CalPERS Abandoning Passive Equity Investing

We promised readers yesterday that we’d describe how Sacramento Bee reporter Wes Venteicher missed the real story in one of his recent CalPERS articles. Note that, as readers pointed out in comments on the direction of his questions in a planned and clearly planted hit piece on Margaret Brown, he fixated on the nothingburger of her apparent loss of some CalPERS-supplied electronic devices…when on top of that, they’d never been lost but only temporarily misplaced in her premises. The real story, as tech-savvy readers pointed out, was that CalPERS has grossly deficient asset-tracking and security policies and procedures.

Venteicher appears contend to be a reliable mouthpiece for CalPERS, flogging minutiae that CalPERS sees as flattering, as opposed to bona fide news. The recent example came on October 21, in CalPERS pulls millions of dollars out of immigrant detention companies. CalPERS wants credit, particularly in Sacramento, for taking a step consistent with Governor Gavin Newsom’s ban of private prisons and immigrant detention centers, which became law on October 11 with the signing of AB32, which makes these facilities illegal….as of 2028. Note that Newsom made a commitment to shuttering private prisons in his inaugural address Assemblyman Ron Bonta, who introduced AB32, also promised to introduce a bill that would require state pension funds to ditch private prison investments. CalPERS’ Sacramento sister CalSTRS had already pledged to do so last November.

Mind you, I’m not suggesting that Venteicher should not have filed this account. It’s become a hot topic even if CalPERS role is minor and the two companies in question aren’t material to the portfolio. In fact, there’s an argument here that it is likely prudent for CalPERS to exit since the move to get rid of private prisons may take hold in enough states to dent the economics of those companies. But the flip side is 2028 is a long way away.

The big issue is what Venteicher missed in material that he likely regarded as simply fleshing out the piece:

“It was an investment decision based on what is best for the fund,” CalPERS spokesman Wayne Davis said.

This is significant because CalPERS is admitting that it is engaged in active stock investing. This is a major move that CalPERS has been advancing on the sly. We’ll turn to the additional evidence in the story and elsewhere that CalPERS is acting more and more like an active investor while not being up front about that. If CalPERS were to admit it was retreating in a significant way from passive investing, this would be treated as news on the order of CalPERS’ renouncement of hedge funds.

Investment orthodoxy is that investors get paid only for taking market risk and illiquidity risk, Being in more asset classes is also desirable because it reduces risk. However there is considerable debate over what “the market” is. Domestic or global? How to decide how much exposure to smaller companies? And investment professional try to depict whiz-bang new approaches as asset classes when the classic academic studies were on broad and clearly differentiated types of investments, like stocks, bonds, cash, and real estate.

Nevertheless, for both institutions and individuals, trying to pick stocks, or market time, or pick sectors is generally seen as a fool’s errand. One of our readers helped develop a strategy that was singled out by Stanford in a formal competition involving five Vanguard index funds which over various time horizons has outperformed 90% of public pension funds. He’s been working pro-bono to try to get public pension funds to adopt it.

Heretofore, CalPERS has largely hewed to investment orthodoxy, although it has done market timing of sorts via its asset allocation. For instance, it reduced risk by cutting its equity allocation right before the 2016 election, so it wound up participating less in the Trump rally that it would have if it had stood pat. 1

However, the discussions about index investing have become muddied thanks to using the same term to mean different things, just the way “progressive” has been badly abused. The point of passive or index investing is to minimize fees and trading costs and avoid trying to outsmart other investors or market time, since even if you can win for a while, the odds are that you will lose over time due to overtrading and wrong-footing.

There are two ways CalPERS is moving away from passive investing, as in using broad-based indexing. One has been via moves like its dumping of private prisons, getting rid of an investment for political or social reasons. The timing of CalPERS’ announcement that it was getting out of private prison stocks came too close to the signing of AB32 for that to look like it suddenly came out of an investment process. Otherwise, you’d have expected it to be covered at a regular board meeting.

But the other reason for trying to claim that CalPERS wasn’t divesting (um, that is what you call it) or motivated by ethics or optics was that that CalPERS cost the fund over $2 billion when it exited tobacco stocks at close to the bottom, right before the Federal/state settlement. Venteicher lists other examples:

CalPERS, nonetheless, has divested from the tobacco industry, Sudan, Iran, manufacturers of guns that are illegal in California, thermal coal and certain companies that don’t meet its environment, social and governance standards. The Legislature recently passed a bill prohibiting investments in Turkey under certain conditions.

Yet CalPERS is trying to pretend that what it is merely tinkering at the margin:

The fund got rid of its $8.8 million worth of holdings in GEO Group and CoreCivic, the nation’s two largest private prison companies, over the last two months as part of broader changes to one of its index funds, Davis said.

“He’s sharpening the focus of all our portfolios and making sure the indexes are constructed in such a way that we mitigate risks and we capture the opportunities that are there,” Davis said.

CalPERS needs to ‘splain itself. First, the “investment decision” if it really was that, to get rid of the prison stock is pure stock picking. So you can’t try that line and then try to claim that that was part of an indexing strategy.

Second, the number of stocks sold out of the total isn’t the germane figure. It’s their market caps versus the total index fund size. And for all those stocks sold, others had to be bought. Was that done to preserve the weighting of the remaining stocks, or were new companies added instead?2

Aside from eliminating more and more types of investment for ESG (environmental, social and governance) reasons, and apparently doing some stock picking too, CalPERS is moving away from passive investing to factor investing. From Pensions & Investments at the end of August:

CalPERS shifted $150 billion in fiscal year 2019 as part of its implementation of a new strategic asset allocation adopted in December 2017 and an interim strategic asset allocation adopted in closed session in March 2018, Eric Baggesen, managing investment director for asset allocation, told the investment committee Tuesday…

The pension fund’s strategic asset allocation implementation includes 15% invested in a new factor-weighted equity portfolio, as well as 35% in capitalization-weighted equities and 8% in private equity, which together make up its 58% growth portfolio. CalPERS funded its factor-weighted equity portfolio from its capitalization-weighted equity portfolio.

Notice this was written to obscure the point. The “capitalization-weighted equity portfolio” is a traditional index fund. An overview of factor investing from Investopedia:

Factor investing is a strategy that chooses securities on attributes that are associated with higher returns. There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors. The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.

Some common macroeconomic factors include credit, inflation, and liquidity, whereas style factors embrace style, value, and momentum—just to name a few.

Factor investing came out of a seminal paper by Eugene Fama and Kenneth French. They argued that the traditional view that investors were just being paid to take market risk (beta) was too narrow, and that a three-factor view, one that incorporated size and value, did a better job of explaining investor returns.

Mind you, we are not opposed to factor investing. It does have the potential to improve returns. But there is a lot of consultant and quant snake oil. There are hundreds of factors. Which to choose? How to implement them? The most widely used approaches are four or five factor models, typically including some of: beta, size, value, momentum, profitability and investment. Critics claim factor investing has flopped in the last decade due to value stocks being duds.

The problem is that while factor investing isn’t the same as stock picking, there is a discretionary element in the choice of factors and how to implement them. Even though CalPERS has been clear that it has made a big move into this approach, it hasn’t been terribly transparent about how it is going about it.

In other words, CalPERS is making big changes to its way of managing stocks. Mind you, factor investing has been around since 1993, so it’s not a wild new idea. But CalPERS has a tendency to adopt fads just as or after they hit their peak. The flip side is judicious use of factor investing is a great aid in reducing unintended correlations, so it really should be able to boost returns if nothing else by reducing risks.

Hopefully the press in general and Venteicher in particular will take more interest in CalPERS investments, since the underfunding is so deep that there is no way for CalPERS to earn its way back to an adequate level. But the depth of the hole means staff may be tempted to take on too much risk or try misguided experiments so as to look like it is Doing Something, as its private equity “new business model” misadventures attests. CalPERS needs more oversight, and with the giant pension fund deliberately going the other way via fewer meetings, beneficiaries and taxpayers really need the media to up its game.


1 CalPERS has been an active investor in fixed income and that had worked well historically; CalPERS was long a top performer in fixed income. But active investment didn’t help CalPERS last year. From Pensions & Investments:

In fiscal year 2020, CalPERS staff will also be reviewing its use of active risk — including weight variances and staff veering from the strategic asset allocation — to increase the discipline in using active risk, Mr. [Eric] Baggesen said.

Mr. Baggesen noted that in fiscal year 2019, the staff’s use of active risk resulted in negative returns. He did not tell the committee how much the use of active risk cost the portfolio. However, in the year ended June 30, CalPERS underperformed its benchmark in the one-, three-, five- and 10-year periods.

2 We understand full well that you don’t need to buy all the stock in an index to perform index replication; indeed, a lot of the art is deciding the most efficient way to minimize tracking error, and than often includes using futures in addition to trading securities.

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  1. Tom Stone

    A hard hitting investigation by the DOJ and state Treasurer is clearly justified.
    Could these problems be due to Russian moles on the Board?
    Has Margaret Brown denied being a Russian Asset?
    Has Jelincic?

    1. The Rev Kev

      Well I’m sure that Attorney General Xavier Becerra will be all over it any time now. Something tells me that CalPERS had better get their ducks lined up and have their investment strategy sorted out soon. I have a distinct feeling that next year the wheels are going to be coming of the world’s economy so it would be better to be prepared for it. After reading this article I am seeing a sort of hit and miss attitude to what they are doing and they are letting events dictate their actions. Not a good place to be.

  2. David in Santa Cruz

    From the PI article:

    Mr. Baggesen noted that in fiscal year 2019, the staff’s use of active risk resulted in negative returns. He did not tell the committee how much the use of active risk cost the portfolio.

    These Board of Administration idiots are fiduciaries, but they don’t demand that their staff account for losses directly attributable to risky strategies. Instead they engage in less oversight.

    There is nothing so difficult as getting a man to understand a thing when his salary depends on his not understanding it.

    CalPERS is seriously underfunded and is failing to hit return targets, but it’s mandarins demand less oversight of where the money has disappeared to. This looks less and less like incompetence and more and more like fraud.

    Follow the money…

  3. Fooled by a ConMeng?

    Yves I appreciate all the good work you do with this blog but the exact opposite is happening. Just about all the active management that existed in the fund has been stripped out under the new management. Internal and external equity active management has been decimated and from what I am told a lot of active management in fixed income has been eliminated or tightly constrained. Other areas that have had active programs have seen them dismantled as well and the quantitative performance component of staff bonuses has been changed to total fund basis and hence really at the mercy of the CIO’s performance. Hard to see there being much potential for outperformance in a fund that at least in the public markets is now almost entirely passive. The bet all seems to be on private equity. Lots of very unhappy people there from what I understand. Makes one wonder why they doubled the CIO’s pay just to run a portfolio that could have been constructed and executed on a broker trading platform

    1. Yves Smith Post author

      Thanks for you interest and input, but with all due respect, you are considerably misrepresenting the post. The post is limited to equity investing, not fixed income, where CalPERS had a sustained top tier record for many years with active investment in fixed income under Curt Ishii (save I believe the year prior to his retirement).

      Second, it is true that CalPERS has been bringing more in-house. However, it is engaged in stock-picking with respect to its ESG rejiggerings, and that is increasing, not getting to be less.

      Third, reliance on quant investing approaches is not passive investing, as we explained. No one would consider Dimensional Fund Advisors, the early innovator and still a leader in factor investing, to be a passive investor.

      CalPERS is moving away from seeking to match broad market performance. It is more and more relying on implementing various “factor weights” to beat those averages. As we explained, not only are there numerous factors but even with mainstream approaches, there are many ways to implement them. The fact that algos are employed does not render this passive investing. CalPERS is making bets on the particular secret sauce of factors it chooses and how it implements them to deliver outperformance. It got good results with a short-term experiment, but CalPERS is a long-term investor, and most factor-based approaches have delivered underwhelming results over the past decade.

      1. Fooled by a ConMeng?

        I appreciate your comment Yves but I think you will find your data is about a year out of date, Sources tell me that the changes I spoke of have occurred in the last three months, a lot of these things have been shut down under Meng after reviews that took place during this summer and early fall.

        I agree with your point about ESG priorities taking the fund away from more conventional benchmarks and are a form of active investing. This is the Board’s prerogative,and staff is compelled to respond. That said my point was more about the death of the effort to add alpha to whatever benchmarks they are mandated to follow in the public markets by either internal or external management. The factor tilting the fund had been doing has been drastically toned down. A swathe of external managers have had their contracts terminated and internal active managers have seen their mandates rescinded. Whatever actual investing chops CalPERS possessed are likely to atrophy under this new regime,

    2. Trustee

      Passive investment is accepting what the market gives without making judgements. The movement to “factor investing” may be quantitative but it is not passive. Alternate betas are active bets deviating from the “market”. Quantitative investing is rule driven to take the emotions out of the decision making but it is not passive. It is loaded with judgement to determine the rules. Internal vs external does not define active vs passive.

      When staff is given the delegated authority to move securities in and out of the benchmark that is not passive. When that authority is used to based on judgements about a stock’s future performance (or social value) that is not passive. (As an aside, it is also easier to bet the benchmark when you get to define it and change it at will.)

      The incentive performance component of staff bonuses is set by Marcie Frost and anyone she may further delegate it to. In investments that re-delegation is to the CIO.

      You point to private equity which is becoming a growing portion of the portfolio. It should not be necessary to point out that private equity is the ultimate active bet. Yet you claim the portfolio is becoming less active. Really?

  4. flora

    In other words, CalPERS is making big changes to its way of managing stocks.

    Considering Frost’s ability (or lack of) I wonder who is behind this change, and who is guiding the investment decisions now? Frost doesn’t seem competent enough to do this on her own.

    Thanks for your continued reporting on CalPERS, PE, and pensions.

  5. Susan the Other

    By the sound of this PE hasn’t worked out as planned for CalPERs. They, CalPERs, are perennially underfunded. In a market that really doesn’t look like it will be functioning within an economy that is growing anywhere near 8% maybe it is time for CalPERs to do some chumming. They could invest (actively) in companies that have set themselves the goal to manufacture/produce/distribute basic consumer goods that will follow the downward trend and thus minimize living expenses for retirees, as well as everyone else. That would be a good place to actively seek some diversity. I do hope this means that PE is stuck in a rut and cannot invest successfully simply because its bz plan is so extractive.

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