, that
>>Sure anything's quite a bit...
>>So I don't, I don't know what
happens to the prior to January
to January 73.
Maybe this was, I don't know.
>>Yeah January 73 was the
beginning of a pretty horrific
recession and...
>>Oh, okay that's why you...
>>...that drew down the
equities so your starting point
was one where equities got hit
really hard and then we finished
with another period that was
>>So if you go back to page 12
it showed the annualized
>>That's a different series.
>>Is that a different series.
>>The S & P 500 forward is
different from the MSCI World.
>>This is MSCI World right?
>>Yeah but if you just look at
S & P 500 over that period you
have 4.9%.
>>Yeah little bet, little better
than the Barclays.
>>Just a little bit of a premium
but I think it's the, it's a time
thing so it's specific to the time
period this relationship but
normally people would uh,
would argue for the equity is
premium based on a much
longer uh, time frame going
back many decades?
Uh, but one of the reason I
think is that it's, it's sort of
been coming down.
We are seeing something
like a 4%.
Allan has a comment.
>>(indiscernible) remember
1982 the World Treasury Bond
was worth 16% and today it's
less than 4.
For that to occur think of where
interest rates would have to be
at the end of the period.
And interest, in theory equities
can grow infinitely but bonds
are limited by their yield and
that's, that's the big story.
And it goes back to Lorne's
whole comment that you have
to live with where you are today
and today you're at the end of a
extremely long low rate of
interest rate cycle and even if
it's flat then we start from yield
to maturity on, on par and that's
the issue.
>>Hey Allan or generally people
should come to the mic.
>>I'm sorry.
>>Does that uh, answer your
question Dr. Diehr?
>>Sort of.
Alright any further questions, J.J?
>>Yeah I noticed in the
scenarios that the one that
seems to be missing is slow
growth and high inflation which
I think is something we need to
seriously think about given the
current political environment.
Joe the other question is how
much of this is a baked cake?
>>How much is a baked cake?
That's an analogy that I've used
in certain settings where staff
does so much work that a
Board of Trustees can't unpack
it so it comes to you as a baked
cake and I assure you that not
our intention to present this as
a, as such because we are
asking you to think about
alternate classification and
we've prepared models and
portfolios that go either way
and we certainly left open the
question of how much risk in
the portfolio and we've added
dimensions to that risk beyond
volatility and we've looked at a
series of portfolios.
We're going to focus on 8 or 9
but you can see they're
probably already what, we
have 40 different portfolios of
different circumstances so I'd
say there's a lot of flexibility for
you to mix and match here.
>>Go, go ahead, excuse me go
>>Because of what?
(indiscerbile) said a couple
things said I, I know, I know
this is understood but I just
wanted; we can be concerned
about the political environment
that just started here in the
United States but we need to
continually remind ourselves
that we are a global investment
and so we need to plan not
based on what pushes in the
United States.
It's a part of it of course but if
we are truly global investors
that we need to take a pull on
one side and maybe a push on
the other.
Some reactions by the United
States even though we are a
major player we are not
accumulative the major player
any more.
We are part of and so as we
discuss that we need to always
make sure that we remind
ourselves of that.
>>Yeah but we're only, as we
heard earlier, we're only truly
global in public equities.
In other asset classes
we're not.
>>To this point.
>>Quick data point - I was
advised that the A Portfolio was
about 30% international today.
>>I think we'll have a chance to
discuss the asset class
strategies in light of the uh,
framework that we are
proposing in the next session
so there'll be plenty of
opportunities to answer these
Okay so moving on to the next
uh, I have my colleagues.
Thank you very much.
So uh, we've discussed a
number of times uh, what the
alternative uh, asset
classification that we are
proposing is.
I think if you look to the lower
right hand corner of this slide
that's what that is and we just
show what the current targets
are and so on.
And this is a, an equal end
portfolio on the board
classifications in terms of
expected return and risk.
So one may look at this and
say, "Well, you know
quantitatively it's not a big shift
but qualitatively it's a big shift."
I think that's a point that Adam
made and that's what I want to
come back to and you asked
this questions Mr. Jones in
terms of highlighting what.
So this is in a quantitative sense
these two are equal portfolios
but qualitatively they're different
in the way that we will, we will
begin to look at these asset
clauses and the way that they
>>Why is it that fixed income is
under the current is part of
>>I'm sorry it's under
>>Combined equity you get
Isn't that the sum of those three
numbers up above?
>>No it's public and private
So it's the 49 and the 14.
>>Okay, okay.
>>Okay, so uh, moving onto
the next item, I apologize this is
a very busy chart but this is
part of the framework that,
around which we had
discussion in our investment
strategy group in terms of the
role of asset clauses and so on.
So what we're trying to say
here is we identify growth,
inflation, and real rates as key
macro risk and what are the
sensibilities of the asset
clauses to those risks?
So for example in the case of
global equities a very high
sensitivity to economic growth
as we showed it before; also
the inflation probably a
moderate sensitivity to rates
and so on.
On the other hand uh, if you
come further down you look at
treasury or government bonds
and, and TIPS they have low
sensitivity to economic growth
uh, and TIPS will have a high
sensitivity to inflation and so on.
So that's the way we, we try to
sort of map this, the assets,
into both the risk framework as
well as the broad
Uh, anything - it was important
for us to understand the
strategic role of asset clauses
for the, the, the SIOs in terms
of how they would think about
developing their strategic plan
for the implementation plans in
terms of how they fit into the
total portfolio.
Do you have a question?
>>Yeah, on, on real estate uh,
low interest rate risk ; I assume
that we're assuming
deleveraged real estate in this
And Ted as it's being recorded
I'm going to note your 'yes'.
>>You're going to get lots of
opportunities for that today.
>>So in terms of the
characteristics of the assets we
want to look at uh, yield or the
income part for the return and
Uh, and liquidity and the
inflation protection and so on
and we also identified the
extent that leverage is present
in the asset clauses in the way
they are implemented.
Unless there are any questions
on this uh, I will move to the
next slide.
>>I just want to ask when you
guys went through this process
how did you weigh the, the slide
that was there earlier which still
sticks out in my mind where the
differential and what is being
paid in as what is being paid
out since there is a shortfall and
obviously appreciation doesn't
contribute to that only cash
How do you, how do you work
that into your decision
>>Yeah so uh, I think Ted will,
will outline uh, what, what the
implications are.
For example, for real estate so
I think uh, I think what he would
say is that there's going to be a
shift in emphasis to core real
estate, income oriented
properties and so forth; stable
income in real estate and we
would look for the same in the
other real asset categories as
well as the global fixed income
Um, but you have to
understand that the allocations
to go there is not that large now
and they're not going to be that
large going forward we think.
So the target yield for the
portfolio is still somewhere
around 2%.
>>And the reason I ask that is
that if, if we asked Allan to lay
that out for example the next 24
months dealing with
(indiscernible) and the rest of
you the way you worked at it
and you projected that, that
deficit, I'm just pulling ;this out
of the air, uh, that differential
would continue for 24 or 36
months and being an index
fund on the global equities are
really in the mode right now to
build the equity growth back so
where does that income stream
come from?
I mean I know we have an
increase because one of the
projections that should lay out
across that 24 months citing is
July 1st of 11 because our core
contributions are going into that
substantially at least for the
locals at that time.
What I consider to be
So you got to figure that into
the formula but those two
overlays have to really kind of
look at each other of what's
going to be coming in from
employers to work against that
and whatever strategy you pick
now if that's going to work over
the next 24 months because
that differential you have to
make up that differential.
>>Yes that's something...
>>Can I cover that a little bit?
I think that Farouki created or
expanded the liquidity bucket
and the liquidity bucket is
intended for that exact purpose
because what we found was
that during kind of volatile
environments that uh, it was
difficult for fixed income which
traditionally provided the
liquidity for a lot of the fund to
handle it.
So that size of that bucket will
kind of determine how much
liquidity, cash needs and it
comes at a cost because it's
lower expected returns versus it
comes from even fixed income
you probably have I would say
100 to maybe even 200 basis
points difference in returns.
If it comes equity it would be
even larger.
So that tradeoff I think will
begin to happen tomorrow and,
and Farouki talks about liquidity
and the need for that and the
cash shortfalls and all these
things so it's all getting
>>You asked where would you
get the income from?
So we're assuming roughly a
2% yield on the dividend yield,
on the global equity portfolio
and then most of the return
from fixed income they give us
in here is a yield, current yield
to maturity.
So that's why I said if you
combine all of that roughly
gives out about a 2% yield
return on the total fund.
So if I expect a return of 7.5%
roughly about 2% of that is, is
yield oriented.
So 2% of 200 billion roughly
give you about 4 to 5 billion
dollars of annual investment
income but we are trying to
enhance that in certain areas
like real estate and so on so
we'll speak to that.
So with that John I'm going to
turn this over to Eric Baggesen
and talk about real equity.
>>Well good morning.
Welcome to our 3 year asset
liability exercise.
Farouki asked us as SIOs to
really talk about what are the
sort of bottom line implications
if we think of this in this sort of
risk characteristic and I think
what pretty much everyone in
this room agrees with is that
equity is highly correlated with
growth risk.
I mean that really is, you know
this is probably the most simple
translation of what is the asset
class represent into the risk
area and that is defined in the
uh, in the role of the asset class
that you see on page 4 of your
Which, are we moving with the
right arrow, or the left arrow?
>>Right is up and left is down.
>>I'm actually going to skip a
slide and point you to page 6
for a moment because this got
out of order.
I wanted us to refer back to the
work that Rob Arnot presented
to the Board in September just
as an illustration.
If you look at the 1982 through
2010 time period and again this
is based on work that is very
much U S centric but if you look
at it you have the sources of
return that happened over that
almost 30 year time period and
a total return for the asset class
of equities of 10.6%.
One of the things that really
stands out in this is the
valuation component, 4.4%;
that represents an expansion of
PE ratios and in large measure
that expansion of PE ratios
happened because of the fall of
interest rates from the double
digit area into the low single
Arnot would have you believe
that is not a likely occurrence to
happen again so that, and
again I'm pointing this, this is
Arnot's work.
So if we think about the 2010 to
2015 sort of time period and
again using Rob's numbers you
see a much more constrained
return expectation for public
equity as an asset class.
So the real implication for us is
if you believe this work of Arnot
What do we do?
How do we migrate this asset
class and try to uh, enhance
the real drivers of return in this
Hopefully I flip back to the
implication page here.
So there are a couple of
different ways that we can try
to increase the return on
Again if you just accept Arnot's
work in a low return
So one possible mechanism
that we could us to try to
enhance the return on equities
is to sort of try to take
advantage of market
inefficiency and treading you
know value added activities.
I have a degree of skepticism
that we can find enough value
added activities in order to
really make up the return
There is absolutely no reason
to believe on a systemic basis
that inefficiencies are going to
continue to exist that you can
profitably take advantage of so
we need to be a little bit
circumspect in what we aspire
to do.
We're also hindered by a large
capital base.
When you're trying to move
around approximately 100
billion dollars it's hard to find
anomalies that can sustain
those kinds of capital flows.
The moment you attempt to
deploy the capital into the
anomaly you start to make that
anomaly disappear.
So your very actions serve to
make the market more efficient
which leads us to the second
implication and this is what I
really believe is, is going to be
the task for global equity in the
coming years is to really try to
identify implementable increase
of exposure to actual underlying
systemic economic growth and
that's really where we think the
large measure of, of our value
added is going to come from.
And when I say value added
particularly think of that in
context of the more U S centric
portfolios that many of our
peers operate.
Okay, so when you think about
returns and equities the return
happens because of the
underlying earnings generated
by the companies in the
We do not have a good source
of information that gives us
earnings expectation going into
the future.
So one of the things that I did
was to look to the IMF, the
International Monetary Fund,
and look at their estimates for
Gross Domestic Product
growth and I'm using Gross
Domestic Product growth as a
proxy for earnings growth
thinking that one will play
through to the other.
Obviously it's a less than
perfect correlation.
What you see on the first
column on this page, and I've
listed this out sorted by the
geographic regions that we are
typically exposed to in the
public equity portfolio.
When you look under the FTSE
all world, all cap column this is
our current allocations so we
have approximately 43% of the
portfolio allocated to the
United States.
In the developed world outside
the United States is another
46% and emerging markets
represent approximately 11%.
The middle column, the IMF
2010 GDP, is a reflection of the
IMF estimates for where this
current year GDP numbers are
going to fall.
So you can see the United
States is a 20, call it 24% for
the sake of simple numbers.
If you actually looked at GDP
weighting going back a decade
or more ago United States
represented over 30% of that
global GDP.
So the United States while
obviously the main, the main
participant is not necessarily
going to be the driver of growth
going forward.
Its role has been diminished at
least to some extent.
When you compare the 43% of
our capital portfolio against the
23% or 24% of GDP growth
that would tend to lead you to
believe that the United States
has a much more highly
evolved financial marketplace.
So we have, we have a lot of
companies that have raised a
lot of equity capital in our, in our
And that's very significant
actually when you look down
and think about where the
development of financial
markets is going to happen in
the future.
So the developed world outside
the United States more or less
in parity between its financial
market development and its
The emerging markets way
under represented in the terms
of financial development.
And the frontiers markets, and
the frontier markets are,
represent almost 136 uh,
countries that are not currently
included in our global equity
Okay and we have 47 countries
that are included in that
portfolio currently.
But the frontier markets actually
represent a significant and
growing piece of economic
activity albeit still coming off of
a small base.
So if we are going to move into
an environment where we're
going to try to emphasize
economic growth in this
portfolio I, well you know if you
just look at growth in of itself
you would see a lot of small
countries that are growing very
That is not something that can
be conceptually deployed in a
CalPERS portfolio.
So I created really it's just a
very simplistic factor that looks
at the IMF's forecast for 5
years GDP growth times the
size of the Gross Domestic
Product of a country to
begin with.
So you're looking in sort of
dollar terms and this is all in
U S dollars.
You're looking in dollar terms
as to where growth is going to
come from over the next 5
years and that's what this last
column represents.
So the United States will
represent according to IMF
estimates something like 18%
of the global growth that will
take place.
The developed world outside
the U S approximately 26%,
emerging markets 46%, and
the frontier markets somewhere
around 10%.
So it's quite apparent that our
portfolio is not necessarily
deployed in a way that is
consistent at least with the
IMF's GDP growth estimates.
So what does that mean and
what kind of growth is even
potentially available?
I took these weights and
converted this relative to the
IMF growth estimates so that
you can the contributions from
each area and the underlying
growth that is implied.
So based on our FTSE all world
all cap weightings the United
States would contribute about
1.8% to economic growth and
you can see the numbers from
down the page to a total of
if you weighted the portfolio
based on gross domestic
product that growth now comes
down because you'd be taking
capital from the United States
and moving it into other places
around the world particularly
the emerging markets you
would see that growth
expectation moving up to about
5.6%; so 100 basis points of
And if you really desire to
emphasize growth in the
portfolio you would weight this
again maybe based on some
kind of a factor and I'm not
suggesting that we actually use
that factor but just as an
indication if you really
emphasize the growth in the
portfolio then you could drive
potential underlying GDP
growth in this thing up to
something more like the 7%
Now is that implementable?
Chances are not because
simply a lot of that growth is
coming from the frontier
markets and I think that we
have to tread very, very
cautiously into those
Even in the emerging market
space we have to be very, very
careful about the implications
for both the ability to repatriate
capital, exchange rates and a
lot of other different aspects in
this portfolio.
But this is really, we think a
large measure of our job is
going to be to figure out how
can we enhance the economic
growth in this portfolio and
there will be no simple answers
to that but that's really the
underlying opportunity for us is
to identify where is population
increasing and where is the
standard of living increasing
along with it?
And I think that's really the
opportunity to us.
>>If I could uh, I just want to
understand what you're saying.
Is, is, the bottom row is total
GDP growth?
The total row is total GDP
>>Yes the total row is, it's just
summing up the contributions
to global GDP growth coming
from the different regions.
>>Okay, and your, is what, is
your, is what you're saying is
your assertion that depending
on the way we invest whether
we invest according to, the way
we do right now according to
the FTSE all world, allocate
our, our the global equity
assets according to FTSE all
world according to IMF uh,
2010 GDP or this third factor
which you say is, is a proxy
right now uh, that we would
contribute to additional growth,
we would be stimulating growth
Is that what you're saying or
am I misunderstanding?
>>No this, no this is just saying
that we would be participating
in whatever return comes
from...Participating in the
growth that is occurring...the
organic growth that would be
>>Okay thank you that helps.
>>But and the need to assume
that it is already priced in it, the
markets, that everybody else
isn't thinking the same so you
need obviously measures of
price earnings or whatever.
>>You're absolutely right Dr.
If the growth in emerging
markets is already valued...In
the PE so for example if the PE
ratio...if the PE ratio of
emerging markets is far higher
for example than that of the
United States and that growth
has already been discounted
then there is no economic
return value to us in doing that
so we have to be very careful
about uh, both the valuations at
the time that you change capital
deployment and about real
You know do you true, is there
truly capacity and is it a
relatively safe place to be, for
us to invest because nothing
obviously could be worse than
for us to deploy capital into a
market and not be able to
get it back.
You know that, doesn't matter
what the return is at that point if
you can't bring it back here.
>>I'm going to wind up asking
another question of all the
asset groups.
The rest of you might want to
think about it.
What does PERS bring to the
table that you need and how do
we structure our portfolio to
take advantage and get paid for
the uniqueness that PERS
brings and if we don't bring
anything you need uh, then
what does that say about what
we ought to be doing with
with the asset class?
>>Well it, that's a question that
I don't know, that might be
Joe's question actually.
I happen to agree with you
when, and what I believe and
that CalPERS brings is the
potential to have a very long
term time horizon which allows
us to potentially position our
portfolio to be a liquidity
provider so that we in essence
become uh, we, we need
ultimately to become contra-
cyclical to what's happening in
the marketplace.
So if the equity markets are
being sold off we potentially
need to be buyers in that
market place which means
obviously we need to have a
free up of capital to do that.
There are, there are a number
of ways that we can attempt to
earn incremental on top of what
we get from our, from our
passive sort of index exposure
in this portfolio.
So we're looking at strategies
that do provide liquidity,
securities and lending is
another area where we can, we
can uh, make incremental
return although we have to be
very careful with how we deploy
the collateral that underlies that
security running portfolio but
the lending activities
themselves generate
Uh, so there's a, there's a
number of different things but
again I am extremely
circumspect as to what I
believe we're going to add on
trading strategies and these
kinds of traditional active
strategies and instead I believe
that in large measure the
private equity portfolio
represents the active
deployment of risk into
enhanced return on top of
public equities.
So we, we need to be very
circumspect and in the public
equity portfolio right now we
take less active risk than
virtually any other segment of
the investment portfolio and
that is because the market is so
There's not a lot of trading
strategies that can add value so
we just need to be very
cognizant of that capacity.
>>Very low cost beta exposure,
very low cost beta exposure
and the ability to take
advantage of being a liquidity
provider is the strategy.
We're exploring plus this ability
to select in certain markets, in
certain conditions managers
who can add active return and
outflow return.
The primary function of equity
as it says here is just to capture
the equity we're risk premium of
beta return.
>>Um, I don't really expect an
answer for this but it's uh, I
think related to J.J.'s question
and that is uh, all of the
strategies you're talking about,
all the packets, uh, have to do
as they properly should I think
but finding good decisions to
make about where to find
growth opportunities.
My question would have to do,
and I think it requires a longer
consideration, about what do
we do to change the base case
especially in the United States?
Do we have, we've been told
we have an opportunity and the
ability especially in concert with
other like minded investors and
of course this is, we've had
some history in corporate
governance and so on but I
think it really has more to do
with where we choose to lead in
terms of some of the important
economic factors that are, that
we have to deal with including
consumer spending in the
United States, what kind of
jobs, what kind of middle class
we have?
It seems to me we can, we can
pick and choose among some
of the opportunities as we come
at it from the right um, I should
say not from the right, the
correct uh, and defensible uh,
set of principles.
Though again I think we can at
least at the margins and
especially in concert with others
and especially in equities
choose a course that might
actually change the game.
>>Chairman, may I add a
comment that uh, I'm trying to
attempt to maybe add to uh,
what's been said to Mr. Jones'
question in terms of what's,
what can CalPERS do?
I think you really look at in, in
terms of returns right?
How can we enhance risk
adjusted returns?
Apart from the policy decision
you make and, and what is the
expected return on the policy
portfolio I think there are two
important components that add
value to that return, to the
policy return.
One, it comes from your uh,
your portfolio design and
construction within each asset
That's a strategic kind of a
decision at the asset class level
and that goes to the point that
Dr. Dear was making I think in
the beginning about how the
sub-asset classes are
Is that allocated very
That's one way to, to, to
enhance return and I think
that's appoint that Eric's trying
to address is how to allocate
the global equity assets across
these different growth
opportunities and then the next
layer of course is the active
management of the trading
strategies where Eric is saying
in the case of global equities
that's not that high but that
could be high in, in areas like
private equity and real estate
and so on so I think that we've
got to look at these two, these
two layers of, of value added
and how we execute them.
>>I recognize that each of the
asset classes do play their
assets a little differently.
I mean one, it's not one
strategy fits all but the point I'm
trying to get to is PERS has
some unique aspects to it, our
size, our long term horizon uh,
the two that really jump out.
And so part of the question is
how do we play to use our
strengths as a unique
You know a unique institution
and get paid for it?
I mean if we bring dumb money
to the market the street picks
us off all day and so how do we
say, "This is our strength and
we bring something unique to
the table and we want to get
paid for it."
And I think we need to address
that in each of the asset classes.
We are not simp, you know I
don't think we, unless we
believe we don't have any
unique strengths that we're
bringing to the market then we
accept the beta return but you
know, so that's you know part
of what I'm trying to get to.
>>Thank you.
We want to John, we can pass
>>Let's keep in mind that we
have, I assume they all take as
long as global equity did but we
try to keep our questions uh, ...
>>Excuse me, move very
quickly, uh, private equity has
many of the same
characteristics as public equity
and clearly it's quite evident
they're highly correlated.
There are some additional risks
associated with private equity
including the concentration of
ownership, higher leverage
amount, and you also have a
problem with lack of liquidity
which, which is evident not only
with the fact that we own
private companies but because
most of our investments are
made through partnerships
which are locked up and the
decision to exit companies
whether they're private or
eventually go public is per the
discretion of the manager.
That being said uh, although we
have concentrated ownerships
in individual companies we
have a very diverse portfolio if
you include all the exposure we
have we own probably about
8,000 companies within the
AIM portfolio.
Uh, and we rely on this
concentrated approach, this
value added approach, from our
managers to align interests
between them and
management to focus only on
value creation.
Ultimately the theory around
private equity is management
usually gets a larger share of
the equity of their company
through options and they only
can cash those in when they
actually create value within their
That means there's very little,
oftentimes probably very little
uh, uh, value from income.
It's primarily an appreciation
asset class.
So one of the key
elements and implications
relate to the ability to find
market and asset uh,
inefficiencies, not just in equity
although we're primarily an
equity player but also on the
credit side and that's played out
to be pretty well over the last
couple years.
Also as I said control oriented
focus, active management of
these companies designed to
generate returns well in excess
of what you can get from the
public markets.
Given the high correlation to
growth with private equity of
course our managers are
seeking to find companies that
have high growth prospects
particularly smaller companies
that can grow either through
M & A activity or just organic
growth that ultimately would be
attractive to acquire as
corporate buyers or eventually
could go public, but another key
element to the AIM program is
restructuring aspects of the
AIM program and that is our
managers putting money to
work when the economy is soft
which we've seen in the last
few years.
We're able to restructure these
companies and we'll position
them to be more stable and
grow over time.
So you definitely need a
economic tailwind for that
strategy to play out but
oftentimes when, when markets
are, are quite soft as we've
seen we're in a crisis this is an
opportunity for private equity
managers to go in and really
capitalize on that situation.
So again, still needs growth
over time but there is that
restructure element that's
critical to our program.
The risks of course because
we're primarily a partnership
investor are our ability to pick
quality managers, the best
managers top (indiscernible)
managers particularly as our
portfolio is a global portfolio and
you know these are 10, 15 year
partnerships where you're
locked up with a manger for
many years so it's important to
both know those markets in
Europe and in Asia as well as
to know the managers.
Particularly in emerging
markets where there's, of
course the distance in itself
creates barriers but the rule of
law is so different, the
ecosystem is so different,
different legal, different
accounting, different banking
structures all create uncertainty
so it's very, very important to
find the best managers and that
is, that will always be a
challenge for us Leverage of
course within the portfolio a big
part of our portfolio is
leverage buyout portfolio
will have a, will be impacted in
soft economic times and uh,
unstable capital markets also
create a situation where you
know we may have less liquidity
when you have lack of stability
in the capital markets both
equity and debt market
Farouki asked me to provide
some, some perspective on
Our current policy target of
about 14%.
We anticipate making
commitments between 3 and 5
billion dollars but I think it's
really important to note that this
is about finding inefficiencies in
the market and not absolutely
being on target with our
allocation some of which we
can't control.
We expect our managers to
have the discretion to deploy
the capital when necessary.
But it is important
there are time when we may
want to make higher levels of
investments and commitments
when we see those
inefficiencies versus times
where candidly you could get a,
a similar return or perhaps a
better risk adjust return from
the other asset classes
particularly in, in the public
markets and I think that really
holds true when looking at
specific markets and Joe used
the example of Japan for
Second largest industrialized
economy in the world happens to
be a pretty poor private market
because the ecosystem doesn't
really work there for private
equity so that's a place where
the public market is just
probably better off to find the
capital in private equity.
>>Sorry I, I'm a little; I know
we're under time pressure but I
feel like it's our job to have a
really robust discussion, so,
okay um, a couple of things;
one is sort of a fall in to what
Steve said earlier and I think
this is an area where there are
many strategies which are
really productive for the
economy and then there are
some strategies in private
equity investing that can be
damaging to the economy or
might you know be, contribute
to some of the uh, challenges
that the economy faces in
terms of recovery.
So I think that's something
that's a part of our discussion
of investment beliefs that I think
we need to have that
conversation and uh, the other
piece you kind of mentioned is
pacing of investments and uh,
one of the things that I think we
need to be cautious about is
uh, what, what often happens is
that when everybody else is
investing more we are investing
more, when everybody else is
investing less we're investing
We tend to invest more during
bubbles and less during troughs
and that is not the kind of
pacing that we want to see.
So I understand that there
might be times where it seems
like there are more
opportunities but I'm wondering
if a more disciplined sort of year
in, year out this is how much
we have to be investing
approach is actually a more
appropriate uh, appropriate way
to look at it or to deploy the
So I'm just challenging you on
that Joncarlo uh.
>>I think that's the
understanding we have
between public equity and
private equity and that
increasing any allocations
above their ... how this is
going to come from public
equity would be the funding
source for much of their growth
so it's going to be very
opportunity specific.
So uh, I think that's what
Joncarlo alluded to when he
said 3 to 5 billion is that it's not
going to be annual every year 3
to 5 but it's going to be based
on the opportunity.
And the cycle as you said is
important because that's one of
the lessons we learned from
the crisis was that we allocated
a lot in the frothy times
because everything was going
up and...
>>Yeah I mean the cycle is
important but it seems like we
haven't always recognized
where we are in the cycle and
it's sometimes when you're in
the middle of it it's hard to see
where you are and no, but I
mean I'm not saying that there
are very many people out there
who are very good at it but
that's why I just have this
concern about a fluctuating
>>That's absolutely right and
the problem is not getting
caught up in the enthusiasm.
At the same time we were
allocating more and more
capital private we were raising
the target so there's was no
constraint there was always
more to be allocated and there
was never a question of
allocating to which private
equity strategy or another.
Now we have the constraint
because effectively we're at the
limit in most of the portfolios.
We recommend don't uh,
include increasing it but just to
show you that there are
investment beliefs here.
We haven't labeled them as
such but one investment belief
is that public equity markets are
very efficient and it's hard to
beat the market.
So we do believe in private
equity there are inefficiencies
that can be exploited so those
are two beliefs and furthermore
that we have the ability to find
those managers who are
capable of exploiting those
inefficiencies in private equity.
To have that private equity
exposure means we take on
illiquidity risk and risk of
leverage in order to earn that
higher return.
Those are beliefs that are in
these two presentations that
are core to the strategies that
we're, we have been using in
proposed (indiscernible).
>>Move to fixed income.
>>The, yeah I wanted feedback
a little bit from Priya's.
Our investment in LBOs uh, I'm
not sure is nearly as good for
the economy as the
investments we do where we're
creating new money into
business opportunities.
Uh, it's you know, but that's a
different discussion.
What, what is unique about
PERS in this space and how do
we get paid for it?
>>It's actually a really
interesting question uh, I
believe that CalPERS has, it's a
huge brand, that uh, needs to
be exploited even more,
particularly internationally uh,
again we invest through our
partnerships and uh, it's, it's
imperative that our partners, or
oftentimes they court us
aggressively because they want
to have CalPERS as, as, as an
investor in their fund.
That reflects our commitment,
long term commitment to that
It's a very competitive world
when they're going out to try to
buy businesses and I assure
you if we're an investor with
those funds they turn around
and tell the companies or the
families that they're buying
those businesses from who
care about what happens with
the company after the fact that
look, our institutional investor
base includes CalPERS and
it's, it's very, very important.
Ways we try to leverage that is
we have been very active with
emerging managers, first and
second time funds.
We're having CalPERS as an
anchor investor in those
It gives them tremendous uh,
momentum in the fund raising
cycle and as a new manager
and they're again approaching;
as they approach companies
and they're saying you know,
"We'd like to buy a piece." or
buy your company along with
Here's an opportunity they can
say, "And CalPERS is one of
our investors." and I think that
shows stability and shows the
quality of the manager.
So we do try to take advantage
of that.
>>And how do we get paid for
>>Well oftentimes when we uh,
when we negotiate uh,
agreements with new managers
we do negotiate special
economic agreements with
them but at the end of the day
it's our ability to find great
managers who based on their
investment judgment and their
investment activities generate
better returns than everyone
>>Thank you.
So global fixed income's role is
pretty much the same as it
always has been.
It's a diversifier for the risk that
equity entails and provides
I passed out something
because there was a comment,
Mr. Jelincic made a comment
about fixed income and I
wanted to show you this and it's
very similar whether it's 1 year
rolling, 2 year, 3 year.
This is the rolling, only for those
about 27% which is the
corporate benchmark, so that's
very small.
The rest of it, of the fixed
income is governments and
agency pass throughs, Fanny
and Freddie so they're less
union and you can see that
there isn't a lot of correlation
with fixed income and that's
naturally because there's a
embedded, big income
component in corporate bonds
and so what I think Mr. Jelincic
was talking about was during
the times of crisis and how a lot
of things go to one and, and
spread, widen out so in general
you can see from this graph,
this is just a graph of those
securities, corporate securities
so non-treasury,
non-government agencies
and the correlation with that
of the S & P.
You can see that it's basically
uncorrelated and, and that's not
surprising so it seems to be, I
wanted to you know put this to
It's being brought up that
there's this high correlation and
it's really not.
So, and this comes to what the
role of fixed income is, is
because really we're trying to
generate as we said the income
and keep the correlation low
with equities and provide some
protection during market
stresses and so what we've
done is begin to change the uh,
the degrees of freedom within
fixed income to reduce the uh,
the returns so that they're less
Because right now in the past
we had allowed much, kind of a
natural uh, as if we were an
external money manager and,
and it was pretty wide in terms
of ranges so we've cut those in
half, passed it through the
policy subcommittee.
Also, that's going to take the
returns down in terms of
excess returns they have been
around 60 to 70 and we think
that uh, that'll probably be
reduced in half but that falls
along line of what Farouki
wants and that, during market
stresses this portfolio responds
a little better.
The second thing is, is this new
idea, it's really not a new idea
it's taking the existing liquidity
portfolio which is right now
being uh, put into short term
securities and really putting
Treasury securities into this.
And as I said before the size of
this is really function of, of a lot
of the kind of less liquid nature
that we've been moving in,
moving towards in CalPERS
and we have a higher private
equity exposure and, and then
this will also handle any kind of
fluctuations and ranges so, in
the equity portfolio, so you, you
put equities within a certain
range in the past and if it went
down and we wanted to get the
equity exposure up we'd have
to sell fixed income and this will
allow this to happen much more
easily uh, you know because
during these crisis many of the
instruments, 30% of the
instruments that we're in, fixed
income is less liquid.
So this new liquidity uh, bucket,
it's really not new it's going to
be occupied by Treasuries, is to
as I said hedge the drawdown
risk of equities, provide some
income, provide some liability
hedge and be a source of
So I'm going to answer Mr.
Jelincic's question because I
know it's coming and uh, fixed
income has done this a long
time ago and thought through
how to take advantage of
CalPERS' size, the liquidity,
and, and the big thing is, is that
we navigate in markets that the
regular market doesn't navigate
so, generally the markets
navigate in mean and agg
space which is to say shorter
duration, shorter interest rate,
maturity, space.
You have decided 30 years ago
to, to have us navigate in much
longer duration space and it
fitted CalPERS need for long
duration or interest rate
exposure to better hedge for
the actuarial issues and so
because we're in that area it, it
allows to kind of uh, not
compete with the PIMCOs of
the world and, and it's, it's a
little bit easier to, to uh, add
some value.
In addition, it's not a cap
weighted index.
It's a, it's a static index so 40%
of the index in, in governments,
U S Treasuries, agencies.
30% is in agency pass
throughs, Ginny Mae, Fanny
Mae, Freddie Mac so there's,
that does not move and if you
watch the Lehman Agg it's
pretty dramatic in the way it
moves up and down in terms of
how much Treasuries so we,
we have taken advantage of
our size.
We also lastly have a very,
CalPERS has traditionally had
a long term focus, when there
are market stress we do adjust
our allocations towards risk
So that's why you begin to see
some of the higher correlations
because we're legging into the
As spreads are widening, as
risks, premiums are wider we
start adding to that trade.
Now we, like everyone, tend to
be a little early and we've tried
to slow ourselves down but at
the end of the trade, end of the
day when you look through the
cycles I think our philosophy
has been proven out and uh, so
we're going to continue to
execute our, our strategy but
we're going to execute it in a
much uh, with 50% less
degrees of freedom.
>>And thanks for asking the
>>Uh, let me just first start off,
Farouki reminded me, so we're
at the, I'm batting cleanup here
so we're at the end of the
I'm going to cover uh, the real
asset class and I'm going to
focus my comments on real
The infrastructure and the
timberland ...
>>Yeah you, you trim the forest
discussion, not clear cut it.
>>...and I do want to put
centrally in focus this rule of uh,
of real estate because really
uh, this year the focus of this
committee and of Joe and SIOs
are so centrally on the rule and
of all the asset classes.
It's probably the most
meaningful and, and uh,
transformative for real estate
than the other asset classes
and one of the reasons for that
is simply real estate's 10% of
the portfolio and really fixing the
roles as you've just heard
exculpated of the rest of the
portfolio is very directional
towards real estate as the
smaller component of the
The second reason for that is
given the very wide variety of
things real estate can be.
There's a, uh, we've called
ourself in the past it can be a
chameleon so there's a great
variety of uh, of types of
strategies real estate can
employ so fixing the role of real
estate, pivoting form the 90% of
the rest of the portfolio is
particularly important and
particularly important given the
experiences that uh, that we've
just come through.
Uh, so given that importance
uh, uh, let me just highlight
really three important things
about the role of real estate.
Uh, first, given the significant
exposure to growth risk in the
portfolio uh, real estate's role is
to diversify that equity
Second, the strategic role of
real estate will be to deliver,
and this is important, we talked
about cash yield and income a
lot today but to deliver the
majority of its return in current
cash yield to CalPERS, that
gets to one of the questions Mr.
Olivera was asking earlier, and
that current cash yield should
be reasonable stable year over
And then third it's also a partial
inflation hedge.
So those, those are the three
primary drivers of the role of
real estate uh, that's before the
The practical implications uh, of
that role for the real estate
program is on a prospective
basis, is that uh, the portfolio
will be primarily structured in
private real estate as opposed
to public.
Further, given the increase
appetite for stable cash yield
there will be a renewed focus
on increasing our exposure to
lower risk, stabilized real estate
when we deploy new capital
So the uh, the summation of
that is really looking at coming
to this committee with a
strategy, with his role in mind,
of private portfolio focused on
stable income producing core
assets to deliver this role for
the fund.
I will say uh, given the existing
role of, of real estate for
CalPERS and the size and
scope of our current portfolio
this type of uh, transformation
for the role of real estate will
take many, many years to fully
It's a 5 plus year timeframe to
fully implement and with that
uh, I will; well, before that I'll
get to J. J., Mr. Jelincic's
question and then open it up
One of the things
that has come out pretty
strikingly to me in looking at the
numbers is just uh, the uh,
value of U S core real estate in
the overall composition of this
The risk and return attributes of
core real estate are a real uh,
value to the overall fund and
looking at our core
competencies I think we can
look back over a very long
history for, for CalPERS uh,
that one, the size of CalPERS
and its long term nature
particularly play into being able
to build and structure and hold
uh, U S core real estate over
long periods of time to deliver
two things; a return, a risk
adjusted return 7, 8% over time
with very low standard of
deviation with the majority of
that return being cash yield to
the fund.
Our size allows us to build
substantial portfolios but allows
us to do it in ways our
competitors cannot.
One, we are not uh, relegated
to merely investing in open
comingled funds.
Our size allows us to build our
own portfolios.
Second, our size and time
horizon allows us to specialize
or pick property specialists
within our core program so that
we're not relegated to pick fund
across property types but we're
able to select uh, property
specialists and we're able to I
think select from among the
best real estate operators in
each of those property
And lastly, that long term time
horizon and our size allows us,
should allow us, to do that at a
cost uh, advantage over our
competitors so that's, that's my
on the fly response to your
And with that I'll be glad to take
any more questions.
>>Yeah Ted I, I think probably
with all of us but I know
specifically what Steve and,
and, Priya have expressed many
times uh, obviously we've gone
through a rough time the last
couple years in real estate like
many people have but on top of
everything you said and I think
it's between the lines is that
absolute alignment of interest
with whoever we're partnering
with which includes not
philosophical things but it also
includes that they're for the
long term play and that during
the cycles that they are not,
because we are the limited
partner in some cases, ones
pushing us trying to move an
asset that we don't want to.
And I think what's really
important over the next several
years is that we build that kind
of reputation out in the
communities across this
country and specifically to the
United States is that when we
come into your community to
build something we're going be
there a long time.
Because we necessarily
because of some things do not
have the reputation in some
communities it just; and we all
understand the circumstances
of why but I think your
strategy's on target and I, I
think as we go forward and I
know you will address this in
your legal agreements and in
who our partnerships are.
I've been very pleased with my
time working with you as the
Finance Chair that, that we do
build that.
If we're coming into your
community to build a, a real
estate asset we're there for the
long term play and it does
answer back to that cash, that
required cash flow that I think
we're going to need over the
next several years.
Thank you.
>>I see no further requests to
speak here, no further
comments from the panel.
Are we...alright we are ready
for lunch.
Let's return at uh, oh let's
return at 10 after 1, we'll take a
couple minutes.