By John Kemp
LONDON, July 23 Nearly five years after it began investing in commodities, the biggest public pension fund in the United States has yet to make any money in the asset class -- highlighting the difficulty even the largest and most sophisticated institutions encounter in wringing returns from investments in agriculture, metals and energy derivatives.
The California Public Employees' Retirement System (CalPERS) had assets valued at $236 billion at the end of March 2012, including $3.6 billion linked to commodity prices, according to the latest quarterly performance report presented to CalPERS investment committee in May.
The system began investing in commodities in October 2007. CalPERS' performance matters because it has been one of the highest-profile institutions to allocate significant funds to the asset class, helping make it more acceptable among traditionally conservative pension funds.
A review of the programme by pension consultants Wilshire Associates in May 2011 noted that the leading investment banks dealing with CalPERS, which included JPMorgan, Societe General, Barclays and UBS, "realise the benefit of having a visible plan sponsor like CalPERS being an active proponent of commodity investment."
But a careful analysis of the programme's performance suggests it has actually lost money. Between October 2007 and June 2011, the programme had a negative rate of return of 6.9 percent per year. Between July 2011 and April 2012, the fund achieved a positive return of just 0.1 percent, according to performance reports published on CalPERS' website.
Detailed data for performance in May and June 2012 is not yet available. By design, however, performance closely tracks the S&P Goldman Sachs Commodity Index Total Return Index , which declined 12 percent over those two months, so it is almost inevitable the programme was down sharply by the end of the second quarter -- ensuring it has been loss-making since inception.
Charts 1 and 2 show a partial time series for CalPERS commodity investments and returns since 2009 ().
This performance analysis is not meant to single out CalPERS. It is meant as a case study that reflects performance problems common across the sector.
Launching the programme, CalPERS stated its objectives were to enhance risk-adjusted returns, diversify the risks in its portfolio, and hedge against inflation ("Statement of Investment Policy for the Inflation Assets" July 2011).
Commodity prices are extremely volatile. From the outset it was understood that the commodity programme would generate extremely variable returns. In one presentation, CalPERS forecast the annual volatility of returns at 21 percent ("Strategic Asset Allocation: Judges' Retirement System II (JRS II) and Legislators' Retirement System (LRS)" April 2011).
But it was also expected the programme would add stability to the wider portfolio owing to the low correlation with other asset classes. And it was believed that commodities would add to performance. In the April 2011 presentation on asset allocation, CalPERS assumed a long-term compound return of 5 percent a year from the commodity programme. After five years, the programme is nowhere near delivering that.
The disappointing performance comes amid broader pressure on CalPERS investment portfolio. In the 12 months ending in June, CalPERS achieved an overall return of just 1 percent, far below the fund's discount rate of 7.5 percent (which has itself been recently reduced).
"The last twelve months were a challenging period for all investors as the ongoing European debt crisis and slowing global economic growth increased market volatility and reduced equity returns," the fund's chief investment officer said in a statement released on July 16.
The commodity allocation is too small to have much impact on CalPERS' overall performance, and the fund is a very long-term investor which can afford to ride out short-term fluctuations.
But the asset class performed below average in 2011/12, despite all the talk of a commodity super-cycle, and dragged down overall returns, at a time when the fund can ill-afford underperforming asset allocations.
The failure to generate consistent positive returns over the last five years suggests something is wrong with the underlying approach.
IF NOT CALPERS, WHO?
CalPERS is among the most sophisticated institutional investors, and as the biggest public pension fund in the United States commands significant attention and expertise from sell-side banks and investment consultants.
If CalPERS cannot make money from an index-based approach to commodity investment, supplemented with an active management overlay, there must be doubts about whether other pension funds will be any more successful.
Part of the problem is staffing. CalPERS has well-known difficulty retaining investment professionals owing to the big difference between compensation in the public and private sectors.
In its May 2011 programme review, Wilshire expressed particular concern about the recent departure of the dedicated fund manager responsible for overseeing the commodity strategy and his replacement by a team that is also responsible for the currency, swaps, sovereign debt and treasury portfolio.
"For internal active management purposes, staff has only one or two investment professionals responsible for researching, implementing and monitoring strategies designed to outperform the broader commodity market. These individuals also cover a number of other asset classes and securities," the report found.
Overall, though, Wilshire rated the programme favourably.
CalPERS utilises a mixed approach which is in line with the current best practice being recommended to pension funds. Approximately 75 percent of the commodity exposure is indexed to the GSCI Total Return Index while the remainder is devoted to active (alpha-generating) strategies.
Wilshire explained "the majority of commodity exposure is done through inexpensive index swaps. Active strategies are then employed as opportunities are present in the market which are implemented via a swap on a custom index that reflects the positions CalPERS desires".
Praising the expertise available in-house, even if it is stretched thinly, Wilshire concluded "the portfolio manager has experience in a variety of commodity markets from prior employment and displayed an understanding of how experienced traders and portfolio managers can add value by exploiting inefficiencies in particular markets."
"Overweighting of commodity sectors which display positive attributes such as positive or less negative roll yield and avoiding those whose value gradually declines as the futures contract ages are at the heart of the commodity programme's active strategies." In o ther words, CalPERS seeks to avoid contango markets and look for backwardations.
CalPERS also uses is commanding position to secure advice from the major investment banks active in commodities: "staff has leveraged CalPERS' unique position within the marketplace and worked with external dealers and asset managers to research potential alpha strategies."
NOT ENOUGH ALPHA
Alpha generation has helped improve performance, but nowhere near enough to offset the drag on index performance from the cost of storage and other features contributing to widespread contango markets.
Between October 2007 and June 2011, the commodity programme suffered a negative rate of return of 6.9 percent, which was better than the negative rate of return of 7.3 percent in the GSCI Total Return benchmark, but not by much.
The problem is that the fund's policies deliberately limit the amount of tracking error between its performance and the underlying index benchmark. If the benchmark is consistently loss-making, as the GSCI has been in recent years, there is not much that the portfolio managers can do about it.
CalPERS is stuck somewhere between fully passive and fully active management. The index-based programme was set up to capture systematic returns which have since vanished. The active overlay is not large enough to escape the grinding losses inflicted by the GSCI.
But a shift to mostly or fully active management would be inconsistent with its original objective and might be uncomfortable for a high-profile institutional investor, which would risk being accused of stoking food and fuel prices.
In the meantime, the underperformance of CalPERS' commodity programme can no longer be dismissed as a blip and must eventually force a rethink -- which is likely to be underway at other pension funds as well.