CalSTRS will employ a new way of evaluating portfolio risk which overlays risk across asset classes, rather than replacing asset classes with risk categories, and introduces six broad risk factors.
After a collaborative and exhaustive analysis, which included consultation with other pension funds, consultants, and managers, staff concluded that “the world is too interconnected and complicated to fit into neat buckets”.
As a result the risk factors will not be used to divide the portfolio by exposure, but rather overlay across the entire $146 billion portfolio as well as be used to dissect each new investment to understand its risks.
The six core risk factors are:
- global economic growth – uniquely, CalSTRS is considering dividing the world by the average age of a country’s population rather than the traditional division of emerging and developed, to determine a measure of expected global economic activity and corporate profits
- interest rate risk
- inflation risk
- liquidity – fluid markets
- leverage/financing
- investment governance risk
In his presentation to the board, chief investment officer, Chris Ailman, said the greatest risk to the fund was a loss of capital followed by a loss of reputation and member trust.
“Risk simply isn’t a single number, it is a multi-faceted concept,” he said. “For the investment portfolio, the greatest risk is a ruinous left-hand tail event.”
He said research by PIMCO and Bridgewater had shown that left-hand tail risk is more like 3 to 5 per cent, not the 1.5 per cent occurrence assumed in traditional economic theory.
CalSTRS staff, and its consultant Pension Consulting Alliance, considered more than 24 different measures of risk.
The inspiration to modify its risk-based asset allocation to one of risk-based portfolio management via overlay analysis, came from an offsite with Martin Leibowitz of Morgan Stanley. At this, staff recognised it may not prove optimal to divide the portfolio into four or five discrete risk buckets, because different investments tend to be exposed to multiple different risks in part and in whole, and are very hard to isolate.
The analysis also found risks were identifiable across time periods including day risk (one minute to multiple days), short-term risks (three months to 18 months) and long-term risk (three to five years or more)
The fund adopted a collaborative approach to its risk analysis, with ATP, Alaska Permanent Fund and CalPERS contributing to the discussion. PIMCO, Bridgewater and GMO also contributed.
Staff and consultants will now develop measures for each risk and integrate the risks into future investment committee reports.
