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California Pensions Adopt New Risk Strategies

California’s two giant pension funds are in the process of changing the way they allocate assets following their combined $168 billion in losses between October 2008 and March 2009 (they have since recouped about $103 billion).

The $146 billion California State Teachers’ Retirement System approved a strategy in February to incorporate a different set of risk factors when deciding how the fund should allocate its capital among different asset classes. The move follows similar changes made in December by the $228 billion California Public Employees’ Retirement System.

The changes that CalSTRS and CalPERS are planning build on modern portfolio theory’s admonition to diversify assets. For their new strategies, the pension funds will not merely aim to build asset allocations that are both diverse and uncorrelated; they will now seek to build portfolios of assets that are diverse and uncorrelated when impacted by various risks that could dramatically affect their value.

The changes are likely to impact the amount of money the two giant pensions target for certain asset classes, like private equity, although any changes are likely to take years due to the size of the positions they hold.

Following the Great Recession, both pension funds began to ask why the usual models, based on simple asset diversification, didn’t work. CalPERS spokesman Clark McKinley put it bluntly in an e-mail to Buyouts: “The usual quantitative risk management models failed to protect us adequately during the financial meltdown.”

Ricardo Duran, McKinley’s counterpart at CalSTRS, agreed. “Going back to the crash, we saw that diversification, particularly in equities, wasn’t working,” he said. “Worldwide, stocks were all moving downward in unison.”

In response to the sharp fall in their portfolio values, both pension funds started looking at risk-based asset allocation. “A lot of the thinking involved redesigning the risk buckets,” said Duran.

Under the CalSTRS plan, managers will model the portfolio’s allocation targets by overlaying six risk factors, including global economic growth risk, interest rate risk, inflation risk and government risk as well as risks due to liquidity and leverage. Government risk refers to regulatory risk, accounting rules and tax laws. Allocation diversity will now be measured by a portfolio’s ability to hold its value when pressured by various risks, including situations when several risk factors are impacting the portfolio simultaneously.

The revampings by CalSTRS and CalPERS attempt to address the limits of modern portfolio theory, which emphasizes diversification by asset class. The idea is that by having exposure to different, non-correlated asset classes, investors could protect themselves from seeing their whole portfolio tank at once.

CalPERS said the advantage to the new approach is that it can better evaluate assets in terms of how they are likely to perform in various market conditions.

McKinley of CalPERS emphasized that because of the pension fund’s size, any changes to the fund’s allocation levels are likely to take place slowly. “No one at CalPERS will be getting on the phone and pulling $5 billion out of private equity overnight, for example,” he said. Changes to CalPERS’s asset allocations targets in 2011, he said, are unlikely to be significant.

CalPERS said it planned to keep its private equity allocation—currently 14 percent of its portfolio—unchanged, although it did make some changes to its allocation targets. It said it planned to reduce funds allocated to fixed income to 16 percent from 20 percent, while doubling its investments in Treasurys to 4 percent from 2 percent.