The CalPERS Pension Fund, has resolved to change its investment allocation next year. The new asset mix reduces public equity exposure adding exposure to private equity, fixed income and real assets.
However, the more interesting angle is that total exposure for the fund is now 105% rather than 100%. That is to say, the fund will borrow to fund its investment portfolio.
Though the fund has significant assets, its liabilities are large too. In fact, over time it’s estimated that what the fund will need to pay out will exceed its assets by around $100 billion on current assumptions. That’s one reason why the fund wants to increase its portfolio return. Leverage may be one way to do that. If you borrow money to invest, then if the markets perform well then your return will be higher.
The Downside Case
However, of course, there’s a catch. One reason estimates of the market’s return are lower than previously is because assets such as stocks and bonds have generally increased in value in recent years. Yes, some of that is due to increased profits from investments. However, a lot of the increase in various assets is simply due to rising asset prices.
For example, the S&P 500 currently trades at around 30x the value of a dollar of earnings, when historically it has typically traded at around half that level. That’s why a lot of forecasters aren’t too optimistic on returns going forward. CalPERS believe it will earn 6.8% on its portfolio, though that’s a reasonable long-term assumption that may be optimistic in current markets.
The recent run up in valuations is unlikely to repeat over the coming years, if history is any guide. Worse, should it go into reverse and valuations decline, then CalPERS have larger problem than they did in the first place. Of course, this may be one reason why CalPERS plans to trimming its stock exposure, though stocks do remain the largest single part of the portfolio.
Now, there are some arguments for leverage. The markets, at least in the U.S., have tended to rise over time, so applying some leverage does tend to increase long-term returns. Though, of course, that can come with a bumpier ride along the way. Drawdowns are more pronounced with borrowed money.
In addition, companies in the stock market have debt too, so they are already leveraged to some degree. The idea of zero leverage in stocks is perhaps a misnomer given the presence of corporate debt that many companies hold. Still, the presence of debt on the balance sheet is one reason stocks are so volatile.
Also, as CalPERS have pointed out, theoretically, leverage can improve diversification to some extent. With a typical portfolio, a lot of the return profile is driven by the stock market. Stocks tend to be the most volatile assets and, given their large weighting, can drive the portfolio perhaps more than is optimal.
If you are borrowing money to fund purchases of diversifying assets, then maybe returns over time will be smoother. However, it seems some of these borrowed funds will find its way into the equity markets and stock exposure has not declined that much with the new allocation. Part of the uncertainty is that 5% of the allocation is now termed “opportunistic”. That’s new, making it unclear how CalPERS will manage the transition. Of course, with billions of dollars, telegraphing the direction and timing of your allocation shifts in advance is never ideal.
Still there may be risks in adding leverage at the point in the cycle when you are perhaps forced to because expected returns appear less attractive. Maybe the signal is that the markets are relatively expensive and adding leverage increases downside risk. Time will tell. The biggest risk in adding leverage is seeing a drawdown relatively soon after you make the shift, so the second half of 2022 may prove an important period for CalPERS.