What's Happening with the Pension Fund? -- Part 16

by Charles Schwartz, Professor Emeritus, University of California, Berkeley
schwartz@physics.berkeley.edu                                January 26, 2003

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

Questions About UC's New Multiple Manager Strategy

While very little detail has been given about the Regents' new Multiple Manager Equity Investment Strategy, we try here to explore the questions that should be asked before plunging into this new venture. It may be that their most prudent course would be to keep that money in the index fund.

Despite their obligations to manage the University's pension and endowment funds for the public benefit, the UC Regents have been most committed to keeping their recent revolution in investment strategy hidden from public scrutiny. After abruptly firing the whole staff of their own Equity Investment program, UC officials have had only the following few words to say about their future plans.

After extensive consultation with outside investment professionals, as well as the UC Regents Investment Advisory Committee and the Committee on Investments, Treasurer Russ has recommended [and The Regents have approved] that the University transfer the internal management of its U.S. equity investments [about $15 Billion] to multiple external managers. Treasurer Russ has also recommended that UC diversify its equity holdings by moving from a single actively managed large capitalization strategy to a range of equity strategies. [11/26/02 press release.] I have made repeated requests to UC for public documents which would explain the analysis, the planning and the discussions that led them to adopt this new strategy. None of those requests have been honored. In this paper we will therefore explore an array of questions that pertain to this matter.

Here, succinctly, are the two arguments UC offers in favor of this change:

  • That external investment managers (i.e. private-sector professionals) will do better than the university's own professional staff.
  • That a better diversification will be achieved by this move to multiple managers with varying investment styles.
  • The following discussion will focus on one classic choice of alternatives: Will the Multiple Manager Strategy be any better than the simple alternative of keeping the equity investments in an efficient Index Fund? [Readers may wonder about my apparent shift in position. When the regents put $11 Billion of their investments into Index funds in 2000, I questioned the basis for that action. I have recently expressed many grave concerns about the rational basis for their demolition of the internal equity investment operations of the UC Treasurer's office and the movement of an additional $15 Billion in stocks into that same Index fund. Here, I put all those issues about past decisions on hold and focus only on their future plans.]

    Diversification & the Multiple Manager Strategy

    The word diversification implies an improvement in the investment performance of any portfolio. But one must be careful. There is a limit to how much reduction of risk may be achieved by "diversification" -- and that limit is defined by the fluctuations/volatility that exists in the market as a whole. The University's established benchmark for equity investments -- the Russell 3000 Index -- covers almost all of the U.S. Equity market and one should be very cautious about claims to achieve better "diversification" than this.

    Different investment managers (stock-pickers) may vary in their success from one-to-another and from year-to-year. The total performance of all investors is the Market. The question is, Can one plan a selective strategy that beats the market?

    The Efficient Market Hypothesis

    My textbook of choice is, "Investments", by Bodie, Kane and Marcus, Fifth Edition (2002) published by McGraw-Hill. In the "Underlying Philosophy" given on page vii of the Preface, these authors say,

    The common theme unifying this book is that security markets are nearly efficient, meaning most securities are usually priced appropriately given their risk and return attributes. There are few free lunches found in markets as competitive as the financial market. This simple observation is, nevertheless, remarkably powerful in its implications for the design of investment strategies; as a result, our discussions of strategy are always guided by the implications of the efficient market hypothesis. While the degree of market efficiency is, and always will be, a matter of debate, we hope that our discussions throughout the book convey a good dose of healthy criticism concerning much conventional wisdom. One example of this "conventional wisdom" was shown in the remarks of Regent Richard Blum at the September meeting of the regents' Committee on Investments: "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." This belief in "the better money managers" shows an unsurprising bias for someone, like Regent Blum, who is himself a successful investor and investment manager. Let's look at some empirical evidence presented in the textbook (Chapter 4). A comparison is made between the annual performance of a large sample of professional mutual fund managers and the Wilshire 5000 Index. Over the period 1972-1999 they find that more often than not, a majority of the professional investment managers fall behind the index, so that an average investor would have been better off simply buying into a passively managed index fund. The annualized total return for the index exceeds the average of the professional (active) managers by the substantial margin of 1.57%. This result allows the possible interpretation that there are good managers and poor managers, with the latter dragging down the average performance of the former. So the textbook then cites further studies (by B. G. Malkiel) who looked at the persistence in performance of individual fund managers: How often does above average performance in one year predict above average performance in the following year? Data from the decade of the 1970s showed that 65% of first-year winners were also second year winners, indicating a significant measure of "talent" over "luck". (A 50% persistence would indicate a purely random process.) But the same study for the decade of the 1980s showed only 51.7% in this win-win category, indicating that there is hardly anything more than luck involved in the relative performance of professional investment managers.

    The Efficient Market Hypothesis says that the current prices of stocks reflect all available information, and therefore any attempt to "beat the market" (by clever picking of stocks that will rise higher than expected in the future) is purely a gamble, with zero expected payoff. Of course, if you have access to privileged information about a particular stock, information which is not yet available to the public, then you may be able to make a killing in the market. But such "insider trading" activity is illegal.

    This is the basis for the widely accepted view (among academics) that in a well-developed market (like U.S. equities) one should simply choose to invest in an index fund. Of course, the investment industry does not accept that theory, since they make their salaries and their profits from the management fees and commissions which they charge their clients. (I'll give some data on that later.)

    Professional Advice from Russell.com

    Seeking a non-academic perspective on these questions, I made a brief search of the Internet and was led to the Frank Russell Company, founders of the Russell 3000 index (and other indexes) and also a well respected investment management and consulting firm. The headline at their website proclaims, "Global Leaders in Multi-Manager Investing" and they offer their services as a "manager of managers" for investors. Here is their pitch:

    Screening Money Managers. Each year, through an integrated worldwide network of more than 50 analysts, Russell evaluates more than 1,700 investment managers and more than 6,000 investment products globally. ... They use extensive qualitative and quantitative research to find some 300 managers who are then subject to further scrutiny. Additional research leads to decisions about which aproximately 100 out of 1,700 managers will ultimately be selected for Russell funds. Using various proprietary factors, Russell determines which managers are currently adding value in their style through superior processes and exceptionally talented individuals. ... This leads me to wonder what plan UC's Treasurer has for selecting his stable of managers to take on the $15 Billion in UC's equity portfolio. However, the most interesting thing I got from Russell was the following. If you simply pick today's top manager for your investment, you may not be prepared for the long run. For example, in 1996, of our total of 293 U.S. equity managers, 75 managers composed the top quartile, or the top 25% of U.S. equity managers. Out of those 75, 17 remained in the top quartile the next year. Exodus from the top quartile was swift and no manager was still there in either 2000 or 2001. They give a bar chart for this experiment, showing the successive populations remaining in the top quartile, starting with an initial set of 293: 75, 17, 2, 1, 0, 0. What struck me was that these numbers fit very nicely (within statistical uncertainty) a sequence that is reduced by a factor 1/4 at each step. That is exactly the result one would get if the relative performances of these expert investment managers was a completely random phenomenon! Thus, Russell's own data supports the Efficient Market Hypothesis and serves to persuade me that one should stay with an Index Fund for U.S. equity.

    The Experience of CalPERS

    The California Public Employees' Retirement System is this country's largest public pension fund; and their experience in recent years is quite relevant to UC's plans. Their website (www.calpers.ca.gov) provides a wealth of data on their investment practices and I have gathered some of that into Table 1, below.
    Table 1.  Selected Data on CalPERS Investments
    Fiscal Year  2002  2001  2000  1999  1997
    Total Investments  143   156   173   159   120  $ Billion
    Domestic Equity:
       Index Fund    43    51    57    56    44  $ Billion
       Externally Managed    10    12    13    12      9  $ Billion
       No. of Ext. Managers    16    21    16    11
       Ext. Management Fees    77    40    --    18      8  $ Million
       Expense Ratio   0.77%   0.33%   0.15%   0.09%
     Data from Annual Investment Reports, available online from CalPERS (some missing)

    The first thing to notice from Table 1 is that CalPERS keeps most (about 80%) of its domestic equity invested in an Index Fund and only a relatively small amount is given to External Managers. (There is also a smaller amount that is actively managed internally.) By contrast, UC has previously put only 30% of its U.S. equity into an Index fund.

    The most interesting data in Table 1 is in the bottom two rows. The total amount of Management Fees paid by CalPERS to its multiple external managers has grown very sharply over these several years, reaching 0.77% of managed assets in the most recent fiscal year. Mutual funds, as used by small investors, typically charge 1-2% management fees. By contrast, UCRP has reported, for many years now, that its total expense ratio (counting both management costs and administrative costs) is only 0.04%. The Index fund offers by far the cheapest investment option, with management fees typically a small fraction of 1 basis point (1 bp = 0.01%).

    So it looks like the CalPERS model is a good deal for the investment industry; and if UC joins that way of investing, then even more cash will flow into the pockets of private investment firms. No wonder that the "investment professionals" that UC Treasurer Russ sought advice from recommended the multiple manager approach!

    The bottom line is: Does CalPERS get its money's worth from the (presumed) superior investment returns achieved by these external investment professionals?  I found a document titled "Executive Summary of Investment Performance, prepared for CalPERS for the period ended September 30, 2002" that gave lots of interesting data. Just looking at the Actively Managed External Domestic equity investments (pages 7-8), we find the results in Table 2 below, which show a significant underperformance relative to their benchmark.
    Table 2.  CalPERS U.S. Equity Investments: Active External Managers
    Performance as of 9/30/02
     Quarter  1 Year  3 Year  5 Year
     Return  -19.0%  -20.6%  -13.3%   -.-
     Benchmark  -16.9%  -18.1%  -12.4%   -.-

    Looking at the reported performance of the individual "Mainstream Managers", I find 20 entries over these time periods showing a poorer performance, compared to their assigned Performance Objectives, and only 11 entries showing better performance.

    Another staff report to the CalPERS Investment Committee (dated March 18, 2002) recommends the hiring of several new external managers for Domestic Equity Growth investments. It summarizes the then-current situation as follows:

    Four of the five growth managers have not met CalPERS' return objectives. Considering that the assets of the growth portfolio range between 45% and 55% of the external active domestic equity portfolio, this has negatively impacted the performance. I do not claim to present a complete review and evaluation of CalPERS' experience with multiple external equity managers, but this sampling leaves me quite uneasy about the prospects for UC's new plans. I look forward to seeing the reports and analyses that the UC Treasurer has prepared on this subject. So far all my requests for such documents have been in vain.

    One more item of interest: the main investment consultant used by CalPERS is Wilshire Associates, the same firm that the UC Regents rely on for advice.


    After this survey (by an avowed non-expert) it is all too easy to see the one certainty that UC's move to a Multiple External Manager Investment Strategy will be a windfall for the private sector investment industry. Whether this move will actually benefit the University is something which is much in doubt -- at least until UC officials choose to release their internal documents which presumably made the case and led the Regents to adopt this new policy. The alternative choice of leaving it in the index fund certainly deserves serious consideration.

    More Disclosure

    We notice that one source of guidance in this matter which was acknowledged by Treasurer Russ was the Investment Advisory Committee, a body of outside investment experts created three years ago under the leadership of Regent Parsky. Here is the identification of these people as they were appointed by the regents:

    Mr. Russell Gould: Senior Vice President for Finance and Investments at the J. Paul Getty Trust. Mr. Gould is a former Regent of the University of California and was Director of the California Department of Finance, 1993-1996.

    Mr. John Hotchkis: Chairman of Hotchkis and Wiley, which manages tax-exempt institutional portfolios of pension, profit sharing, and endowment funds. Mr. Hotchkis is a former Regent of the University of California.

    Mr. Robert G. Kirby: Senior partner of The Capital Group Partners, L.P. and formerly Chairman of the Board of Capital Guardian Trust Company of Los Angeles. The Capital Group is a holding company for a number of investment management subsidiaries operating on a global basis.

    Mr. William R. Hambrecht: Founder and Chairman of WR Hambrecht & Company, an online investment bank focusing on emerging growth sectors, including technology and the Internet, and former co-founder of Hambrecht and Quist, an investment banking firm specializing in emerging high-growth technology companies.

    [Source: Minutes of the U.C. Regents 3/16/00 and 5/18/00]

    So we note that three out of four of these outside experts are immersed in the investment business. Not so fast. I now learn that Mr. Gould (the fourth member) is right in there with the rest of them. He is, and has been for several years, a Principal and Managing Director of Metropolitan West Financial, LLC. This is a diversified financial services holding company, based in Los Angeles, which, through its group of companies, has about $60 Billion in assets under management.

    [Trivia quiz: What famous person was hired by Metropolitan West Financial, just over a year ago, to be the company's vice chairman?]