What's Happening with the Pension Fund? -- Part 7

by Charles Schwartz, Professor Emeritus, University of California, Berkeley
schwartz@physics.berkeley.edu                             April 23, 2001

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

The Controversy Drifts Along

I am still waiting, empty handed, for the University of California Office of the President (UCOP) to fulfill their promises for a thorough review of and response to my earlier critiques of the work by Wilshire Associates, investment consultants to The Regents.

In the meantime, some informed feedback from academic colleagues leads me to re-investigate the question of how the previous UC Treasurer's investment performance stacks up relative to standard market indices; and the conclusions found here reinforce the earlier doubts about Wilshire's professional competence and integrity.

Waiting for the Official Discourse to Begin

It is now almost three months since the original letter from University Auditor Patrick Reed (see text in Part 6) conveyed the promise, on behalf of President Atkinson, that my series of papers and letters - analyzing and criticizing the regents' new investment policies as designed by Wilshire Associates - would receive a thorough review and response by the top officials responsible for this area. I have yet to receive a single scrap of such material.

Mr. Reed has been responsive to my steady stream of email, asking "when?"
On February 26 he wrote,

Professor Schwartz--You are correct that the data recently received from Senior Vice President Mullinix [his letter dated February 15, 2001, which was discussed in Part 6] was not the material to which I've referred in my letters. That broader response has been drafted by the treasurer's office and is under review before being submitted. I will inquire about it's status again early this week.
And on March 21 he wrote,
Interim Treasurer DeWitt Bowman has informed me he has additional information ready to send that addresses recent questions.
And on April 21 he wrote,
[DeWitt Bowman has] informed me that he has drafted for Senior Vice President Mullinix's review a response to the inquiries in question, and he is following up with Mr. Mullinix on the status of his review of that draft.
It sounds a bit like, "The check is in the mail," but I'll try to remain patient and hopeful for some intelligent discourse with UCOP.

It is not as if UC officials have lost interest in Wilshire Associates. At the March meeting of the Board of Regents, the President's Office recommended, and the Regents approved, that Wilshire Associates be given a new three-year contract to serve as the University's General Investment Consultant, at an average fee of $450,000 per year. I had written to President Atkinson in advance of that meeting, suggesting that this decision should be postponed until after the many serious allegations against Wilshire had been answered; but he ignored this advice.

Some Unofficial Responses Prove Interesting

Throughout this investigation, I have sought to encourage feedback from my readers and among those who have responded are some academic colleagues with substantial professional expertise in the area of financial investments. In particular, two individuals have, independently, written to offer their criticisms of something I said in Part 3. Here is what one of them wrote:

Your evaluation of the Treasurer's performance in part 3 of your critique is at the very least open to criticism and an alternative interpretation. Consider the five and ten year annualized returns ending as of the last full fiscal year. The Treasurer's five and ten year average US equity returns (including their non-US equity investments) were 22.2% and 17.4%, respectively, while those of the S&P 500 were 23.8% and 17.8%, respectively, and those of Russell 3000 were 22.8% and 17.5%, respectively. These performance numbers do not support your contention "that the UC Treasurer's investment strategy (well informed stock-picking) has consistently and significantly outperformed the major index funds."

Where my previous data in Table 1 of Part 3 looked at the total fund performance of UCRP (the University's pension fund), this writer has separated out the equity (stock) portion for comparison with market indices. I decided to do a more thorough study of this past history and, earlier this month, asked the Treasurer's Office for further data on both the Returns and the Risks of the Common Stock portion of UCRP investments over the past 20 years.

Table 1, below, shows the annualized Returns for UCRP investments in Common Stocks, compared with the S&P 500 Index. The UC returns lag behind the returns for the S&P 500 by 1.6%, 0.4%, 0.5%, 0.6% for the 5-, 10-, 15-, 20-year intervals, respectively. (For analysis of pension funds, one should focus more on the long time periods rather than on the shorter intervals; on this point Wilshire and I are in agreement.) Table 1 confirms the quoted writer's observation about superior returns for the S&P 500 over UCRP Common Stocks.
Table 1.  Comparing Returns for UCRP Common Stocks and
the S&P 500 Index   (as of 6/30/00)
              Over the last...  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%
  Data are Annualized Returns, as provided by UC Office of the Treasurer

But the proper evaluation of portfolio performance rests upon not one but two measures - Return and Risk. This is textbook wisdom and, here again, I am in agreement with Wilshire Associates on this general principle of portfolio analysis. Table 2, below, shows the comparative data on Risk for UCRP's Common Stock investments and the S&P 500. Here we see that UCRP has shown a decidedly smaller Risk (standard deviation of annual returns), lower than the Risk of the S&P 500 by 1.0%, 1.1%, 1.4%, 1.4% for each of the four time intervals.
Table 2.  Comparing Risks for UCRP Common Stocks and
the S&P 500 Index   (as of 6/30/00)
              Over the last...  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%
  Data are Standard Deviations of Annual Returns, as provided by UC Office of the Treasurer

This presents us with an interesting puzzle: How do we judge UCRP's Common Stock performance relative to the S&P 500 when the S&P 500 shows greater returns but also greater risk? If you regard this as a question of investment philosophy, we know that The Regents have clearly said that minimizing risk was their top priority in revising their investment policies.

If you approach this as a quantitative problem, then we find that this "interesting puzzle" is well covered in the textbooks. [My reference is, "Investments," by Bodie, Kane and Marcus, 4th edition 1998; see Chapter 24, Portfolio Performance Evaluation.] Among the several methods for finding "risk-adjusted returns", it appears that the favorite is a relatively simple calculation called the M2 Measure of Performance. I have carried out these calculations and the results are shown in Table 3, below. Now we see that on this "risk-adjusted" basis, UCRP Common Stock returns outperformed the S&P 500 Index in all but the shortest time interval: by 0.5% at 10-years and 15-years and by 0.3% at 20-years.

(Other methods for comparing the performance of investment portfolios to market indices require the calculation of quantities called alpha and beta. I requested those numbers as well from the Treasurer's Office but they were unavailable.)
Table 3.  Risk-Adjusted Comparison:  UCRP Common Stocks vs. 
the S&P 500 Index   (as of 6/30/00)
                 Over the last...  5 years 10 years 15 years 20 years
Risk-Adjusted Returns for
UCRP Common Stocks
 23.2%  18.3%  18.1%  17.7%
S&P 500 Returns  23.8%  17.8%  17.6%  17.4%
>>>Difference  -0.6%  +0.5%  +0.5%  +0.3%
  Calculated by the M2 (Modigliani-Modigliani) Method, using data from Tables 1 and 2.

Now I want to turn to the Russell 3000 Index, as an alternative benchmark for evaluating the performance of UCRP Common Stock investments. The relevant data are shown in Table 4, below. Looking at the (unadjusted) returns, we see that the Russell 3000 shows an advantage for the shorter time intervals (5- and 10-year annualized returns) - as noted by our correspondent, quoted earlier - but for the longer time intervals we see that UCRP did slightly better than the index. Looking at the comparison of Risk data, however, we see that the Russell 3000 carried a substantially larger risk than UCRP. The "risk-adjusted" numbers at the bottom of Table 4 show UCRP with an advantage over the Russell 3000 amounting to one full percentage point for the longer time intervals. (One full percentage point in additional returns compounded over 20 years adds up to many billions of dollars in additional assets for UC.)
Table 4.  Comparing UCRP Common Stocks and 
the Russell 3000 Index   (as of 6/30/00)
Over the last...  5 years 10 years 15 years 20 years
Annualized Returns  
UCRP Common Stocks  22.2%  17.4%  17.1%  16.8%
Russell 3000  22.8%  17.5%  16.9%  16.7%
UCRP Common Stocks  17.6%  14.7%  16.5%  16.1%
Russell 3000  18.3%  15.7%  17.7%  17.6%
Risk-Adjusted Returns
UCRP Common Stocks  22.9%  18.3%  17.9%  17.7%
Russell 3000  22.8%  17.5%  16.9%  16.7%
>>>Difference  +0.1%  +0.8%  +1.0%  +1.0%
  Calculated by the M2 (Modigliani-Modigliani) Method, using the above data.

This comparison between the UC Treasurer's past performance in Common Stocks and the Russell 3000 Index is of considerable importance to the new investment policies recommended by Wilshire Associates and adopted last year by The Regents. Following Wilshire's advice, thirty percent of UC's equity investments (amounting to about $8 Billion) was moved out of the Treasurer's office and put into an externally managed Russell 3000 Index Fund. Judging by the past performances - using the data in Table 4, even without the "risk-adjusted" calculation - this move into the index fund may be expected to produce lower returns at a higher risk! It looks like a dumb thing to do.

New Questions for UCOP and Wilshire

One of my strongest complaints about the Wilshire Investment Strategy Study has been that it contained no information at all on evaluation of the past performance of the UC Treasurer's investments (see Part 2 and Part 3). I must wonder why this is so.

The sort of data gathering and analysis I have displayed in the previous section is what undergraduate students in Business Administration are taught to do in a basic course on investing. I am sure that any competent professional investment consultants can and do carry out even more sophisticated analysis for their clients.

When Wilshire Associates first submitted their proposal to provide investment consulting services to The Regents of the University of California (in February 1999), they laid out a detailed list of Objectives and Required Information that explicitly included the sort of data and analysis I have been talking about. Yet no information on this topic is to be found in the documents made available by the University.

This leads me to pose the following questions to UC President Richard Atkinson:

A. Did Wilshire Associates carry out any quantitative analysis/evaluation of the past performance of the UC Treasurer's investments?

B. If so, did Wilshire Associates provide any report on that subject to the University?

C. If so, why was that report not made public; and why was it not provided in response to my formal request, last July, for relevant public records?