Saturday, September 11, 2010

CalPERS’ Proposed Investment Classification

As mentioned in my book, CalPERS has been studying the idea of reclassifying its investments for the purpose of adding clarity to its asset allocation efforts. Pensions & Investments Online reports that CalPERS suggests the reclassification shown below, although this may not be its final form: the proposal is contained in a memo that will be considered at a November meeting of its Investment Committee, and differs from an earlier proposal that was floated in March.
The reclassification is clearly a move away from an asset class-based schema toward a more functional classification of investments. Although the old classification included one category – inflation-protective – that is clearly functional in nature, the new classification includes four functional categories, with only “real assets” as an asset class-based category.

The inadequacies of an asset class-based schema are abundantly clear to any Investment Committee that has struggled with one, and CalPERS has made a laudable attempt to circumvent them. It would be unfair to nit-pick over the proposed reclassification, since it may still be subject to modification, the details of how its categories will be defined remain unclear and how allocation based upon them will be implemented has not been discussed. However, it is not just an aesthetic objection that the proposed reclassification retains an asset class-based category.

The point of a functional classification is to underline the portfolio role of the instruments that comprise the investable universe. The function-based categories that CalPERS has defined pretty much cover the essential tasks that a portfolio must perform on behalf of the institution:
• to preserve capital against inflation and deflation or credit crisis;
• to provide current income to meet distribution requirements and to enhance tactical flexibility; and
• to increase the endowment to allow the institution to expand its activities if its trustees so choose.
Many, if not most, investments exhibit characteristics that help fulfill more than one of these functions – dividends, for instance, provide income from the “growth” allocation that is surely welcome. But this can be accommodated within the schema by distinguishing between investments’ primary and secondary portfolio roles. So where does the asset class-based category of “real assets” fit in? Investments in this category will presumably be selected in order to perform one or more of the essential portfolio functions – if not, why allocate to them at all? So CalPERS’ unwillingness to follow the logic of its proposed classification system and restrict itself to four functional categories seems inconsistent.

The advantage of functional classification is that it puts first things first: optimization among asset classes is not the first priority of an Investment Committee. Before it reaches any decisions regarding the disposition of its assets, a Committee should ponder what it wants to accomplish with the resources at hand. For example, if it is an inescapable duty to make a 7% distribution of assets in each of the next three years, questions of the disposition of its portfolio resources must follow from that requirement. If it is an immature defined benefit program, the Committee is instead likely to focus on the pursuit of growth. The appropriate asset allocation follows from such decisions, so classifying investments by their portfolio function aids the Investment Committee in performing its primary task.

It is in this context that CalPERS’ retention of a “real assets” category seems odd. Maintaining positions in real assets is not a function that an institution needs to accomplish: they, like any other investments, are means to an end. Timberland and infrastructure are primarily income-producing investments, but with a measure of inflation protection. Real estate as a broad category encompasses prime office buildings, with similar characteristics, but also development projects that more closely resemble growth equity. The logic of CalPERS’ classification schema suggests that investment categories that fall under “real assets” should be redistributed.

There is at least one category of investments – one so-called asset class – that poses significant challenges to CalPERS’ functional schema: “absolute return.” Presumably it provides some protection against inflation (if it cannot produce a real return, why invest in it at all?). A real return is clearly a minimum requirement for investments that fit into the “growth” category, but investments that can only meet this minimum standard represent rather poor candidates for fulfilling the function of increasing the endowment. Although its returns may be “absolute” in most market conditions, its tail risks tend to be closely related to those of the assets on which its strategies are employed, so its adequacy as a hedge is debatable. Few such investments provide current income. CalPERS’ proposal has generated some controversy, and I suspect that not the least reason for this is that it cannot find a natural classification for “absolute return.” This begs the question of whether this is in fact a flaw, or carries the unexpected implication that “absolute return” does not fulfill any essential portfolio functions very well.

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