Stephen Gilmore – CalPERS' Total Portfolio Approach (EP.486)

Stephen Gilmore is the Chief Investment Officer of CalPERS, which at $600 billion is the largest public pension fund in the U. S. and one of the largest institutional pools of capital in the world. Stephen joined CalPERS eighteen months ago from a career spanning Wall Street, the IMF, and two of the most innovative sovereign wealth funds, where he was Chief Investment Strategist at Australia Future Fund and CIO at New Zealand Super Fund. Our conversation dives into the theory and implementation of the Total Portfolio Approach, drawing on Stephen's experience at Australia and New Zealand, and his plans for CalPERS. We cover the TPA mindset, its fostering of sound governance and accountability, comparisons to Strategic Asset Allocation, challenges of implementation, and the adaptation of the model at CalPERS.  Stephen is one of the most experienced practitioners of TPA in the world. Our discussion pairs well with my recent conversation with Ashby Monk, as more allocators learn and consider this approach to managing assets. Learn more about our Strategic Investments: Thema https://www.thema.ai/ted. Our Valentine's Day gift to you: 50% off your first year of a Capital Allocators Premium subscription. Use code WELOVECA50 at checkout. Learn More Follow Ted on Twitter at @tseides https://twitter.com/tseides?lang=en or LinkedIn https://www.linkedin.com/in/tedseides/ Subscribe to the mailing list https://capitalallocators.com/ Access Transcript with Premium Membership https://capitalallocators.com/signup Editing and post-production work for this episode was provided by The Podcast Consultant (⁠ https://thepodcastconsultant.com/https://thepodcastconsultant.com https://thepodcastconsultant.com/⁠ https://thepodcastconsultant.com/)

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  One of the things that has detracted value from the CalPERS experience has been a tendency to be too procyclical. If you think back to the time of the financial crisis, first assets were liquidated, risk was taken off. That was done in part because of concerns about liquidity, concerns that didn't need to be acted upon, but there was an information challenge at the time. Information on liquidity has improved greatly since then, but risk was taken down. If you're a long-term investor, that's exactly the time to be putting on risk. The same thing has happened when markets are more exuberant. Risk has been taken up. One of the big advantages of having a total portfolio approach, with a reference portfolio is you tend to have a more stable risk appetite through time.

• 0:45Speaker 00

  It'll be transparent if risk is taken up or down. Management now becomes more accountable. Because under a strategic asset allocation, yes, the management can make a recommendation to the board on the SAA. The board adopts it. Then the question is, who owns it? Because it's combined. It's a joint thing. With our proposed approach for the total portfolio, the board adopts a reference portfolio, and that corresponds to a particular amount of risk. But it's the management that is using its initiative to propose the portfolio and to invest the portfolio. The management becomes more accountable. It also becomes clearer, how has the management team done relative to a simple off-the-shelf portfolio?

• 1:32Ted Seides?

  I'm Ted Seides and this is Capital Allocators. My guest on today's show is Stephen Gilmore, the Chief Investment Officer of CalPERS, which at $600 billion is the largest public pension fund in the US and one of the largest institutional pools of capital in the world. Stephen joined CalPERS 18 months ago from a career spanning Wall Street, the IMF, and two of the most innovative sovereign wealth funds, where he was Chief Investment Strategist at Australia Future Fund and CIO at New Zealand Superfund. Our conversation dives into the theory and implementation of the total portfolio approach, drawing on Stephen's experience at Australia and New Zealand and his plans for CalPERS.

• 2:18Ted Seides?

  We cover the TPA mindset, its fostering of sound governance and accountability, comparisons to strategic asset allocation, challenges of implementation, and the adaptation of the model at CalPERS. Stephen is one of the most experienced practitioners of TPA in the world. Our discussion pairs well with my recent conversation with Ashby Monk as more allocators learn and consider this approach to managing assets. Before we get going, Valentine's Day is right around the corner. I found there's two types of red in the air, the sweet scent of love and the red of jealousy, envy, and frustration. It's love we're all after.

• 3:00Ted Seides?

  In my younger years, I was a forlorn romantic in search of happily ever after. Once I found it, the second time around, much of Valentine's Day has been a beautiful thing. That's after the redness of stress that goes into the run-up to the big day. For those still searching and feeling the red of jealousy, envy, and frustration, no, you're not alone. Many are in your shoes, and the rest of us will tell you it's not all roses on the other side. So what do you do when you're feeling stuck and a little lost, looking for a special someone or a special gift to give your special someone? We have an answer for you. Knowing that every top has a bottom and every love has heartache, we'd suggest a gift that

• 3:45Ted Seides?

  keeps on giving. And what better way to celebrate together than the love that comes from a premium subscription to Capital Allocators, where you get thousands of pages of transcripts, a weekly email with wisdom and hot takes, and a community of like-minded lovers of the show. Our gift to you for this holiday, how about a 50% off your first-year subscription? Just hop on the website and use the code WELOVECA50 for your discount. You can see the call notes for the capital W in WE and capital C A in WELOVECA50. Since we want to share the love all year long, you can use that discount code anytime, not just in these weeks leading up to Valentine's Day.

• 4:31Ted Seides?

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• 5:16Ted Seides?

  so you can easily turn new insights into the briefs, models, and memos you'd otherwise build by hand. It was designed to work like an extension of your team, so it remembers your projects, follows your templates and processes, and links every output to its source so you can see where each conclusion came from. The best way to judge its quality is to give it a whirl. Pick the research task on your desk before your next committee meeting and hand it to SuperAnalyst. Start a free trial at alphasense.com/capital and see what it has ready for you. Capital Allocators is also brought to you by RidgeLine, the investment management platform built for firms who are rethinking how work gets done.

• 6:00Ted Seides?

  You're at your desk looking at a line graph of your firm's growth. The line is moving sideways, linear growth, and you know exactly why. You're constrained by your operational bandwidth that's been the same for so long, it just feels like the cost of doing business. RidgeLine is built to change that line's trajectory, to be the inflection point that takes your growth from incremental to accelerated with the team you already have in place. RidgeLine is the only AI-native investment management platform that brings together the front, middle, and back office with one set of data and powerful AI agents that automate away operational drudgery, so your talent can shift from managing old technology to materializing new ideas.

• 6:47Ted Seides?

  RidgeLine helps asset and wealth managers understand and improve their firm's growth trajectory. To see how your firm compares to 16,000 of your peers, visit ridgeline.ai/trajectory. If you file Form ADV, your firm is already there. Then talk to RidgeLine about how you can do more with the team you already have. Capital Allocators is also brought to you by Juniper Square, the operations partner trusted by the leading private market GPs. One theme that keeps coming up on the show is GPs that build the strongest and most durable relationships with LPs are the ones that have both strong returns and strong operations.

• 7:30Ted Seides?

  AI raises the stakes on operations and having Juniper Square as your operations partner helps ensure your data is organized, accurate, and accessible, so you can unlock operational alpha. That's why thousands of GPs trust Juniper Square. Learn more at junipersquare.com/capitalallocators. Please enjoy my conversation with Stephen Gilmore.

• 7:57Speaker 00

  Stephen, wonderful to see you. It's great to be here, Ted.

• 8:00Ted Seides?

  Take me all the way back to your start in finance.

• 8:04Speaker 00

  It goes back to university, studied economics, then went and lectured in finance for a year before going off to the Reserve Bank in New Zealand. Then we're traveling, picked up a job at Chase Manhattan in London, derivative structuring, FX options, then a detour to the IMF for six years, then back to the markets with Morgan Stanley. I was an emerging market strategist, then went across to AIGFP, was there for a while, then off to Future Fund in Australia, New Zealand Super, and now Kelpus.

• 8:39Ted Seides?

  There's a lot of steps there. In your time at Wall Street, what were some of the different roles that led you to understand how you thought about markets?

• 8:50Speaker 00

  It's an interesting question because you learn something in each role. When I was at Chase before the merger with JP Morgan, I got to sit in the dealing room and to combine different products. I got to sit with the swap traders, the floating traders, the option traders, and I would structure transactions. Seeing things from different perspectives was very helpful. I still think about going through the pricing on a floating swap. That was insightful. Then moving to the FX options desk, it was quite a revelation because when you come from an academic background, you think it's all about the formula and you don't really understand how people derive

• 9:34Speaker 00

  or how they trade implied vol. That was another lesson. There are lots of incidents like that. Those are two early ones that stand out.

• 9:41Ted Seides?

  So along the stops along the way, the last one you mentioned was AIG FP, which for those who remember was part of the epicenter of the financial crisis. So I'd love to hear about your experience there.

• 9:53Speaker 00

  I was there during the financial crisis. I started at AIG FP in London, which traded under the name Bonk AIG, which was the European arm. From 2004 until 2009, I was working primarily on emerging markets, had created an investable emerging market index business, which was going pretty well. That was a fairly small part of what was happening at AIG FP. The problematic part of the business related to super senior protection on multi-sector CDOs, that became problematic with the subprime. There were issues with liquidity. The repo market froze up and we all know the story of what happened with AIG. I learnt a lot from that time.

• 10:38Speaker 00

  One of the things that really impressed me was the quality of the people at AIG FP. They had really good people. I thought a lot of Joe Kasana, who ran the place. He was super smart, very knowledgeable across many things. One of the lessons that came out, of course, was that no matter how good a person is, things can always go wrong. It was important to challenge, to stress test. One of the things that made it problematic for FP was it came down to liquidity challenges.

• 11:08Speaker 00

  Sometimes you can't anticipate that the repo market is going to freeze up. You can't necessarily anticipate how the rest of the market is going to perform. You always want to think about what can go wrong, even though you've got brilliant people. In the case of FP, they stopped entering into new super senior transactions of that elk from late 2005, well ahead of the final denouement in 2007, 2008. It wasn't soon enough.

• 11:38Ted Seides?

  What led you to make the move from Wall Street to Australia Future?

• 11:44Speaker 00

  I'd been in the public sector and the private sector, and I liked both. After the financial crisis, I wanted something else to do. One of the opportunities that came up was to work with Future Fund in Melbourne. Being a New Zealander, it's closer to home. So I went off to Melbourne. After a short period of time, I ended up running the strategy team there and thoroughly enjoyed it because the Future Fund had started in 2007, had quite a large pot of money. It was a startup with a lot of capital. So we had to think about how to invest. The Future Fund had actually been one of the beneficiaries of the financial crisis

• 12:26Speaker 00

  because it had a low risk portfolio going into the crisis. So it had a lot of cash to invest when assets were very cheap. It was a pretty exciting time.

• 12:36Ted Seides?

  What did you see as the core principles of portfolio construction when you were there?

• 12:42Speaker 00

  That was largely shaped by the CIO at the time, Dave Neal. One of the core things was to have a joined up process to build a portfolio that was designed to achieve the ultimate objective, rather than to have lots of segmented asset classes. Yes, they had asset class teams. The idea was to think of the portfolio as a whole. So you didn't have all these intermediate targets that became known as our total portfolio approach.

• 13:10Ted Seides?

  You saw that both at Australia and then later back home, New Zealand Super Fund. What are some of the subtle differences in two? Two different sovereign wealth funds applying the total portfolio approach.

• 13:24Speaker 00

  You've got to understand the objectives of each of the organizations. One thing that I spent quite a lot of time thinking about when I arrived at New Zealand Super was why Future Fund and New Zealand Super did things quite differently. Future Fund was set up in 2006, started operating in 2007. So it was later than New Zealand Super, which got going around 2003. They had a lot of similarities, sovereign wealth funds, both in Australasia. New Zealand Super had larger risk appetite than Future Fund. The reason being, it had a longer horizon.

• 14:08Speaker 00

  It was getting small contributions over a long period of time. The distributions from New Zealand Super were going to be some way off in the distance. Future Fund had started with a lot of money to begin with, 60 billion Australian dollars. The last thing you want to do when you've got a big money to start off with is to lose a chunk of it. You're going to be conservative. They also started at a time when assets were cheap. They had a lot of liquidity and were able to benefit from those high prospective returns because of the cheap assets. That worked pretty well for a while. Future Fund was discretionary, active, a short horizon

• 14:49Speaker 00

  because the expectation was that they would have to make distributions to the budget come 2020. It turned out not to be the case, and those distributions have been put off further and further. The team at the beginning didn't know that. If they had known that, I imagine the Future Fund would have had a higher risk appetite through time. But that wasn't the case. Going back to your question on the approaches to the total portfolio, you've got to think of what the objectives of the two organizations are and how they react to those objectives, and also lived experience. Future Fund's lived experience was that discretionary investment worked reasonably well. It had also been reasonably cautious because when they started. The reward for risk was quite high.

• 15:35Speaker 00

  New Zealand Super had risk on during the financial crisis, had a large drawdown, had stuck with the strategy effectively, and then became more structured in terms of the philosophy, adopted a total portfolio approach. Both organizations did that around 2010. New Zealand Super was far less reliant on external skill, tended to think more about having a stable risk appetite through time. A lot of the active risk was more systematic, trying to rely on the advantages that the organization had, advantages like a long horizon, a fairly stable risk appetite, and tried to take advantage of that mean reversion. That worked well. Both organizations have been very successful, but successful in different ways. In the case of New Zealand Super, total portfolio approach, they have a reference

• 16:20Speaker 00

  portfolio. Future Fund, total portfolio approach, doesn't have a reference portfolio. They both have an understanding of how much risk they're taking, so they will focus on that risk appetite. Future Fund will move around quite a lot in terms of active risk and it used to be quite discretionary. New Zealand Super, much more systematic.

• 16:40Ted Seides?

  The concept of this one has a reference portfolio, this one doesn't, but both under the umbrella of total portfolio approach, which lots of people are talking about now. What does total portfolio approach mean to you?

• 16:53Speaker 00

  It's more about a mindset. The most important thing is that the portfolio is built to try and achieve the ultimate objective. The ultimate objective for Future Fund now is CPI plus four to five. That's what the portfolio is constructed to do. In New Zealand, it's less clear in terms of having a specific return objective. The focus is on the risk appetite and generating wealth for future generations of New Zealanders, and it's to help the budget manage the cost of an aging population. But in both cases, The focus is not on what is referred to as a strategic asset allocation. It's saying, what's the best portfolio?

• 17:37Speaker 00

  And there's a competition for capital across the portfolio, across asset classes in both cases.

• 17:43Ted Seides?

  To the extent that a strategic asset allocation approach has defined buckets, defined targets, that there are guardrails put in place. Sometimes you hear about total portfolio approach, other than there's a reference portfolio that's got some simple stock bond risk appetite. It feels less guardrails around what the expectation should be. How do you go from, we want to achieve this objective to a portfolio construct underneath that, that someone on the board, a governance structure can get their arms around and say, okay, this is our version of the total portfolio approach?

• 18:20Speaker 00

  Let's talk about KALPOS, for instance. Under the strategic asset allocation, which is currently in place, the management team has the discretion to vary the asset allocation within certain ranges. What we did was to look at how much that variation would aggregate up to in terms of the leeway management had been delegated. We estimated that that amounted to around about 450 basis points of active risk, using all the policy ranges. With the transition to a total portfolio approach, we weren't asking for that much active risk. We were asking for more flexibility in how we used it. The guardrails are still there in terms of the active risk.

• 19:04Speaker 00

  What has changed is that there's more discretion to deploy that active risk in different areas. With that additional discretion comes the responsibility to be more transparent. We will be more transparent with the board in terms of the proposed portfolio and the rationale for future strategies.

• 19:24Ted Seides?

  After some time in the seat at New Zealand, how does one go from being home in New Zealand to being quite far abroad in California?

• 19:35Speaker 00

  I grew up in New Zealand. My first few jobs were in New Zealand. When I was at Reserve Bank, I did what a lot of New Zealanders do, and that is take a year off to travel. That one year ended up being 30 years. I went from New Zealand, I ended up working in the UK, then working in the US, then back in the UK, then in Hong Kong, then back in the UK. Then off to Melbourne, then Auckland. I also spent some time in Tajikistan when I was at the IMF. Lived there for two years. For me, living in different places is normal. I've lived in six different countries, 10 different cities. It's not unusual.

• 20:17Ted Seides?

  So geographically, it fit. How did you end up professionally deciding to make this move?

• 20:23Speaker 00

  I've been at New Zealand Super for five years. It's a great place and it's nice being home. I got a call from a recruiter. They mentioned the CalPERS role. Frankly, I wasn't that interested. It's a tough gig. But the call prompted me to think about it some more, to do some due diligence. I thought, there's so much potential there. When the recruiter called back, I was more open. And the recruiter immediately got Marcy on the phone. She's very persuasive and very engaging. Not long after that call, like the same day, the recruiter called me and said, we want you to interview with the board subcommittee. Shortly thereafter, I interviewed with the board subcommittee. And great questions, and I really enjoyed the interaction. That's what I wanted the role.

• 21:05Ted Seides?

  In past conversations with Matt at New Zealand and Raf at the Future Fund, they both emphasized the importance of sound governance in being able to make the model work. What's your perception of the lived experience of CalPERS? Knowing you've seen lots of different CIOs over the years.

• 21:23Speaker 00

  One of the things that has detracted value from the CalPERS experience has been a tendency to be too pro-cyclical. If you think back to the time of the financial crisis, first assets were liquidated, risk was taken off. That was done in part because of concerns about liquidity. Concerns that didn't need to be acted upon, but there was an information challenge at the time. Information on liquidity has improved greatly since then. But risk was taken down. If you're a long-term investor, that's exactly the time to be putting on risk. The same thing has happened when markets were exuberant. Risk has been taken up. One of the big advantages of having a total portfolio approach,

• 22:07Speaker 00

  with a reference portfolio is you tend to have a more stable risk appetite through time. And it'll be transparent if risk is taken up or down. I'd like to think there's a governance improvement there. I would also like to think that management now becomes more accountable. Because under a strategic asset allocation, yes, the management can make a recommendation to the board on the SAA. The board adopts it. Then the question is, who owns it? Because it's combined. It's a joint thing. With our proposed approach for the total portfolio, the board adopts a reference portfolio, and that corresponds to a particular amount of risk.

• 22:48Speaker 00

  But it's the management that is using its initiative to propose the portfolio and to invest the portfolio. The management becomes more accountable. It also becomes clearer, how has the management team done relative to a simple off-the-shelf portfolio? It should improve accountability, and those are all governance improvements.

• 23:08Ted Seides?

  When you came into CalPERS with this thought, from your experience, you'd like to shift the portfolio to total portfolio approach. What did you find in the portfolio in the process of trying to figure out this is the right TPA model for CalPERS?

• 23:27Speaker 00

  When I first came in, my focus wasn't on rapidly moving to a total portfolio approach. My intention was to spend three to six months listening, learning. We're about to start an asset liability management review, which occurs every four years. The question for me was, do I want to push to go down this route of a total portfolio approach now, or do I wait for years? And I didn't really want to wait. We really did this in a stepwise fashion. One of the first things we did was to show the board how a risk-equivalent portfolio had done compared with CalPERS portfolio. It was revealing for people, because you can take a simple combination of equities

• 24:11Speaker 00

  and bonds, and it will track the actual portfolio very closely. And that'll be the case for most pension funds. Once I saw that reaction, I thought we should go further and take people on this total portfolio journey. I saw a few other things which made the process easier. You want to get the right alignment and you want everyone to be investing the portfolio as a whole. Some years earlier, Marcy had changed the compensation structure so that everyone got rewarded on the basis of the whole portfolio, not their asset class. That was quite important. The team had done a lot of work on liquidity, had invested a lot of time, a lot of efforts, and really good work was done on that. That was a particular advantage for looking at

• 24:53Speaker 00

  the whole portfolio. I saw some elements there which were really helpful when one wants to go down this route.

• 24:59Ted Seides?

  How did you think about the skillsets of a team that are accustomed to strategic asset allocation investing compared to this idea that you're going to compare assets across asset classes?

• 25:12Speaker 00

  One of the things with a strategic asset allocation is that you do have policy ranges. You can deviate. In practice, teams tend not to deviate too far from benchmarks. There's a psychological alignment. Conceptually, if you were to speed up the SAA process, the review, to do it more continuously, it would look more like a total portfolio approach. If you have that thought process, we're just going through the exercise more frequently and we're becoming less anchored to what the SAA is. That's getting you part way towards that mindset of a TPA, thinking about how the competition for capital takes

• 25:53Speaker 00

  place. You have to go out and have some sort of common language for looking at different investments. That can be difficult because different asset classes think about returns differently. If you're looking at private equity, you'll think about IRRs, you'll think about multiples. If you're looking at infrastructure, you might think about discount rates. If you're looking at real estate, you might think cap rates. Some people will focus on money weighted returns, some people will focus on time weighted returns. You've got to come up with something that everyone can work with. That takes time. Likewise, when you're looking at the cost of capital, you have to be thinking about, well, is this a reasonable proxy? Especially for the private markets because you've got infrequent valuations.

• 26:39Speaker 00

  So that takes time as well.

• 26:41Ted Seides?

  When you bring this down to brass tacks for CalPERS, considering the needs of that pool of capital, what reference portfolio have you recommended?

• 26:50Speaker 00

  We've recommended a 75% equity, 25% bond portfolio. We've recommended an active risk range around 400 basis points. That's a growth orientated portfolio and it's a function of our time horizon. It's also a function of our funded status. We're just over 80% funded. It's reasonably similar to the current portfolio. A little bit riskier than the current portfolio, but not a lot.

• 27:16Ted Seides?

  What common language have you come across those asset classes as you describe to start to understand how to compare the real estate asset to the public equity, to the private equity?

• 27:27Speaker 00

  You should think about funding all the investments out of the reference portfolio, funding them out of some combination of equities and fixed income. In our case, it's US Treasuries. You want to risk match the investment you're making with some combination of equities and bonds. In reality, it's going to be the equity risk that dominates. You're obviously looking at things like equity beta is one of the considerations. You've also got to be thinking about how you charge for illiquidity. Because if you are investing in a liquid asset, you've given up some optionality and that's of some value. How much, of course, will depend a bit on the institution, depending on how much liquidity you have.

• 28:11Speaker 00

  It also can be a function of base currency and currency hedging and so on. Those are some of the considerations.

• 28:16Ted Seides?

  As you're getting ready to figure out how you're going to make these comparisons, I'd love to hear, in your time at New Zealand or in your time in Australia, what was an example of comparing that common illiquidity premium that you would want from a private equity or venture capital asset to a public equity beta?

• 28:37Speaker 00

  In both of those countries, in New Zealand and Australia, a lot of the investing was offshore because they've got relatively small domestic capital markets. One of the biggest considerations related to foreign currency and the hedging of those foreign currencies, and of course, for comparing assets, you would want to look at things on a hedged basis so you can compare across countries. That has implications for liquidity because in both Australia and New Zealand and Canada for that matter, when there's a negative shock, equities are going to fall, but those currencies will also weaken, so there's a liquidity consideration.

• 29:19Speaker 00

  That's different if you happen to be a US-based investor, or it has historically been different. That's one consideration. You've got to look at the big factor, which is equities, and you're normally looking at regression analysis, but then again, you've got to think about what is the market value at a point in time, and these things are infrequently marked. There can be a lot of discussion and debate. In the end, you want to get something that's reasonable.

• 29:44Ted Seides?

  As you go to implement, how do you think about, in the context of funding some risk budget in the reference portfolio, directly managed versus outsourced to managers?

• 29:57Speaker 00

  From a couple's perspective, we do manage some of the public liquid markets internally, but it's more difficult to do that in the private markets. It relates to skill sets, the size of the team, the breadth of expertise. I don't anticipate that we will be particularly active, direct privates apart from co-investment, but I expect that we will become more active in the public markets, given the balance sheet management and our improved liquidity management.

• 30:30Ted Seides?

  As you're looking at making these trade-offs and particularly making these shifts over time, what does the data and information?

• 30:38Ted Seides?

  That you need to aggregate look like on a dashboard on your desk so that you can make an informed decision.

• 30:45Speaker 00

  The data and analytics are hugely important. One of the things we have been doing at CalPERS is embarking on an effort to simplify some of the systems we're using to get that better whole of portfolio view. That's a multi-year exercise. You essentially want to be able to aggregate in a common language. Historically, we've tended to have best of breed, you know, applications by asset class. That can be great for a single asset class, but it's not so good when you want to combine everything. So you've got to be thinking about the right trade off between that asset class functionality and the whole of portfolio. Bias is to try and have a better view at whole of portfolio.

• 31:31Ted Seides?

  What is it that you're looking at to understand what you own so that you know how markets might be impacting what's in your portfolio?

• 31:41Speaker 00

  A lot of the portfolio risk is going to be dominated by equity risk. The 75 equity, 25 bond reference portfolio, that simple construct will do a good job of approximating what our actual portfolio looks like. So you can stress test it. It may be that some things have a stress beta, which is higher than what you might get with the 75 25, some things might be lower. What's most important is to be thinking about how the portfolio performs under different scenarios. People have looked at historical scenarios. They've looked at actual events, but of course, any of these shocks that you're going to experience is probably going to be different from the past.

• 32:24Speaker 00

  There may be similarities, but you're not going to get an exact repeat because people have learned market structures are different and so on. Quite important to understand how the portfolio performs given a growth shock or given an inflation shock or given a real rate shock or a risk premium shock, other structural changes. Scenarios will play a more important role as we go forward. The reality is you cannot immunize the portfolio to all these different shocks because then you won't generate any decent return. It's more about understanding what might happen, being prepared for those. And if there are some outcomes that are unacceptable, then you can do something at the portfolio level to mitigate those risks.

• 33:03Ted Seides?

  So at any point in time, once you have your portfolio built out, the marginal investment you might want to make needs to be additive, marginal contribution of the portfolio.

• 33:13Speaker 00

  Conceptually, yes. The practicality, of course, is difficult to compare every single investment with every other one. But if you have that common language, you can approximately do that. You've also got to look at the investments that are already in the portfolio. It's not just the new ones. Even the ones that are in the portfolio now continue to have to earn their place.

• 33:32Ted Seides?

  In a strategic asset allocation model, that incremental investment is probably someone's assessment of better alpha. If it's a new manager in public equities, we think that manager is better than the manager we have, maybe in the construct of what we're trying to find. What might the similarities and differences be in that incremental investment in a TPA approach?

• 33:55Speaker 00

  With an SAA, the asset class is probably thinking about how additive that investment is, given the asset allocation. Let's say it's an asset class with a 10% allocation. They'll fill the bucket up to that 10%. Now, it could be that is suboptimal. It could be that the return from the marginal investment in that asset class is less than it could be in another asset class. Or possibly it could be that it's a lot better and the team should be doing a lot more. You could be under invested or over invested, depending on the relative attractiveness. If you've got a 10% allocation, you're probably going to look to diversify that portfolio.

• 34:37Speaker 00

  You don't want to have a too concentrated an asset class portfolio. But when you're thinking about its contribution to the whole portfolio, you should be much more comfortable in having a more concentrated asset class portfolio, because it gets diversified away at the whole portfolio level. Those are some of the differences. It's also one of the reasons why it's hard to hold an asset class as accountable in a total portfolio approach, because the asset class may have been asked to do something for whole of portfolio considerations. The assessment of the contribution is really the contribution to the whole portfolio, rather than just looking at the asset class on a standalone basis.

• 35:17Ted Seides?

  If at any given time you identify an opportunity set that is a good fit for the portfolio and seems particularly attractive in that current environment, how do you think about sizing?

• 35:29Speaker 00

  You want the sizing to relate to your degree of conviction in the investment. You're also going to be looking at the overall portfolio characteristics. Typically, any individual investment isn't going to make that much of a difference at the whole portfolio level.

• 35:43Ted Seides?

  How do you think about how to measure appropriate diversification in a TPA approach?

• 35:48Speaker 00

  Scenario analysis is important. Let's take a simple example, equities and bonds. Do they diversify? Is a bond exposure going to diversify an equity exposure? Well, it may. It depends on what's happening. Take the example of inflation shock. If inflation goes up, nominal bonds are going to be hit. Equities are probably going to be hit as well. If you have a growth shock, it's going to be the opposite. Equity is going to benefit. Bonds are probably going to be hit. So bonds are diversifying there. You need to look at what's driving the event, rather than simply looking at historical correlations. One needs to be thinking about multi-dimensional scenarios and to think about how the portfolio

• 36:33Speaker 00

  behaves, given those scenarios.

• 36:36Ted Seides?

  Among the tried and true principles that have worked for a long time for some of the strategic asset allocation models. Rebalancing and private market exposure always comes up. How does the concept of mean reverting rebalancing work within a TPA approach?

• 36:52Speaker 00

  I don't see any difference. Future Fund, New Zealand Super would be rebalancing. Typically, what you would do with the forms of total portfolio approach that I'm familiar with is you would have a target portfolio anyway. You would be aiming for something. We've got a reference portfolio. You're rebalancing the risk back to the reference portfolio level. If you're the future fund and you don't have a reference portfolio, you'll still want to think about equity equivalent exposure, and they'll want to rebalance back to that. It will be similar. In terms of the privates, that's an interesting one because with private market exposure, you can't move that anytime you want because they're liquid.

• 37:35Speaker 00

  And the relationships involved, the investing teams will need to have clarity over a multi-year runway. In the organizations I've been in, there's usually some sort of runway or plan over multiple years. The target portfolio has to take that into account so that the teams have decent planning horizon and so they can manage relationships.

• 38:03Ted Seides?

  Have you thought about the trade offs of active and passive within the portfolio?

• 38:08Speaker 00

  In terms of reference portfolio example, that's passive. You will want to take active risk when you think you're going to get paid for it. It's as simple as that.

• 38:18Ted Seides?

  How has that come through about where you're choosing to invest actively?

• 38:23Speaker 00

  It helped us in the past. The equity team, the fixed income team had been good at generating good information ratios, but it hasn't been scaled, which I found interesting because there have been constraints on the active risk that can be taken and sub constraints. I look at this and think, well, these are great information ratios in some of these strategies. Why aren't we doing more? There's a question as to how far these can be scaled.

• 38:48Ted Seides?

  One of the big differences in the seat today from where you've been is the size of the asset pool itself. What are some of the areas where scale helps?

• 38:59Speaker 00

  Size helps a lot when thinking about the cost of transacting. You can improve your negotiating position because of your size. You can have very strong partnerships with economics works for both parties. I see the benefits to that. We've been taking advantage of that in recent years in our private equity portfolio. There was a period where we were under invested in private equity and the strategy has changed. It's been particularly successful since 2022. The focus there has been on relationships, having that partnership, having that alignment. A key part of that has been getting more co-investment. There are economic benefits to that.

• 39:43Speaker 00

  That partnership works when you get better information flow. We've done a good job of selecting managers. Those things more likely when you've got a somewhat larger team and asset pool because you can cover more ground and you can get access. You can't necessarily scale in the same way. On net, it is an advantage in an area like that. There are going to be some places where it's a disadvantage because you can't scale.

• 40:11Ted Seides?

  What are some of those?

• 40:12Speaker 00

  If I was thinking about hypothetically, StatA Hub or something, how much could we do?

• 40:17Ted Seides?

  When you've decided there's a particular opportunity where it makes sense to pursue active management, how do you think about the size of an active manager, their assets under management as a fit for the CalPERS portfolio?

• 40:30Speaker 00

  Given our scale, it's hard to make small investments because they don't move the dial. Some of these emerging managers can be our performers. You want to take advantage of that, so you need to find the right framework and mechanisms for getting access to those smaller emerging managers. The reality is that the bulk of capital is going to be invested through larger managers because of the size of our portfolio.

• 40:55Ted Seides?

  The governance boards, guardians, New Zealand, Australia.

• 41:01Ted Seides?

  Are thought of as very sophisticated investment pools of capital. And in the public pensions in the US, typically, the people serving on the boards do not come from finance backgrounds. How has that changed how you thought about approaching the portfolio?

• 41:16Speaker 00

  It's true. The nature of the boards are different. The boards in Australia and New Zealand, ones I dealt with, comprise investors. There's a different type of conversation. But CalPERS, the board, is the ultimate governance body. Our move to a total portfolio approach pays attention to that. It's the management team that has the investment experience. We should be accountable for it. It becomes clearer. The board has the overall oversight. The asset liability management model remains the same. We've just moved to a reference portfolio and we define the active risk a little differently. Ultimately, there's more clarity around who is accountable. It's the management team that has the investment experience.

• 42:01Speaker 00

  The board has the governance experience.

• 42:04Ted Seides?

  What are some of the subtle favorite features of yours that you've seen at TPA that you'd like to apply to CalPERS?

• 42:14Speaker 00

  One thing that stands out is aligning the active risk to a level of conviction. If you've got lots of silos by asset class, you don't necessarily do that. Back to New Zealand Super, I used to describe the active performance of New Zealand Super in baseball terms. If you look at all the different investment strategies, when I first looked at the analysis, I thought, well, actually, the hit rate or the batting average is pretty ordinary. That's not that unusual. But the slugging average was amazing. The areas that it did best in, it had a lot of risk allocated. Those areas that it performed best in were the areas of highest conviction as well. That was something that has been a feature.

• 42:57Speaker 00

  That's something that's important for CalPERS to think about where our advantages are and to make sure we're allocating capital proportionally.

• 43:06Ted Seides?

  When more and more people are thinking about total portfolio approach, where have you found that others are well positioned to do it that may not? Or where they're really not going to be able to replicate it?

• 43:20Speaker 00

  It's probably smaller teams that are better positioned. In our case at CalPERS, yes, it's a larger team, but we had some of the enabling conditions. We had the alignment in terms of the compensation, the improvements in terms of liquidity management, and we've got a capable team. Those things are all helpful. The fact that we'd embarked upon a data and technology transformation was also helpful. To make it work, you need to have good collaboration. That's a key thing. Having people that speak with one another are aligned with the ultimate objective.

• 43:54Ted Seides?

  How have you tried to bring that culturally from what you've seen to operate in that type of collaborative way?

• 44:01Speaker 00

  One of the things we've done at the level of the leadership team is to call out collaboration. When people are assessed for performance, collaboration is one of the key leadership competencies. We've heightened that in terms of how much focus we give to it. There's focus on communication, outreach. We've had lots of questions and answers and discussions. When you do that in the big forum, people don't feel that comfortable speaking up. There's been a lot of outreach at the team by team level. Early on, there was some discomfort in the private markets because people were thinking New Zealand doesn't have much exposure to private markets. The reality is Future Fund does. And if you look at the TPA adherence,

• 44:46Speaker 00

  they tend to have a bigger exposure to private markets. So there were a lot of misunderstandings because you've got to look at the organization and where its relative advantages are when thinking about their allocation. There's been an education process, Q and A, listening, discussion, and it's ongoing.

• 45:04Ted Seides?

  How do you anticipate making investment decisions?

• 45:09Speaker 00

  The key is to make sure that you've got the right blend of bottom up. Input and top down. When I think about the top down, you're thinking about the overall risk levels of the portfolio. You're thinking of the active risk budgeting and the way that gets allocated. From the bottom up, you're wanting to make sure that you see the ideas being socialized and being shared across the organization. In the end, if you are deploying capital, you want to be confident that it's going to beat the cost of what you're selling to invest it. You need that consistent framework for thinking about that. If someone wants to invest in infrastructure, we're going to effectively have to sell some equities and bonds to do that.

• 45:53Speaker 00

  If it's infrastructure, it's probably going to be a liquid, there's going to be some charge for that. The investing teams are going to have to be thinking about what's the opportunity cost of making this investment? And if everyone is looking at the same framework for assessing that opportunity cost, then you've got a model for making those investments. The teams will go out and try and find good opportunities. It may be that when you look across all the different opportunities, that there are some relatively good ones and some areas and some that are less interesting. And we should be able to discuss that as a team and upsize those ones that look more attractive.

• 46:31Ted Seides?

  When something's close on the margin, who ultimately makes the call?

• 46:35Speaker 00

  A lot of us delegate it down to the heads of the various teams. We raise the biggest questions to an internal committee of the various asset class heads. Ultimately, it typically is the head of the asset class that makes the call, up to a particular size.

• 46:52Ted Seides?

  Do you bring the heads of the asset class together so they're not just thinking about their asset class?

• 46:57Speaker 00

  Absolutely, essential. Internally, we have what is called a total fund management committee. We meet fortnightly. We also have some of the committee that looks at the underwriting of deals, but those will only be the largest transactions. Those people get together fortnightly on these committees.

• 47:15Ted Seides?

  As you think about stress test analysis in your risk assessments today, what most concerns you?

• 47:22Speaker 00

  When I look at our portfolio, you're exposed to growth. I would like to have a greater exposure to diversifying strategies. Those things are things on the back of my mind. In terms of what causes me to lose sleep, it's probably there being some unfortunate event. And it's hard to forecast. You hope that you have the maturity to look through that and to take advantage of those unfortunate events. It's probably a function of behavior. How do we react when some adverse event occurs? I think about that. Do we have sufficiently strong governance arrangements to have gotten through that pro secality? That's been a challenge for us in the past.

• 48:08Ted Seides?

  Have you thought about increasing use of technology, maybe AI, in improving the efficiency or the output of the investment process?

• 48:16Speaker 00

  It's a continual process. We've spent a lot of time working on liquidity analysis, the analytics there. One of the things I did when I first came in to CalPERS was to say that, you see, and I can see the portfolio on my phone. And I can see lots of different reports. We couldn't do that at CalPERS when I arrived. But now I can see a lot of reports on my phone. The team have seized that. So really good initiative to make that work.

• 48:42Ted Seides?

  With the breadth of asset ownership over a long period of time, imagine there's a lot of data that comes from that. Have you thought about the potential for AI in improving what you can know?

• 48:56Speaker 00

  It's a hard one because I don't know that I can necessarily access all the data that would be relevant. We were early investors in private equity. It'd be great to be able to look at the lessons that were learned early on, but I don't know how accessible that information is. There are probably missed opportunities going forward. We can build information systems to capture more than we have in the past. That's an area where we should have a true advantage, given our scale, given the connections, given the access that we have.

• 49:29Ted Seides?

  Given the seats you've sat in, you're particularly well positioned to understand how large allocators might change their investing over the next five or 10 years. I'd just love to get your thoughts on that.

• 49:43Speaker 00

  Allocators often think about the past and project forward. There's always a theme. There was the Yale model, maybe it doesn't work so well now. Then there's the Canadian model, maybe there's some issues with that as well. Now people are talking about TPA. It has to be fit for purpose going forward. TPA will get more traction, but it's hard because you've got to have that collaboration. There's going to be more thinking about the privates versus publics because you can see the efforts to try and give retail access. Interested in how that all plays out.

• 50:19Ted Seides?

  Any other general thoughts?

• 50:21Speaker 00

  Right now, a lot of those entities, asset owners outside the US, are conscious of the great exposure they have to US assets because of the size of the US capital markets, the performance of the US equity market and so on. There's a desire to diversify away from the US. That's probably going to be difficult because the other capital markets are this deep. The entrepreneurialism in the US is a standout, but it is going to be a theme over the next period of time. There's also going to be more thought about other regulatory interventions. I know that some regulations have been scaled back. Issues in national security become more relevant, whether that's security or supply chains.

• 51:03Speaker 00

  I can imagine there are possibly going to be more national security related factors to be thinking about when it comes to the financial markets. One thing that I wouldn't like to see would be forms of capital controls. But that's quite possible. So we need to think about those sorts of things, things that haven't been in play for decades. They were in play back in the eighties.

• 51:26Ted Seides?

  How do you incorporate that into the implementation of the investment portfolio?

• 51:32Speaker 00

  It's less of an issue for us in the US than it is for others. It really is thinking about stress tests and scenarios.

• 51:41Ted Seides?

  When you put together a series of stress tests, how do you think about what historical scenarios you want to populate it with, or what future economic scenarios you put in that are enough, but not too much?

• 51:54Speaker 00

  We used to do this at New Zealand Super. I sprung a stress test on folks at Future Fund back in 2011. We've probably done less of that at CalPERS, but recently we had a great little exercise, which was initiated by the team, and this was liquidity shock. When you design these things, you have to make them realistic. You want to get engagement from the team. I think back to the one we did recently. People came in on a Monday, and they don't always do that because the core workdays for us are Tuesday, Wednesday, Thursday. We had all these people in the room. We had our treasury team, the ops people, the various asset plus heads and the total fund people.

• 52:37Speaker 00

  And we had the shock that was designed by the people overseeing some of our liquidity management. We made it so that certain key people were away. It worked really well. A lot of lessons from it. Those are the sorts of things you need to do fairly regularly. Exercise those muscles.

• 52:53Ted Seides?

  I'd love to hear an example of an opportunity that you've pursued with the team at CalPERS that feels like just the right fit for this particular pool of capital.

• 53:06Speaker 00

  There are quite a few things that might be just the right fit, in the sense of they Are something that aligns with those advantages that we have. Things like our time horizon size and so on. There are times when we can negotiate economics which we think are favorable to both sides. We have done some of that in private equity. The thinking with the total portfolio approach is more around this is a good investment. If we think it is, it's less important where it sits. If you're sitting there with a strategic asset allocation and you've got all these asset classes, it could be that you've got a hybrid. Where does it sit?

• 53:48Speaker 00

  Or there could be something that's new and you don't have a bucket for it. And it's hard to do. With a total portfolio approach, you look at what are the return and risk characteristics of this investment? And does it make sense to the portfolio? If it does, you're more likely to do it. Now, it could be in an opportunistic bucket in an SAA, but it fits more neatly in the total portfolio approach because you can think about cost of capital on a consistent basis across asset classes. Those sorts of things that might have formed when the cracks are things that will be more relevant for us now, given the way we're moving.

• 54:24Ted Seides?

  What do you hope the portfolio looks and feels like five or 10 years from now?

• 54:30Speaker 00

  Five or 10 years from now, I hope we're more fully funded than we are at the moment. A lot depends on what happens in the market. I would like to think that we have improved information systems, those regular scenario tests and that we're comfortable with the range of outcomes. I would like to think that we have a greater range of diversifiers within the portfolio. I would also like to have a more systematic dynamic asset allocation process in place. I would like to think we've got more of those things that would fit between the buckets in an SAA type environment because I think that's an advantage for us now.

• 55:11Ted Seides?

  So after the end of whatever stretch period of time, five or 10 years or longer that you're in this seat, what would feel like a success to you?

• 55:21Speaker 00

  It would be a success if we were more fully funded. It would be a success if people thought that Coopus was using its potential better in terms of the asset and the mandate, the talent we have. It would also feel successful if people thought this total portfolio approach has worked.

• 55:42Ted Seides?

  Oftentimes, when you think of a public employee seat in the US, it's very prestigious. It's a big seat, may not pay that much. There's some intrinsic pull that someone may have, maybe their parent in your case, or as a teacher or whatever it was. I'm curious what that is for you in a seat in California, not your homeland.

• 56:01Speaker 00

  I like the purpose. It's quite meaningful. We're investing for 2.4 million members. There's something about these asset owner roles that I enjoy because you get to work in the markets, which is intellectually interesting. You get to think about the economics and the politics. You get a seat at a table, you get involved in interesting conversations. It's a privilege to be able to do this, particularly if you're doing it for a good cause. Intellectually, it's great to keep learning. When you're dealing in the market, you have to keep learning. It's also good to solve problems. It's that combination of things that appeals to me.

• 56:40Ted Seides?

  Steve, before I let you go, I want to make sure I get a chance to ask you a couple of closing questions. Before we get to the closing questions, I want to tell you about one of our strategic investments. We've made a few, and each are working on a product or service we think will be valuable to our community. One is Thema. For all the private equity managers out there, Thema uses AI to help map the landscape and source private businesses. It's incredible what a well-designed AI tool can do to accelerate the discovery of businesses in private markets. There's a link in the show notes so you can learn more. And here are those closing questions. What was your first paid job and what did you learn from it?

• 57:20Speaker 00

  My first paid job was a student job. I was a laborer, doing all sorts of manual work. That job brings back memories because I remember my first day on the job. A group of us started that day. We were given tools like crowbar, pick, shovel, and we were asked to dig up a road.

• 57:42Speaker 00

  It was a metal road. It was hard work because we only had these tools. At the end of the day, I went home. I had seven blisters on my two hands. My father looked at me and thought I needed toughening up. He got some denaturalized alcohol and just poured it on my hands because that toughens up the skin. It stung. From that time, I wasn't sure whether they're testing us as new joiners, but it got easier after that. I enjoyed doing that manual work.

• 58:12Ted Seides?

  Which two people have had the biggest impact on your professional life?

• 58:16Speaker 00

  People who know me know that I don't stick to the script. So I'm not going to mention just two people. The people that have had the biggest impact have been folks who've taken a chance on me. I did a master's degree in economics. Normally, people in New Zealand who did that would go off and work in the Treasury or the Reserve Bank. Did the Reserve Bank later, I was offered a job at the Treasury, but didn't go there. I was offered a job at one of the universities in New Zealand to lecture on finance. I hadn't studied much finance, but they wanted an economist. I thought, oh, that's good, I'll do that. So that was Lyle McLean, who was the dean of finance, accounting of finance at Otago. He took a risk on me, I enjoyed that.

• 59:01Speaker 00

  And I got to spend some time with Simon Benninga. He wrote one of the standard texts on financial engineering. He was teaching us option pricing and that got me thinking more about finance. I went from there to Reserve Bank. Then when I went traveling, I picked up a job at Chase Manhattan. That was a bit of a risk. I'd come from a central bank. I got parachuted into derivative structuring. It was Sykes Wilford, who was one of the senior people at Chase who took that risk with me. That was great. IMF, same thing, moving from FX options to IMF. I had that central bank background, so it wasn't such a leap. Go back to the market, same thing.

• 59:43Speaker 00

  People at Future Fund, Dave Neal, took that risk hiring me. It's those sorts of people who've been prepared to take someone who's come from maybe a nonlinear role.

• 59:56Ted Seides?

  What brings you the greatest joy?

• 59:58Speaker 00

  I really like walking in the mountains in the bush, being with nature. From a professional perspective, I like seeing people grow. It's great seeing people you're working with or people who work for you do well. They make you look good. I really get a kick out of that. I like solving puzzles and of course, spending time with friends and family.

• 1:00:18Ted Seides?

  How's your life turned out differently from how you expected it to?

• 1:00:22Speaker 00

  It's turned out very differently. If you'd asked me when I was a teenager, what I was going to do? I thought I would work in the wildlife service. I wanted to spend time outdoors. I didn't think I would be living in other countries, so quite differently.

• 1:00:39Ted Seides?

  Last one, if the next five years are a chapter in your life, what's that chapter about?

• 1:00:44Speaker 00

  It's probably about what you've already asked, how have things gone at CalPERS? I would like it to be a story of success. I would like it to be a story of fulfilled potential. I would also like it to be a story of using my leisure time better and doing the things I enjoy.

• 1:01:00Ted Seides?

  Stephen, thanks so much for joining me. It's so great to hear about your latest seat.

• 1:01:04Speaker 00

  Thanks very much, Ed.

• 1:01:06Ted Seides?

  Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com, where you can access past shows, join our mailing list and sign up for premium content. Have a good one and see you next time.

• 1:01:21Speaker 02

  All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.