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CalPERS has included direct investments in commodities in its new programme. Gail Moss examines how and why

In 2006 the 13-member administration board of the California Public Employees' Retirement System (CalPERS) approved a pilot programme for direct investment in commodities as a way of diversifying its portfolio and providing another hedge against inflation.

CalPERS is the largest pension fund in the US, with assets of over $250bn (€161bn). The scheme provides retirement and health benefits for around 1.5m state and local public agency employees and their families.

The programme's objective was to add incremental diversification to CalPERS' investments while meeting or exceeding the return of a pre-specified commodity futures index after fees. Commodities experts had advised the CalPERS board that an investment in a commodities futures index reduces the volatility of fund returns, cuts losses and generates gains during severe downturns in bond and equity markets.

A sum of $500m was approved for investments directly linked to the prices of energy, metals and agricultural products, and in companies that produce and distribute such natural resource commodities. At the time, CalPERS invested 8.4% of its assets in the natural resources sector, across its stock, bond and real estate portfolios, focusing mostly on energy and raw materials production and distribution. But there was no direct investment in the asset class.

Once approval had been given, additional staff were hired to administer the programme, make investment decisions, monitor risk, and report on activities and performance.

In March 2007 CalPERS invested $450m in commodities, using swaps to track the S&P GSCI Commodities Index fund, which has 24 sectors weighted towards energy. The fund kept the investment total at $450m, putting earnings into cash and other collateral.

CalPERS says it took a measured approach, while critics were saying that it came late to the party. The fund is a long-term investor that does not jump in and out of the market on a short-term, speculative basis.

The fund says its commodities strategy was a long-term investment plan for the coming natural resources-constrained decades that was developed well before the recent jump in commodities pricing.

Last December CalPERS CIO Russell Read made a successful presentation to the board, promoting the introduction of an inflation-linked asset class that would have four components, including commodities.

This has now been incorporated into the new board-approved asset allocation for 2008 to 2010, adopted to deliver optimum risk-adjusted investment returns over the next three years.

The new inflation-linked asset class (commodities, infrastructure, forestry and inflation-linked bonds) has a target allocation of 5% of total CalPERS market value. Public and private equities amount to 66%, fixed income 19% and real estate 10%.

CalPERS believes its investment approach is innovative, in that it captures both the investment benefits of commodities while improving the risk and return characteristics of the fund's related stock, bond and real estate investments.

The fund says it is a patient investor that takes a measured approach, with no rush to dump lots of money into this market sector.

Within the fund's portfolio, the commodities sub-asset class has a target of 1.5% of total CalPERS assets, with a discretionary investment range of 0.5-3% of total assets. The target and ranges give staff guidance for the three-year period, but investment officers will invest on an opportunistic basis.

The fund raised its total commodities market investment to $1bn in March. That sum includes investments tracking the S&P GSCI Commodities Index fund as well as some direct commodities investment strategies that the fund declines to specify. It says doing so would affect it adversely in a competitive market.

The fund's commodities investment is in swaps, which are more efficient to manage than direct investments. But, its investments are fully collateralised. It does not use leveraging of the sort that has been associated with hedge funds. It has a dollar in cash for every dollar in swaps. And it has no significant hedge fund investments in commodities.

So far, corporate governance demands have not impeded the programme. The CalPERS administration board has approved each phase of commodities investing without resistance. Since inception, the programme's returns have ranged between 10-20% - well above the fund's target of CPI plus 5-7% a year on average.

CalPERS says it is satisfied with the performance of its commodities programme to date, and will continue to invest in this sector, depending on market opportunities and stated allocation ranges.

"We believe commodities is one of the most important global investment themes over the coming two decades, which is natural resources production and distribution," says Read. "We foresee generally strong commodities prices, particularly with the continued increase in the consumption of commodities in emerging markets. Fears of a slowdown in the US could temporarily dampen some of the demand for commodities, but overall we'll be seeing over the coming business cycle that demand strains possible supplies in energy. Commodities will likely be strong, with continued high prices creating disproportionate opportunities in the capital markets for companies that produce and distribute those commodities."

CalPERS also says it supports the initiative led by the US Commodity Futures Trading Commission (CFTC) to increase the transparency of energy markets futures.

The fund believes that its exposure to the markets has little impact on long-term commodity prices and that it should welcome the CFTC inquiry into the factors affecting the price of crude oil.

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