Can CalPERS Really Get A 7% Return From Stocks?
As reported in CIO magazine, the California Public Employees’ Retirement System (CalPERS) terminated 14 out of 17 of its outside equity managers late last year and cut the allocation to outside management from over $33.6 billion to less than $6 billion. That represents a total of $181 billion in equity that will be managed in-house. The reason, according to CEO Marcie Frost, is that the outside managers (who presumably were active managers focused on stock picking) underperformed their benchmarks and hadn’t contributed enough to achieving CalPERS’ 7% equity rate of return target. This is a classic example of doing the right thing for the wrong reasons.
As I have frequently written, stock picking just doesn’t work. No matter how scientific the methodology may sound, in the end it’s just pure guesswork, because no one can predict the future. So putting almost all the equity under in-house management – which I assume will follow a more passively-managed index strategy – is a good move. And the cost savings, which Frost estimated at $80 million, makes it even better. That’s an additional guaranteed annual return for all CalPERS pension holders!
However, the requirement that portfolio managers must be able to achieve whatever return the pension fund decides it needs is so wrong that it warrants a further discussion. Such logic assumes that CalPERS management somehow has the ability to dial up a specific return. Unfortunately the capital markets do not work that way. That’s because of the two primary factors that quantify returns – company performance, typically measured by net profit, and investor sentiment, which can be measured indirectly through a company stock’s price/earnings (P/E) ratio – neither are predictable.
Obviously CalPERS has to plan for the future, which does require estimating future returns. But annual returns are frankly impossible to determine in advance. (Back in January 2019, after experiencing the previous December’s 9% loss, did you guess that the S&P 500 would end the year 2019 with a 30% gain?) And while longer-term return predictions are just as problematic, one can apply statistical tools to come up with a target that has at least a better chance of being close to what actually turns out.
The primary factor on which most of the financial industry bases their S&P 500 growth estimates is current stock price valuation. Studies have shown that over time valuations tend to return to their mean (average). One common valuation measure is the Cyclically Adjusted P/E ratio, better known as the CAPE ratio. Today the S&P 500 CAPE ratio stands at 32.5, almost two standard deviations above its historical average of 17. When this measure has been this high in the past, the average annual S&P 500 return over the subsequent decade has been very low. And imagine what a full return to the mean by this metric would do to the S&P 500. From 32.5 to 17 is a drop of -47%. How would CalPERS management react to that?
Among the many financial firms that report long-term average annual stock market return predictions, JP Morgan’s estimate of 5.6% over the next ten years is among the more optimistic. Others are as low as 3.1%. No one is predicting a return as high as 7% except for CalPERS. And diversified portfolios that include other types of assets are likely to sustain even lower returns over the next decade.
CalPERS is doing the right thing by not wasting money on trying to pick stocks. But targeting a long-term 7% annual return sounds overly optimistic. If they’re wrong it will either be their pension holders or the taxpayers who will pay the price.