Alternative Investments

CalPERS using leverage, alts to hit return target

In general, leverage offers large investors a number of benefits and opportunities as well as risks, said John Delaney, Philadelphia-based senior director, investments, and portfolio manager at Willis Towers Watson PLC, in an email, noting he was not commenting specifically about CalPERS’ plan.

Some of the benefits are that leverage allows investors to be “more efficient with their capital in terms of allowing portfolios to gain or increase exposures without dedicating physical dollars to get those exposures.”

Willis Towers Watson recommends that asset owners add leverage to make their portfolios more efficient from a return and risk management perspective, he said.

“Most of our client base uses leverage within their Treasury overlay programs,” he said. “Those that have not used it historically continue to consider it.”

Adding leverage in a Treasury overlay program or within an asset allocation can have the same effect, Mr. Delaney said. Leverage also has the benefit of making investors more flexible in how they manage their portfolios, he said.

Leverage also allows investors to quickly increase or decrease equity beta or duration of the portfolio without having to wait for a physical equity or bond settlement.

The risks include added volatility because the portfolio’s notional value is higher than its dollar value, which could make the portfolio lose more money in a downturn than it might without the leverage. And added leverage makes keeping an eye on liquidity “crucial for managing risk and maintaining exposure,” to ensure the portfolio has enough liquidity to replenish collateral should the assets being levered decrease in value, Mr. Delaney said.

“Largely, investors just need to be aware of how volatile the interest rate environment has been and is likely to continue to be, given the uncertainty around inflation expectations” and conduct stress tests to ensure their portfolios can withstand potential movement in interest rates, Mr. Delaney said.

CalPERS’ new asset allocation is designed to achieve its 6.8% expected rate of return. The current asset allocation is only expected to produce a return of 6.2%.

In addition to increasing alternative investments, the new target allocation also decreased cap-weighted public equity by 5 percentage points to 30%, reduced factor-weighted public equity by 3 points to 12%, cut Treasury bonds by 5 points to 5%, decreased mortgage-backed securities by 3 points to 5%, increased investment-grade corporate bonds by 4 points to 10%, retained its 4% allocation to high yield, increased emerging market sovereign bonds by 4 points to 5%, and eliminated its 1% liquidity allocation.

The leverage in the new asset mix is in investment-grade corporate bonds and high yield, Ms. White said.

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