What's Happening with the Pension Fund? -- Part 13

by Charles Schwartz, Professor Emeritus, University of California, Berkeley
schwartz@physics.berkeley.edu                                November 4, 2002

>> This series is available on the Internet at http://socrates.berkeley.edu/~schwrtz

Lies, Damn Lies and Statistics

We expose an attempt by some of the University's top officials to manipulate the statistics on UC's past investment performance and thus create a distorted picture of the choice between internal and external management of the pension funds.

     At the September 18, 2002 meeting of the UC Regents' Committee on Investments I watched a very cunning show. Let me tell you about it. Regent Gerald Parsky, Chair of the Committee, introduced the subject as follows.

Parsky: "[Agenda Item] number 602 is a discussion in open session of our portfolio analyses and investment transactions. And I would introduce this by saying that the Treasurer's Office has been engaged in a very extensive review of the entire portfolio. He has brought forward to the Investment Advisory Committee a number of thoughts and analysis both on risk and on performance. And I really want to compliment the office for the thoroughness with which they are looking at this area. It is very important and I would urge the regents to take a look at it because it really begins to analyze the performance of the entire portfolio."
" You can see this lays out the portfolio on a consolidated basis, fixed income and equity. When several of us on the Investment Advisory Committee saw this; we wanted to do, wanted the Treasurer's Office to do a more detailed analysis of what impact the bond portfolio had on the overall performance and what impact the equity portfolio had because in looking at how these portfolios should be managed going forward, you have to assess what the performance was of each one. And finally you also have to assess, well, if one element was better or not as good as the benchmark, how much risk was taken in achieving those returns. So we have been pressing the Treasurer's Office to do that kind of analysis, over a long period of time, not just in the current year or two but over a ten year period."
     This sounds sensible, except that there is nothing new about giving details separately on the stocks (equity portion of the investment portfolio) and the bonds (fixed income portion): this separation can be found in any Treasurer's report over many years past. What is more, in various earlier reports (up to the latter part of 2001, when the new UC Treasurer, David Russ, took over) one can also find data on both investment Returns and Risk, although the former usually dominates. Strangely, it appears that data on the risk measurements of the investment portfolios has virtually disappeared, under Mr. Russ, from the most detailed reports available, namely, the Quarterly Performance Reviews. (These reports may be found at http://www.ucop.edu/treasurer )

     At that September meeting Mr. Russ gave a detailed presentation to the regents, with many pages of data on performance (returns) of the investments, over various time periods and with detailed comparison to the benchmarks that have been adopted. Here is a most interesting portion of that presentation, with additional comments by Parsky and also by Steve Nesbitt, the University's investment consultant from Wilshire Associates.

Russ ... "This next page, eight, is a representation of the returns in the retirement plan equity, the internally managed active equity portfolio, Cumulative Alpha. Alpha would be the difference between the benchmark and the portfolio. In this case it is a negative return over a long period. Now, you have been presented with these numbers in the past through all your investment reports. I don't know if you have ever seen a chart of this sort. But what it shows is, along the x-axis, that would be the benchmark returns. So anything above that would be greater than the benchmark; below, less than the benchmark. It's a very clear representation. And you can see that in the long run there have been periods of outperformance and then underperformance but the net effect over this ten-year period, on an annualized basis, was a negative return relative to the benchmark."

Parsky: "Just to pause on that. The benchmark that David has used is the benchmark that was in place at the time. So it was the S & P for the period when it was the S & P and it shifted to the Russell 3000 as we shifted. So, this is a fairly dramatic chart when you take a look at it over a ten year period."

Russ: "It is relative to the historic benchmark that has been reported to you in the past."

Nesbitt: "I might also mention that again this is annualized. So over a ten-year period, while it shows minus 1 percent, that's on an annualized basis. Over the total period it is 10 percentage points relative to the benchmark."

President Richard Atkinson: "That's why this term 'cumulative' is a little confusing."

Others: "Yes." "It is." "Yes."

Nesbitt: "I would just also add that If you extend this back to the early 1980s when performance records for equity were first kept at the Treasurer's Office, this pattern is roughly the same through the eighties. So the cumulative deficit over 10 years is 10 percent, the cumulative deficit going back to 1983 is a little more than 15 percentage points. So it is kind of a slow and steady underperformance."

     This is a pretty damning picture being painted of poor performance by the internally managed equity investments in the University's pension fund. I have several serious criticisms, however, concerning these experts' presentation and interpretation of the data.

     The graph shown by Russ had data on the difference between the returns of the UCRP Equity portfolio and the benchmark, averaged results over various time-periods within the last 10 years, ending up at June 2002. This is the basis for Nesbitt's statement that "the cumulative deficit over 10 years is 10 percent," and that sounds like a big loss attributed to the internal management of equity investments. The data in the graph, however, show a lot of fluctuation from year to year. For comparison, if I ask the same question about the performance over the period up to June 2000 (the time when Wilshire's new investment plan for UC went into effect), the answer is that UCRP lagged behind the benchmark by only 4 percent (cumulative) over the previous ten-year period. So you can get quite different conclusions (10% deficit, or 4% deficit, or ...) depending on which data you select to emphasize.

     But there is actually something much more dishonest going on here. The data presented by Russ and emphasized by Parsky and by Nesbitt was only concerned with comparative Returns. It made no reference at all to comparative Risks (and this despite Parsky's earlier remarks about looking at both returns and risks.)

     It is a fundamental idea that some investments or types of investments carry a greater risk and therefore must provide a greater return on the average. Lower risk investments offer, on average, lower rates of return. When comparing two performances, such as your portfolio and some market index, it makes sense to look simply at the difference of returns only if both have the same risk. In fact, here they do not. The accepted way to measure risk is to calculate the statistical quantity "standard deviation", which measures fluctuations of the returns over some extensive period of time. Let us see now how the picture changes when we examine both sets of data.

     In April 2001, I requested detailed data on these questions from the UC Treasurer's Office. Mr. DeWitt Bowman, the Interim Treasurer at that time, provided me with authoritative numbers which are displayed in Tables 1a (Returns) and 1b (Risk). This is data for UCRP and for the benchmark S&P 500, looking back over various periods of time (5-, 10-, 15- and 20- years) from the end of fiscal year 2000.
Table 1a.  Annualized Returns:  Performance as of 6/30/2000
 5 years  10 years  15 years  20 years
UCRP - common stocks  22.2%  17.4%  17.1%  16.8%
S&P 500  23.8%  17.8%  17.6%  17.4%

Table 1b.  Annualized Risk (Std. Dev.) : Performance as of 6/30/2000
 5 years  10 years  15 years  20 years
UCRP - common stocks  17.6%  14.7%  16.5%  16.1%
S&P 500  18.6%  15.8%  17.9%  17.5%

     These Tables show consistently lower returns and also consistently lower risk for the UCRP common stock portfolio, compared with the S&P 500 stockmarket index. It is not a trivial matter to say what conclusion one should draw from this comparison that involves both returns and risks. (A different example: comparing the data on UCRP common stock investments and the Russell 3000 index, over the 15- and 20-year periods up to 6/30/2000, we saw that UCRP had a larger return and a smaller risk. In such a situation one can say that the UCRP performance was unquestionably better.)

     A major claim to fame of economists over the past decades is a set of arithmetic procedures for making useful comparisons in the non-trivial situation. The common phrase is to compare "risk-adjusted returns", some way of combining both return and risk numbers for a useful comparison. There are several methods described in the textbooks.

     In one of my earlier papers in this series (Part 7) I reported calculations using one of those formulas, the Modigliani-Modigliani method. Combining the data sets in Tables 1a and 1b in that way, UCRP came out with a better risk-adjusted return than the S&P benchmark over the 10-year, 15-year and 20-year periods.

     A different calculational procedure gives something called "alpha", which is not the same as the quantity called "alpha" in the data presented to the regents by Mr. Russ. The textbook definition is the difference in annualized returns (this is the part given by Russ), corrected for the relative risk of the portfolio compared to the benchmark. I do not have the resources to do that calculation properly. However, I have been able to estimate the correction and I find that the true alpha (the risk-adjusted difference in returns) puts the UCRP equity portfolio ahead of the S&P500 index, completely contradicting Russ, Nesbitt and Parsky. I hope some professional can do this calculation correctly and tell us the exact result.

     Still a third method, much favored in textbooks, is to calculate what is called Sharpe's Ratio, which involves again both return and risk data. I have found some authoritative data on Sharpe's Ratio, calculated for UC's General Endowment Pool Equity portfolio and for the relevant benchmark. This data is reported in the Quarterly Performance Reviews for December 2000 through September 2001. In two reports the UC portfolio had the same Sharpe's ratio as the benchmark, and in the other two reports the UC portfolio had a higher (better) Sharpe's ratio.

     Thus, on the basis of this information, I conclude that either:

     But it gets even worse. Here is another speech by Regent Parsky, near the end of the session.

Parsky: "[These] comments that David is making have led us in the Investment Advisory Committee to urge him to now take a much harder look, in light of this, take a much harder look at the equity portion of the portfolio in relationship to performance; and the bond portfolio in relationship to risk, to see what kind of recommendations we can come forward with, going forward."      As I sat in the audience at the regents meeting and listened to Regent Parsky, I was astounded at the audacity of his statement. For the equity portion of UC investments, they would measure only the return, relative to the benchmark, ignoring consideration of risk; and for the bond portion of the portfolio they would do exactly the opposite! It was not just the abstract logical inconsistency of such a plan that shocked me; but rather I knew exactly what the outcome of such a biased analysis would be. My earlier studies had also looked at return and risk data for the UCRP bond portfolio; and the result was that the bonds had higher returns as well as higher risk than the benchmark (just the opposite situation from that of the equity portfolio.) Again, I had found that a comparison of risk-adjusted returns showed that UCRP's bond investments had beat the benchmark over that earlier 10-year period.

     It now seems clear to me that these guys are playing a most dishonest game. (Heads I win and Tails you lose.). They are skewing the data to make the past UC investment performance look bad.

     But what is the purpose of this hatchet job? Read some comments by a couple of other regents, from earlier in the session when Mr. Russ presented data on recent performance of the investments.

Regent Judith Hopkinson: "I think the important thing to focus on on this page is, if the regents will look under U.S. Equity, policy benchmark. And lets just look at the second quarter. The policy benchmark was a minus 13.1 percent; the index fund did slightly better than the benchmark ... And the internally managed is significantly worse than the benchmark. And I think that's the key issue here to focus on."

Parsky: "As we go forward in analyzing what should be done it's important to break these out and look at relative performance."

Regent Richard Blum: "Gerry, Just to follow on Judy's remarks. I think the number you probably want to look at - anybody can have a good quarter or a bad quarter - really is to look at your five-year numbers and your two[ten?]-year numbers of the money that's managed internally and you will see that the five-year number is 2.3%, and the ten-year number is 10.3%. You would have done substantially better ... The fixed income portfolio did substantially better than the equity portfolio over a five-year period and about the same over a ten-year period. And obviously in equities you take a substantially greater risk or in principle you shouild be. And so I think it calls into question, certainly in my mind, as to whether really you can put together an internal group of managers that would compete with the better professionals that manage money in companies that do that. And I think one of the disadvantages the University clearly has is the ability to attract people because of compensation issues. It is very hard I think for the University to compete with the, you know, the better money managers."

     I am not much of a sports fan but I think this is what they call a "full court press." It looks like a conspiracy to raid the Treasury of the University of California: they manipulate the data to make it appear that the internally managed investments had done poorly relative to what one might expect from putting your money in an index fund or giving it over to some other external investment managers.

     Following adoption of the first Wilshire recommendations in 2000, the regents moved $11 Billion in UC's investment assets out of house, and into index funds managed by private investment companies. Here they come for another bite.

     At the August 6 meeting of the Investment Advisory Committee there was a Closed Session Item for Discussion, "Possible Addition of Active External Equity Managers"; and at the October 29 joint meeting of the Regents' Committee on Investments and the IAC there was a Closed Session Item for Action, "Implementation of Multiple Active Investment Management Programs." I filed formal protests about excessive secrecy in both cases, but got no response.

The Players - Update

     In Part 5 I gave some information about several regents who were key players in the first-round privatization of UC's investments, noting their connections to private sector investment management.

     The Investment Advisory Committee was established by the Regents a couple of years ago to provide inputs from some private sector investment experts. Three regents - Parsky, Hopkinson and Blum - also sit on that advisory committee and serve to connect that body to the Board of Regents. Some background on Regents Parsky and Hopkinson was given earlier.

     Richard C. Blum is the newest member of the UC Board of Regents, having been appointed by Governor Davis earlier this year. The following background comes from Hoover's ("The Business Information Authority") online resource.

Investment firm BLUM Capital Partners (formerly Richard C. Blum & Associates), manages more than $3.5 billion in assets. The partnership invests in primarily US firms, providing capital for such transactions as share repurchases, acquisitions and divestitures, and privatizations. BLUM often takes an active role in management. It oversees investments for wealthy families, corporations, and university and philanthropic endowment funds. Richard Blum, who founded the company in 1975, is a Democratic Party activist and husband of California Senator Diane Feinstein. A student of Eastern thinking and an adventurer, Blum took part in a historical 1981 attempt on Mt. Everest with Sir Edmund Hillary.
     On a more general note, readers may find it interesting to see the full scorecard of regental appointments made by Governor Gray Davis:
  Regent   Campaign Contribution to the Governor
 Hopkinson  $  50,000  ($175,000)*
 Johnson  $       500
 Lansing  $    7,500  ($15,000)*
 Moores  $232,751
 Marcus  $140,000
 Pattiz  $210,000
 Lozano  -
 Saban  $400,000
 Blum  $  75,000
*Amounts in () indicate additional contributions from the individual's company.
Source: various newspaper reports.