Conservative investment strategy yields modest returns.

FOR all its muscle, the 900-pound gorilla is not the nimblest animal in the jungle.

That's the reality faced by the California Public Employees' Retirement System, whose $166 billion portfolio has averaged neither extravagant gains nor distressing losses.

At the end of the 2003 calendar year, the pension fund's investments had gained 23.3 percent--close to but still lagging the Dow Jones Industrial Average (up 25.3 percent) and well behind the wider S&P 500 Index (28.7 percent).

With much of the portfolio parked in equity index funds, those returns ought not come as a surprise, said Michael Flaherman, a former chairman of Calpers' investment committee. "It's intrinsically a fairly passive approach," he said.

That approach is about to get a bit more aggressive--if in a modest way.

Following the lead of many money managers, the fund's investment staff plans to reduce its asset allocation in equities to 65 percent from the 67.8 percent held as of Feb. 29. Calpers will also increase its allocation in alternative investments such as venture capital funds (7 percent from 4.7 percent), and real estate (9 percent from 6.6 percent).

"They feel the equities markets aren't going to do what they did in the '80s and '90s," said Jim Hawley, a business professor at St. Mary's College in Moraga, who tracks Calpers. "They feel these other areas are more likely to produce higher returns, which is the obvious reason for doing it."

This conservative approach to investing has both helped and hurt the pension fund, Hawley said. Although it has missed out on the booms in certain markets, its policy to not heavily weight any one area provides insulation from dramatic losses.

That was especially true during the technology bust of 2000 because Calpers had been slow to pick up on the boom in technology stocks that started in the late 1990s.

While the Dow fell 6.2 percent in 2000, 7.1 percent in 2001 and 16.8 percent in 2002, Calpers reported negative returns those same years of 1.4 percent, 6.2 percent and 9.5 percent. The wider S&P 500 index was even more volatile.

Local flair

Calpers had been historically underweighted in venture capital, but decided to increase its exposure to the asset category in 1998. "Fortunately, they didn't have the opportunity to put much of the money out the door," Flaherman said. "They had the good fortune of not having dramatic exposure."

Although the portfolio is not weighted in any particular industry, it is weighted geographically, with 11 percent of its portfolio invested in California.

"Like many other pension funds, they have a political and economic interest in investing locally," Hawley said. "They're dependent on how California does and certain sectors within California, like real estate."

The focus on California real estate has proven to be a safe bet, though it, too, has not been a standout performer.

Its 10-year return on real estate investments is 9.7 percent, about even with the National Council of Real Estate Fiduciaries index that is used as a benchmark. Calpers has outpaced that index modestly on three- and five-year returns, but its one-year return of 5.1 percent fell well off the 7.7 percent one-year gain seen by the real estate index.

Although the fund is moving away from equities and into other assets, John Chalker, managing director of LM Capital Group in San Diego, said the transition will be slow. "They take their assets very seriously, and they view moving into higher-risk markets very cautiously," said Chalker, whose company manages about $170 million in assets for Calpers.

Hawley said the passive approach toward investing may be the best option for a fund its size, but it's not a role model for many other institutions.

"I haven't seen any discussion of Calpers as a shining light of investment strategy," he said. "My general sense is that Calpers follows a pretty standard asset allocation strategy."

Returns by Asset Class **

Category                1-Year     3-Year     5-Year

Domestic Equity           0.20%    (11.3%)    (1.7)
International Equity     (6.3)     (13.3)     (3.8)
Fixed Income             15.5       11.4       7.9

Total Fund                8.5%       1.8%      4.6%

* Years ended Dec. 31.

** As of June 30, 2003.

Source: Calpers