“The factor modelling is to try and get a better grip on risk and account for some of the more extreme events that are possible.” In this model, the CalPERS investment team identified six factors and about 11 security types or building blocks. In this alternative asset classification the factors are government bonds (which includes government nominal and inflationlinked bonds as the building blocks), income (investment-grade debt, securities lending and credit enhancement), growth (public equity, private equity, real estate and high-yield bonds), inflationlinked (infrastructure, forestland, commodities), market neutral (absolute return), and liquidity (short-term fixed income). “It is clear from recent experience that having a portfolio of equities and corporate bonds turns out to provide little by way of diversification if there is a major slowdown in economic growth, so economic growth is a risk factor,” Dear says. “We are trying to understand more generally the difference between real diversification and apparent diversification.
“The other issue people are aware of is the tendency of correlations to converge during times of stress, so you can model that by making certain prescriptive assumptions or you can try to build factor models that attempt to lay that out. And then the risk issues: do you want to design portfolios that have a maximum loss and see what happens there?” The likely outcome is the CalPERS investment portfolio will move to this model, but Dear hesitates to put any particular deadline on that move. “I’m sure we’re heading that way, but what I can’t say is are we going to complete all that work so we’re ready to commit the organisation to a significantly different asset allocation methodology in 2010. That’s why we’re doing both. But we are devoting a considerable organisational effort. If we adopt that method, terrific, we’ll refine it, if we don’t finish the work to the level at which we’re comfortable implementing it, we’ll keep working it till we and our board are there,” he says.
He likens the move to the way a number of the large Canadian funds allocate, with risk being the driving force of capital distribution. “We’re moving to a risk-based asset allocation system, making allocations based on risk and not on asset, and then tying together short-term decisions and even compensation to this risk-based, risk-budgeted system.” Under this methodology, allocations to fixed income can rise compared to the type of investment by asset buckets that CalPERS does now. But Dear says it remains unclear whether there would be any increase to fixed income. “In the factor model, fixed income falls into various buckets depending on whether it is corporate, mortgages or high-yield. It’s possible the overall allocation may increase but I genuinely don’t know. In my job, I’m sort of the last one to decide,” he says.