Total Portfolio Approach Replaces Pro-Cyclical Strategic Asset Allocation

The Total Portfolio Approach: Unpacking CalPERS' Shift Beyond Strategic Asset Allocation

This conversation reveals that traditional Strategic Asset Allocation (SAA) often leads to pro-cyclical behavior, forcing institutions to sell assets at market bottoms and buy at peaks, a direct contradiction to the goals of long-term investors. Stephen Gilmore, CIO of CalPERS, argues that the Total Portfolio Approach (TPA), particularly with a reference portfolio, fosters a more stable risk appetite and greater management accountability. This framework is crucial for large, long-term asset owners like CalPERS, offering a more nuanced way to manage risk and capitalize on opportunities, ultimately aiming for better long-term funding and operational efficiency. Those who manage significant pools of capital, especially public pensions and sovereign wealth funds, will find this analysis particularly advantageous for understanding how to align governance, risk management, and investment strategy for sustained success.

The Hidden Cost of "Safe" Buckets: Why SAA Fails Long-Term Investors

The prevailing wisdom in institutional investing often centers on Strategic Asset Allocation (SAA), a model that divides a portfolio into distinct asset class "buckets" with defined policy ranges. While seemingly robust, Stephen Gilmore argues this approach can inadvertently lead to detrimental pro-cyclical behavior. During market downturns, concerns about liquidity or perceived risk can prompt liquidation, forcing investors to sell low. Conversely, during market exuberance, risk is often taken on. This reactive stance directly undermines the core objective of long-term investors who should, by definition, be seeking to deploy capital when assets are cheap and de-risk when they are expensive.

Gilmore highlights this issue by referencing CalPERS' past experiences. "One of the things that has attracted value from the CalPERS experience has been a tendency to be too pro-cyclical," he states. This tendency manifests as selling assets during the financial crisis due to liquidity concerns that, in hindsight, were not as dire as perceived. The consequence? Missing out on opportunities to buy assets at their lowest point. The inverse is also true: taking on risk when markets are frothy. This pattern suggests that SAA, by its segmented nature, can obscure the overall portfolio risk and incentivize short-term reactions rather than long-term strategic positioning.

The Total Portfolio Approach (TPA), particularly when coupled with a reference portfolio, offers a compelling alternative. Gilmore explains that a reference portfolio provides a clear benchmark for risk appetite, making deviations transparent. This transparency, in turn, enhances management accountability. Under SAA, recommendations are made to a board, but ownership of the resulting portfolio's performance can become diffused. With TPA and a reference portfolio, management proposes and invests the portfolio, making their performance directly comparable to a simple, off-the-shelf benchmark. This shift moves from a joint responsibility with the board to a clearer delegation of investment execution, where management is directly accountable for the outcomes relative to the established risk parameters.

"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 and it'll be transparent if risk is taken up or down."

-- Stephen Gilmore

This stable risk appetite is not merely about avoiding drastic swings; it's about creating a consistent framework for decision-making. It allows management to proactively adjust risk based on conviction and opportunity, rather than reactively to market sentiment or liquidity crunches. The TPA mindset, as Gilmore describes it, is about building the portfolio to achieve the ultimate objective, not just to meet intermediate asset class targets. This holistic view is essential for large institutions with long horizons, enabling them to better navigate market cycles and capitalize on opportunities that a siloed SAA approach might miss.

The Illusion of "Safe" Buckets: How SAA Fosters Pro-Cyclical Behavior

The fundamental flaw Gilmore identifies in SAA is its tendency to create a false sense of security within asset class "buckets." While these buckets are designed to manage risk, they can also become psychological anchors, preventing managers from reallocating capital where it is most attractive or necessary. This is particularly evident when considering the interplay between liquidity and risk. During crises, the immediate need for liquidity can override long-term investment principles, leading to forced selling at depressed prices.

Gilmore elaborates on this point, noting that in the past, "various assets were liquidated... because of concerns about liquidity concerns that didn't need to be acted upon." The critical insight here is that the perception of liquidity risk, rather than an actual inability to meet obligations, drove these decisions. This reactive behavior is a direct consequence of a system that prioritizes distinct asset class management over a unified portfolio view. When risk is managed within silos, the aggregate risk appetite of the entire portfolio can become volatile, even if individual buckets appear to be within their prescribed ranges.

The TPA, with its emphasis on a reference portfolio, addresses this by providing a consistent measure of total portfolio risk. This allows for a more informed and stable risk appetite, independent of the immediate pressures within specific asset classes. The implication is that management can make more deliberate decisions about deploying or reducing risk, based on a holistic understanding of the portfolio's overall risk-return profile. This is particularly advantageous for entities like CalPERS, which have long-term liabilities and should be focused on generating sustainable returns over decades, not reacting to quarterly market fluctuations.

The Accountability Gap: Who Owns the Decision Under SAA?

A subtle but critical consequence of SAA, as Gilmore points out, is the potential diffusion of accountability. When management recommends an SAA to the board, and the board adopts it, the ownership of the portfolio's structure and subsequent performance can become ambiguous. Is it management's recommendation, or the board's adoption, that dictates the outcome? This can lead to a situation where neither party feels fully responsible for the aggregated results, especially if the portfolio underperforms or exhibits undesirable pro-cyclical behavior.

"Under a strategic asset allocation... the board adopts it then the question is who owns it because it's combined, it's a joint thing."

-- Stephen Gilmore

The TPA, by contrast, shifts this dynamic. By adopting a reference portfolio that represents a specific risk level, and empowering management to invest the actual portfolio relative to that reference, accountability becomes much clearer. Management is not just executing an SAA; they are actively managing the portfolio's risk and return against a defined benchmark. This direct comparison to a simple, off-the-shelf portfolio--like a 75% equity, 25% bond mix--makes it evident how management's active decisions have performed. This enhanced accountability is a governance improvement that can lead to better decision-making and a more disciplined approach to investing.

The Long Game: Delayed Payoffs and Competitive Advantage

The TPA, by fostering a stable risk appetite and clear accountability, enables a focus on delayed payoffs and the creation of durable competitive advantages. When an institution can consistently deploy capital based on conviction rather than market sentiment, it can exploit opportunities that others, constrained by SAA or short-term pressures, will miss. This is where the "discomfort now, advantage later" principle comes into play.

Gilmore's experience at New Zealand Superannuation Fund, where they adopted a TPA with a focus on systematic, long-term investing, illustrates this. By avoiding the temptation to chase short-term trends or react to market volatility, they could maintain a consistent strategy. This allowed them to capitalize on mean reversion and take advantage of their long investment horizon. The TPA facilitates this by providing a framework for assessing opportunities not just on their immediate return potential, but on their contribution to the overall portfolio's long-term objectives.

The challenge, of course, is that these delayed payoffs often require patience and a willingness to endure short-term underperformance or perceived inactivity. Most organizations, accustomed to the visible actions of SAA, may find this approach less intuitive. However, as Gilmore suggests, for large, long-term asset owners, this is precisely where a sustainable advantage can be built. By focusing on the underlying risk and return characteristics of investments, and funding them from a common reference portfolio, TPA allows for a more rational and strategic allocation of capital that pays off over extended periods.

Key Action Items

• Embrace the TPA Mindset: Shift from managing discrete asset class "buckets" to viewing the portfolio as a unified whole, designed to meet ultimate objectives. (Immediate)
• Establish a Reference Portfolio: Define a clear, simple reference portfolio (e.g., 75% equity, 25% bond) as a benchmark for risk and return. (Over the next quarter)
• Enhance Management Accountability: Implement a structure where management is directly accountable for portfolio performance relative to the reference portfolio and active risk budget. (Over the next quarter)
• Develop a Common Language for Investment Comparison: Create a framework that allows for consistent comparison of risk and return across all asset classes, including private markets. (This pays off in 6-12 months)
• Align Compensation with Total Portfolio Performance: Ensure that incentive structures reward contributions to the overall portfolio's success, not just individual asset class performance. (Immediate)
• Invest in Data and Technology for Whole Portfolio View: Prioritize systems that aggregate data and provide a unified view of portfolio risk, exposures, and performance. (Ongoing investment, pays off in 12-24 months)
• Regularly Conduct Stress Tests and Scenario Analysis: Systematically test the portfolio's resilience to various shocks (e.g., liquidity, inflation, growth) to identify vulnerabilities and refine strategy. (Ongoing, quarterly exercises)