CPP Investments' CIO Discusses Leverage With CalPERS' Board
As CalPERS adopts a new asset allocation that adds 5 per cent leverage to the entire portfolio, board members gathered key insights on how the strategy will work including the lessons from Canada Pension Plan Investments which currently applies 22 per cent leverage to the portfolio.
Edwin Cass, chief investment officer of Canada Pension Plan Investments (CPP Investments) shared the experience of the C$541.5 billion Canadian fund where a seasoned leverage strategy adds diversification and maximises returns without increasing risk.
Cass explained to CalPERS’ board members that many people associate the use of leverage with increased risk. Although leverage can be used to increase risk, CPP Investments’s use of leverage leaves its risk tolerance unchanged.
The Canadian fund invests based on a mandate to maximise returns without undue risk or loss and has an above average 85 per cent equity risk target – more than a standard 60:40 portfolio due to the fund’s long-term investment horizon and funding ratio.
Leverage is used to maximise return at its current level of risk – increasing the overall fund performance on a risk adjusted basis – by increasing diversification. Diversification, Cass told CalPERS board members, “is the one free lunch in investment.”
CPPI borrows money and adds leverage to the portfolio to get access to less risky assets. Increasing the fixed income allocation this way helps mute tail outcomes, namely correlation which Cass said is capable of “sinking a portfolio.”
“The portfolio has a higher risk-adjusted return and is a bit more robust. The important part is not to increase risk but decrease bad outcomes,” he said.
There are different measures of leverage. Top of house at CPP Investments is a total financing leverage – the amount of money the fund borrows physically or synthetically to increase exposure to its balance sheet. Today it is applying 22 per cent leverage to the portfolio below a limit of 40 per cent set by the board.
Sources of leverage
CPP Investments uses different sources of secured and unsecured leverage over the long and short term. The sources of leverage have expanded over time – as you diversify your asset mix, so you diversify your sources of finance, he said.
Today, sources include commercial paper issued in the domestic, US and UK markets for terms out to 30 years. Elsewhere, it borrows in the repo market while around one third of its exposure comes through derivatives, short selling derivative contracts.
A team of around 25 people follow the market, analysing the cheapest way to borrow and where to find staggered maturities. Cass told CalPERS’ board members that it costs more to borrow over longer maturities, however on the flipside borrowing longer-dated means there is less maturity risk and CPP Investments doesn’t have to go into the market and rollover debt, a dangerous exercise when liquidity is scarce like in March 2020.
According to the fund’s data, financing costs were $1,217 million in fiscal 2021, a decrease of almost 50 per cent compared to $2,429 million for the previous year, attributable to lower effective market interest rates.
Cass explained that alongside important board approvals, it also looks to rating agencies to help it set a comfortable level of leverage that helps ensure it can maintain its AAA status and comfortably meet liabilities.
“Rating agencies are another check on risk management,” he said. Other lenses through which to view leverage include peer analysis. CPP Investment’s peers in Canada follow a similar model.
“We are at the low end compared to Canadian peers regarding the amount of leverage we use. We get comfort from looking at our peer organisations.”
He added that from a strategic perspective, the fund’s use of leverage is not dynamic. However, on a day- to-day basis it can fluctuate depending on where it sees opportunities in the market.
Next the conversation turned to governance and reporting leverage, particularly its impact on liquidity ratios. At CPP Investments, the board has insight of the total financing leverage program with a particular eye on liquidity levels.
The pension fund has floors to its liquidity coverage ratios, below which the organisation is put at risk.
Cass said his priority is to target a level of liquidity that does more than simply allow the fund to meet its liabilities. For example, he wants money on hand through cycles to re-up with private equity funds. Elsewhere, the variation margin in derivative contracts requires capital on hand.
He said that inflation doesn’t hold much of a risk for the fund’s leverage strategy. Sure, inflation increases borrowing costs, but the fund always ensures its financing costs are adequately compensated with expected returns.
Cass warned that taking on too much leverage would put the portfolio in harm’s way. He said that leverage and liquidity are linked, and March 2020 illustrated the importance of keeping enough liquidity on hand to help platform companies in the investor’s large private equity allocation.
At the large Canadian fund a special committee came into play to control capital going out the door and ensure liquidity levels through the 2020 crisis. It was stood down nine months later.
Cass concluded with a note on the importance of board oversight of a leverage strategy. He said investors should understand why they use leverage, ensure transparency, and anticipate how the portfolio will behave in times of stress.
He advised on a “crawl, walk, run” approach and reassured CalPERS’ board members that watching how the portfolio reacts to leverage will imbue confidence in the strategy.
Below, I embedded the recent CalPERS' board meeting where Ed Cass, CIO of CPP Investments, spoke to their Board about the use of leverage (fast forward 3 hours into clip at minute 3:03:00).
I took the time to really listen to Ed's comments carefully and I also discussed the use of leverage at Canadian pensions with another expert who shared great insights.
First, Ed's comments on leverage.
He began by giving an overview of how and why CPP Investments uses leverage in the portfolio:
A lot of the reticence about the use of leverage is most people associate the use of leverage with increase of risk. And certainly leverage can be used to increase risk, there's a lot of people in the market that do it.
That is not why we use it as an organization. Our mandate is to maximize returns without undue risk of loss. When we took a look at that mandate, we first looked at what kind of level of risk we can subject the portfolio to and we have an objective function that ties that to a level of risk we end up targeting.
We express that, for communication purposes in an equity-debt equivalence and we target a portfolio of 85 equities and 15% fixed income assets which is more risky that a standard 60/40 0r 65/35 portfolio.
So, we have an above average risk tolerance which stems from our funding ratio and long-term investment horizon.
Once we establish that, the second part of that mandate is to maximize returns at that level of risk and really that's why we use leverage. We use leverage to increase the overall risk-adjusted return of the portfolio. We don't use it to increase risk tolerance, we use to maintain the same level of risk targeting equivalent to an 85/15 portfolio, but we use it to increase diversification.
As you've probably heard, diversification is the one free lunch in investment. We kind of believe that and you can take a look back at the last five years and that wasn't the case as it was difficult to beat a concentrated portfolio of equities, but over a long-term time horizon, we think it adds materially to the risk-adjusted return of the portfolio.
So, we use leverage to expand our balance sheet primarily to try and risk-weight our holdings better. One of the keys of diversification is to try to get rid of concentration in a portfolio.
It's interesting, if you look at the standard 60/40 portfolio in a risk contribution sense, equities absolutely dominate that portfolio, so variation of returns in that portfolio is almost 90% driven by the equity content in that portfolio and only 10% by fixed income despite the fact that it's a 60/40 portfolio.
One of the keys about investment management diversification is to try to balance those risks a bit better.
Unfortunately, if you're targeting 85% equity risk like an organization like ours, that's a tough chore to do because trying to get that risk content through things like fixed income is relatively difficult because fixed income is difficult because it doesn't the same risk content as equities have.
So, we made a purposeful decision to borrow money to get exposure to less risky assets with a view of increasing our overall performance on a risk-adjusted basis.
I wouldn't say it stops there because in one sense, you're diversifying the portfolio, increasing risk-adjusted returns, but we spend a lot of time taking a look at tail outcomes, things that really sink the portfolio in bad times when correlations go to one and all your assets go down at the same time.
There are some assets that provide diversification in that sense. Historically, fixed income has been a great diversifier so if we can borrow money to allocate more in fixed income risk, it helps balance out that equity risk. At the same time, it also helps improve some of those tail outcomes, so we feel we have a portfolio that has a higher risk-adjusted return and will also act in a more robust manner in adverse setups.
It's really those two things that have driven our decision. The important part is it's not to increase risk, it's to decrease risk of bad performance and bad outcomes in times of times of bad market events.
Ed then answered what CPP Investments considers leverage and how much leverage the portfolio operates with today:
Yet another question that appears simple on the face of it yet it's really complicated.We went through the exercise of talking about leverage about eight years ago when we first introduced leverage. Our board members challenged me about leverage at the time and said "we don't understand leverage, for us it only means one thing" and I remember replying at the time "actually it's way more complicated than that, there are so many different measures of leverage."
We have three different ratings agencies looking at our leverage and each one of them has a slightly different leverage test with a slightly different bent in terms of what they're trying to assess.
The measure that we use at the top of the house is something called total fund enhancement leverage and that's the amount of money that we borrow physically or synthetically to increase the exposures of our fund. You can think of it as the amount of leverage we use to expand our balance sheet to try to get those diversified sources of risk in, and that's netted across each category.
A really simple example if we wanted to diversify our portfolio from 85/15 into something more balanced, we can say let's drop our equity down to 75%, let's borrow 50 dollars and let's put that all into debt. In that case, we consider ourselves to have total financing leverage of that 50 dollars that we borrowed to allocate to a fixed income asset class and then we end up with a portfolio of 75% equities, 75% debt, 50% borrowing or leverage.
That's what we use in terms of portfolio design so it makes it explicit that we are borrowing money to increase exposures of the fund and we're also making sure people realize it's a strategic choice that we are making. So we're doing it to increase diversification, we are trying to maintain that same overall level of risk and we are going to use whatever total financing liabilities ratio to set a cap on the amount of leverage we use.
It's not the only thing that we look at in the context of all the different ways you can assess leverage. We also look at unsecured borrowings and we put a cap of 10-15% of total fund assets. We also take a look at risk-weighted liabilities which is a way of assessing all the leverage you use in your portfolio on a risk-weighted basis. So, if you invest in a total return swap for equities that would be viewed as more risky financing than a total return swap for fixed income and that coverage on that is a bit tighter.
In terms of the amount of leverage we use, right now we are using around 22% at the top of the house. Our board limit for total financing liability (TFL) is around 40% so we have quite a bit of headroom between here and there.
When we came to try and triangulate on where our use of leverage should be we look primarily at the ratings agencies and try to see on where they'd be comfortable with us using leverage and still maintaining our AAA credit rating.
A lot of the credit agencies center around a very low risk of not being able to meet the payment come due. No more than a 2 basis point chance where you have a situation where liabilities come due and we try to back that into our TFL, we end up with a limit of 60-65% where the rating agencies would be comfortable with our leverage without affecting our AAA credit rating.
Ed then discussed how they look at what their peers do in terms of leverage and they are on the lower end when compared to their peers but it's important to note that CPP Investments' risk tolerance (for base CPP) is much higher than its peers (based on a 85/15 portfolio) and unlike its peers, it's not a fully funded pension plan.
In terms of how dynamic leverage is, Ed said from a strategic level, it's not very dynamic at all, it's around 35% which is where they want to get to. On a day to day basis, it fluctuates depending on where they see opportunities in the market using their factor based approach across the 35 programs.
He used the example of investing in private equity. "If we invest in PE, it like levered public equity, so if we invest $100 in private equity, we consider that to be $130 public equity and our leverage on a day to day basis fluctuates around that because we try to keep that 85/15 constant al the time."
In terms of sources of leverage, he said they are constantly trying to expand their sources for a few reasons. One, their asset classes are diversified so it makes sense to diversify on the liabilities side too and not be beholden to one source of financing. "It also allows for some flexibility because different sources of financing carry different costs at different points of the cycle, so there's pints where equity collateral is in demand so you can finance equities very cheaply and points where commercial paper is in demand and more advantageous."
At the higher lever, term debt and commercial paper issued in many different currencies, repos, and securities lending program. And lastly, notional size of Libor leg in a total return is part of their TFL, so physical and synthetic borrowing is part of their leverage sources.
There's an internal team of around 25 people that follow the market, analyzing the cheapest way to borrow and where to find staggered maturities.
Anyway, take the time to watch the entire discussion below, Ed is really, really smart and super nice to have shared his insights with the CalPERS' board.
I did have a chance to discuss leverage with another expert this weekend and explicitly asked him about critics who think CalPERS is better off making a strategic allocation to cash.
"This is the typical Pavlovian response but it's completely wrong." he shared.
"Leverage and liquidity risk management are tied to the hip, you need to build strong foundations to do this properly but once you have those foundations, everything else is secondary, meaning if you don't have those foundations, never mind strategic and tactical asset allocation, you will end up taking on more risk and jeopardize your fund."
He agreed with Ed, leverage is used to add important diversification but he broke it down into three components:
- Leverage as a source of cost reduction
- Leverage to optimize your balance sheet management and tap into structural alpha
- Leverage to increase diversification and increase risk-adjusted returns.
According to this expert, if done properly, you can extract an additional 50 basis points of added value just by optimizing your balance sheet properly across many asset classes. "And this doesn't add to overall risk."
Interestingly, he called this balance sheet management “structural alpha” that all pensions should be doing
He gave me an example of how you can invest in a greenfield infrastructure project to capture an 8% return or invest in a brownfield project with a 4% yield and known cash flows and use leverage to enhance your risk-adjusted returns. “You’re better off doing the latter to increase your risk-adjusted returns.”
He also gave me other examples of sources of leverage, total returns swaps, repos, issuing corporate paper or term notes, bridge financing in private debt, etc.
"A fund like HOOPP or OTPP with a higher fixed income exposure can use repos more easily than others that don't have high FI exposure. You can also issue commercial paper in different currencies to manage currency risk."
He emphasized, however, to do this properly, you need the right internal teams with the right competencies and the right governance for accountability and compensation purposes.
The discussion of leverage and balance sheet management is fascinating, there's a lot more to cover and this expert opened my eyes to how Canadian funds can evolve to better manage their total fund exposures.
Below, I embedded the recent CalPERS' board meeting where Ed Cass, CIO of CPP Investments, spoke to their Board about the use of leverage (fast forward 3 hours into clip at minute 3:03:00). Please take the time to watch this.