CalPERS Risk-Factor Approach to Asset Returns

peopleHistorically, investors have heavily relied on the equity risk premium to reach annual return targets. The confidence of this model has been tested. Mean-variance optimization models did not help out asset owners during times of catastrophe. Like many large institutional investors, the California Public Employees’ Retirement System (CalPERS) is rethinking its approach to asset allocation and portfolio diversification. During the global financial crisis, both bonds and stocks dropped – the correlation between the two major asset classes turned positive. This paradigm shift from traditional asset classes to a risk-factor stance is still new territory. There is no industry standard or consensus on risk factors.

Economic Periods Length Prized Factors – Park Alpha
Decade of Lowered Inflation 1982-1991 Inflation
Rising Bull Market 1992-1999 Credit, Liquidity, Growth
Post-Tech Hangover 2000-2003 Real Interest Rates, Liquidity
Housing Boom 2004-2007 Growth, Political
Great Recession 2008-2011 Real Interest Rates
The Long Road to Recovery 2012-Present

Major events and crises force board members and investment staff to rethink their investment model. The theory of risk-factor allocation is that if a single risk factor harms a portfolio, the impact is confined within allocation to that risk factor. Investment consultants tend to look at average asset class returns. On the other hand, the risk-factor approach addresses the cause rather than effect. [ Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view content. ]

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