(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, March 28 The California Public Employees' Retirement System (CalPERS) continued to cut its exposure to commodity futures at the start of the year, even as the largest public pension manager in the United States increased its total inflation hedging sharply.
CalPERS pushed its allocation to inflation-linked assets to almost $10 billion by the end of January, 3.9 percent of the total fund, up from $7.6 billion, 3.0 percent, at the end of December. It was easily the largest allocation to inflation protection since the fund began reporting monthly numbers in this format in November 2011.
But CalPERS continued to shun commodities in favour of other means of protecting its members against rising prices. The allocation to commodities was cut to just $1.3 billion, down from closer to $1.6 billion at the end of December, and just a third of the $3.5 billion allocated at the end of September.
Instead, the fund boosted its hedging through a large $2.4 billion allocation to what it terms "tactical inflation assets," which can be allocated to either commodities or inflation-linked bonds depending on fund managers' short term views. Allocations to inflation-linked bonds also rose marginally (link.reuters.com/sug96t).
CalPERS's portfolio manager for fixed income and commodities, Andrew Karsh, has denied the fund is giving up on commodities. "The fund's shift (last year) from commodities to inflation-linked bonds may be short-lived and did not reflect a change of strategy," Karsh said in an interview with the Financial Times ("CalPERS turns back to commodities" March 19).
"Historically, commodities are like an insurance policy for your portfolio," Karsh said. "If we do see CPI go up, normally it would be led by energy prices and food prices. From that perspective, commodities would be a much stronger hedge." Karsh denied that commodities have less potential to rise than in the past.
END OF INDEXING
The tactical allocation could give the fund an opportunity to significantly increase its exposure to commodity futures prices if it sees a good short-term opportunity.
It completes the fund's transformation from a passive index investor into something far more active akin to a hedge fund.
CalPERS had already adopted an enhanced index strategy, which aimed to track total returns on the S&P Goldman Sachs Commodity Index, but allowed managers to vary the portfolio up to 25 percent to generate extra returns. In practice, the enhanced strategy has not made much difference. Returns have closely resembled the plain GSCI.
The tactical allocation will allow CalPERS to take a much more active approach - putting funds into commodity markets when it anticipates prices will rise, or roll returns from holding a long position in backwardated markets will be high, and scaling back when markets look like peaking or are mired in contango.
Overall, this is a sensible evolution of an indexing strategy that has so far produced disappointing returns since October 2007. Provided CalPERS can time the markets correctly, it should produce superior returns.
It marks a big retreat from the buy-and-hold long term strategies pension funds cited as a justification when they first began investing in commodities in the middle of the last decade.
The focus is now on short-term tactical returns and immediate inflation protection rather than reaping long-term risk premiums from shouldering unwanted price risks for commodity producers.
But the more active approach is not without risks. CalPERS will need to get its timing right, which is notoriously difficult. Many commodity hedge funds, which employ experienced traders to pursue active strategies, have struggled in the last couple of years, as commodity prices have flattened out.
Moreover, if the pension manager starts shifting $2.5 billion into and out from futures markets in response to short-term views about the direction of prices, it could add to volatility. CalPERS risks losing its status as a "passive" index investor and being treated more like an active hedge fund.
CalPERS's decision to slash the amount it invests semi-passively in a commodity index, and partially replace it with a tactical allocation system, marks the beginning of the end for indexing. In future, pension funds seem likely to get exposure to commodities through active approaches, or via hedge funds, rather than passive systems. (Editing by James Jukwey)