Wilshire’s annual review of the US$190 billion CalPERS’ internal risk managed absolute return strategies (RMARS) has revealed a number of anomalies compared with its other global equity investments, including an over-reliance on quantitative tools and inadequate staff compensation incentives. In addition, an examination of the underlying investments in six of the hedge fund-offunds (hedge FoF) portfolios, conducted by Wilshire for the first time, revealed a “surprising number” of macro, commodities and currency funds in the portfolios. It concluded that there may be more macro, currency, commodity or directional risk in the program than the investment committee prefers, and this has been reflected in the performance of the portfolio.

Wilshire has made a number of recommendations to the investment committee on the back of this review, including the possible separation of the public equities and RMARS benchmarks to better deal with the effect of the portfolio’s beta overlay on overall fund performance. Another option would be to treat RMARS as a pseudo asset class for the purpose of benchmark computation by allocating 46 per cent to global equities and 3 per cent to RMARS. Meantime, Wilshire found the level of third party due diligence on hedge FoF investments is not consistent with other investments in CalPERS’ global equities holdings. Currently, there is no clear oversight of staff activities regarding external hedge FoF investments. Wilshire says the investment committee should either clearly delegate these investments to staff, or require them to be monitored in the same way that corporate governance and traditional external relationships are.

While qualitative factors are considered during manager due diligence, CalPERS staff use quantitative tools for a significant portion of the modelling and allocation process. “We believe that sector allocations and manager selection need to be based as much on qualitative assessments of the true value they add as on purely quantitative projections. “We don’t discount the value of quantitative tools, but believe it is important to make sure the qualitative input of staff and the outside advisors will continue to override the quantitative factors when the aggregate wisdom of all parties involved recommends a different investment approach than the models dictate.” The consultant also provided a point-by-point scoring of all aspects of the RMARS program. CalPERS scored 252 out of a possible 300, reflecting its strong team and their clear success at managing the portfolio.

However the lessthan- perfect score was due to organisational-level issues such as senior management turnover and lack of retention incentives. “Staff turnover for CalPERS is high at both the senior and junior levels, including the departure of the SIO for global equities, two CIOs and the CEO over the last few years,” the report said. “Lack of long-term retention incentives has led some staff to consider the organisation as a stepping stone to better compensation in similar positions elsewhere. Turnover for this strategy is a risk.” Employees receive a performance bonus only, with other incentives such as direct ownership and profit sharing non-existent. Wilshire conducted on-site due diligence on the RMARS program’s two external consultants, Union Bank of Switzerland in Connecticut and Pacific Alternative Asset Management (PAAMCO) in Newport Beach, California And for the first time it also reviewed six of the external hedge FoF managers onsite. The funds reviewed were 47 degrees North, ERAAM, Ermitage, PAAMCO, SPARX and Visions.

No consultant or manager advises CalPERS staff regarding hedge FoF investments and this was the first time that Wilshire or any non-staff met with these managers. Subsequently Wilshire advises the investment committee should provide direction to staff and Wilshire regarding whether or not it would like future investments to be reviewed by a third party – as is the case for corporate governance managers and external traditional equity managers. According to the report, recent performance has not lived up to the “absolute return” portion of the acronym. For the past five years to the end of March it has retuned 2.7 per cent versus a benchmark of 8.8 per cent, but it outperformed the return of the entire universe of hedge FoFs, which was 1.7 per cent for the period.

“However the underperformance begs the question of the nature of the investments in the RMARS portfolio. CalPERS’ performance is reflective of the universe of hedge FoFs in general, but is it reflective of what the investment committee expects of this program?” About 20 per cent of the monthly excess returns exceed the bonds of plus or minus 2 per cent, which Wilshire said seemed a bit high. The investment committee should discuss whether this is the level of risk it was anticipating when this program was created, it said.

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