by Charles Schwartz, Professor Emeritus, University of California, Berkeley
firstname.lastname@example.org 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.
Here, succinctly, are the two arguments UC offers in favor of this change:
The following discussion will focus on one classic choice of alternatives:
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.
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 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:
The Experience of CalPERS
The California Public Employees' Retirement
is this country's largest public pension fund; and their experience in
recent years is quite relevant to UC's plans. Their website
provides a wealth of data on their investment practices and I have gathered
some of that into Table 1, below.
|Total Investments||143||156||173||159||120||$ Billion|
|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|
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
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
relative to their benchmark.
|Quarter||1 Year||3 Year||5 Year|
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:
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.
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. 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
West Financial, just over a year ago, to be the company's vice