A Columbia Business School case study on CalPERS has criticised the fund for being “opaquely transparent”, with a computation of investment expenses revealing the fund pays three-to-four times its peers in fees.
Written by Columbia professor of business Andrew Ang and Columbia CaseWorks fellow, Jeremy Abrams, Californian dreamin’: The mess at CalPERS examines the political, governance, staff and funding obstacles that the fund has faced.
One of the enduring aspects of the fund, according to Ang, is the lack of true transparency of reporting. While there is a lot of publicly available documentation, CalPERS does not report any meaningful numbers, he says. For example, the fund does not report a single management expense ratio (MER) figure.
“CalPERS does not directly report its expense ratios, or even its proportion of internally or externally managed funds,” the report says.
Ang and Abrams calculate total investment expenses by summarising investment expenses from several tables in the 2011 annual report, including the statement of changes in fiduciary net assets, schedule of fees and costs for private equity partners, schedule of fees and costs for absolute strategies program, and the schedule of commission and fees (see table).
According to the case study, in the fiscal year ending June 30, 2011 CalPERS’ expense ratio was 1.7 per cent for internally managed funds, 1.6 per cent for externally managed funds and 1.7 per cent overall.
This is significantly greater than CalPERS’ peers globally.
Associated with transparency
A 2012 CEM Benchmarking study, which examined the organisational design of 19 of the world’s largest funds with average assets of $90 billion, found these funds spend an average of 46.2 basis points on external management, compared to 8.1 basis points on internal investment capabilities.
Ang, who describes the case study as “sad”, says not only is CalPERS paying significantly more than its peers in investment expenses, but because of its reporting it is difficult to see where value is added.
“The fund can start a reform process with transparency. They are transparent, everything is there, but they are opaquely transparent and need to report meaningful numbers,” he says. “For example, there is not one MER number recorded – the case study had to calculate both the total internal and external costs.”
Associated with transparency, Ang says, is the way the fund uses benchmarks.
“With more successful funds, the benchmarks are often simple, stable and easy to follow. They represent a
feasible alternative to the investment strategy in an indexed way, then you can see the added value.”
With CalPERS, he says, it is hard to see the costs and how much value is being added.
“For example, the fund has a huge cost for real estate but you can’t see what they’re spending it on,” he says.
“This is a clear symptom of management. You manage what you measure but you can’t see it directly at this fund. All this money is going out the door and you can’t see what it is for.”
The case study points to a number of political and governance issues the fund will need to overcome in order to position itself for success.
But on the investment side it also details the reactive nature of some of the decision-making, including the lack of a strict rebalancing policy before 2007.
Ang says lobbying for legislative change would be the best, but most difficult, way to make changes to the fund.
“It’s difficult because it requires political willingness, which is very difficult, but it could create something: a phoenix from the mess,” he says.
“But really working within the current structure of piecemeal reform is necessary. CalPERS could look to emulate best practice of funds within restrictive circumstances, for example, Alaska, which has done well on a shoestring budget.”
Ang, who will teach the case to his business class in the fall with an emphasis on the tremendous opportunities for change at the fund, says he deliberately didn’t speak with anyone at CalPERS “because I wouldn’t get approval”.
| AUM | Expenses | Expense ratio |
|
| Internal expenses | |||
| Consultants and professional services | 87,337 | ||
| Cost of lending securities | 44,631 | ||
| Real estate | 1,893,044 | ||
| Other | 576,541 | ||
| Brokerage costs | 48,948 | ||
| Total internal | 155,781,798 | 2,650,501 | 1.7% |
| External expenses | |||
| Domestic equity | 12,492,750 | 83,281 | 0.67% |
| Domestic fixed income | 899,122 | 9,217 | 1.03% |
| Global equity | 12,720,128 | 57,472 | 0.45% |
| Inflation linked | 2,376,846 | 81,669 | 3.44% |
| Real estate | 17,063,352 | 288,299 | 1.69% |
| Consultants | 48,707 | ||
| Attorneys, custodian and others | 76,643 | ||
| Alternative investments | 34,398,914 | 658,879 | 1.92% |
| – private equity | 28,908,879 | 516,858 | 1.79% |
| – absolute return strategies | 5,490,035 | 142,022 | 2.59% |
| Total external | 83,507,665 | 1,310,930 | 1.57% |
| Total AUM | 239,289,463 | 3,961,431 | 1.66% |
Source: “California Dreamin’: The Mess at CalPERS”, Columbia CaseWorks
Collated from the Comprehensive Annual Financial Report (CAR) 2011 and Annual Investment Report 2010 and 2011
Emerging markets debt is typically seen as an asset class in which investors can gain alpha through using active and usually external managers that charge for their niche access to segments of the market and on-the-ground local expertise.
However, two large institutional investors – Danish pension fund PFA and New Zealand Superannuation Fund – are taking a different approach.
PFA’s internal investment team has managed their emerging markets debt for more than a decade. Their holdings encompass the spectrum of available securities from US-denominated and local currency sovereigns to corporate debt.
New Zealand Super, the country’s sovereign wealth fund, approaches fixed income with the overriding aim of capturing the broadest exposure possible.
To achieve this goal the fund’s investment team have customised its own index, which attempts to capture the broad fixed-income universe, including emerging markets debt.
Both approaches are at odds with the approach advocated by top global consultants Top1000funds.com spoke to (click here to view story), who unanimously favoured investors seeking external, active managers for emerging markets debt.
PFA and tactical autonomy
PFA senior portfolio manager, Ulrik Roux Wolke, heads up the emerging-markets-debt team at the fund. He says that PFA generally favours internal management, and, despite the distance of the Danish fund from the markets it is investing in, emerging markets are no different.
“We believe in retaining knowledge internally; it adds quite a lot of value, also in terms of asset-allocation purposes and also for getting an overview of the market,” Wolke says.
“Every time you outsource, you lose a lot of knowledge. You can, to some extent, also argue that you cannot choose a manager if you don’t have a deep knowledge of the asset class.”
Emerging markets debt makes up 25 per cent of the fund’s strategic allocation to its credit bucket. The remaining credit allocation is split between 50 per cent investment-grade, developed-market corporate credit and 25 per cent US high-yield.
Of this 25 per cent strategic allocation to emerging markets debt, 85 per cent goes to hard-currency sovereign, with the remaining 15 per cent assigned to local-currency sovereign.
Wolke and his team are given autonomy to make tactical allocations to emerging market corporate debt.
Having the freedom to act tactically without pre-determined limits, which for external managers are often around such things as credit quality, is one of the advantages of internally management, according to Wolke.
“We prefer not to limit ourselves to very mechanical rules such as investment grade only. Rules such as credit quality are not a good substitute for risk management with in depth knowledge of the credit risk,” he says.
“I understand if you have an external manager but it is one of the positive sides of internal management that you can have a dialogue instead of having to impose rigid and not very workable rules.”
Wolke rejects the notion that external managers benefit from being close to the markets they are investing in, saying that being in Copenhagen and investing in emerging markets is no different to bond traders in London managing global portfolios.
“I also travel a lot and I am regularly visiting the markets in which we invest,” he says.
The internal team has the capacity to invest in ways that are essentially the same as an external manager, according to Wolke.
On and off benchmarks
PFA benchmarks its internal emerging-market performance on the JP Morgan EMBI Global Diversified index.
The internal team then takes a number of off-benchmark positions. While he was not prepared to disclose the current positioning of the fund’s emerging markets debt portfolio, Wolke did say the fund takes off-benchmark positions, including in euro-denominated bonds, emerging-markets corporate and local debt.
Wolke says the off-benchmark positions are generally aimed at gaining an average credit quality that is higher than the index.
JP Morgan’s EMBI Global Diversified index has an average credit quality of Baa3/BBB-.
“I don’t believe in a strong rally of anything at the moment, so I think it is better to provision a bit and have some buffers,” he says.
The team also uses derivatives for a small proportion of its emerging-markets-debt portfolio.
“The advantage of derivatives is that you get a cleaner exposure. If you want exposure to a give credit risk, you can do it a lot cleaner without liquidity premium or a special duration segment which could be influenced by a couple of big investors,” he says.
The strategic allocation is also unhedged with the internal team free to make tactical hedges on a currency-by-currency basis, Wolke says.
The current position of the emerging markets debt is underweight local debt and corporate debt due the internal team seeing more attractive opportunities in US high yield.
Wolke identifies strong fundamentals in US high: “For the moment there is fairly positive redemption and maturity profile for the debt.”
The strong balance sheets of US corporations and good spread also adds to the case for US high yield, according to Wolke, who says the shorter duration of US high yield also makes it easier to manage potential interest-rate risk.
However, while there is a fair amount of tactical autonomy, Wolke says there is a view that the strategic allocation provides a base level of diversification.
“The 50/25/25 split is probably the minimum it can get down to in order to retain the diversification effect… The new norm is a lot of things are correlated, but I still think there is a need for diversification, otherwise you expose yourself to a lot of credit risk,” he says.
Kiwi customisation
Diversification is a key advantage of New Zealand Superannuation Fund’s approach to the positioning of its fixed-income portfolio.
The fund’s head of asset allocation, David Iverson, says that the fund has chosen to index its fixed income. The internal investment team uses its own bespoke blend of global, high-yield and emerging-market indexes to capture the broadest exposure possible to the total fixed-income universe.
“There is no single index that gives us a suitably broad exposure, so we have customised our own benchmark to capture the fixed-income universe as best we can using existing well defined and well accepted benchmarks.”
The primary index is the Barclays Capital Global Aggregate Bond Index, with the investment team also using an emerging-market hard-currency-debt index and a global high-yield index from the same Barclays family of indices. In addition, the fund also adds into its customised benchmark a global inflation-linked bond index.
“When we put these together, the global high-yield index and the global aggregate index have underlying criteria that creates a small overlap, but they virtually more than 90 per cent of the emerging-markets-debt index,” Iverson says.
“This means that we have emerging markets debt securities already in our customised index, so we have already captured that segment of the market.”
Iverson explains that the internal investment team generally sees little value-add from traditional external managers in the fixed-income space.
“Have we gained a broad exposure to the fixed-income universe is the first question,” he says.
“The second question – to go active or passive – depends on whether we think the manager can outperform the benchmark. Based on our current assessment, there isn’t enough additional return that managers can add in order to make it worthwhile to go active.”
Weighty issues
The current exposure to emerging markets debt is limited to hard-currency exposures.
This exposure represents 1.8 per cent of the fund’s total fixed-income exposure. Because the fund has a more-than-80-per-cent allocation to equities, at the total fund level this represents a 0.4 per cent exposure to emerging markets debt in its benchmark portfolio and 0.2 per cent in its actual portfolio.
Two years ago the fund decided to diverge from allocating assets according to a long-term strategic asset allocation and now actively allocates assets away from a reference portfolio.
Iverson, who was formerly head of Russell Investment Consulting in New Zealand, says that the reference portfolio is comprised of low-cost, simple investments capable of achieving the fund’s objectives. It then becomes a basis against which active decisions are made and assessed
The reference portfolio acts as a measure of the performance of the investment team. In addition, it is also a real measure of the internal team’s decision-making and also acts as a governance benchmark. A small internal team is only needed to operate the reference portfolio.
The approach the investment team takes to indexing its fixed income portfolio takes a lot of the complexity out of the decision-making process around how to maintain a relevant exposure to fixed income relative to increasing proportion of the total fixed income universe.
While the actual allocation to emerging markets is relatively small at this stage, the customised index has the capacity to increase exposure to emerging markets as they become a bigger slice of the fixed-income universe, Iverson explains.
“In the first instance, what we do is we try to capture the market in proportion to its market capitalisation and whatever size of the emerging-markets-debt universe. So, say if there is more issuance, then the market value increases and the weight automatically goes up,” he says. “We don’t have to think about how large the emerging-market universe is becoming and to reweight to it.”
The global trend in emerging markets debt (that sees the market for hard-currency sovereign debt shrinking as more emerging-market countries start issuing debt in their local currency) has provided food for thought for the investment team.
Maintaining breadth of the fixed-income portfolio means that the fund is investigating gaining exposure to local debt, Iverson says.
“There is a reasonable amount of emerging markets debt in local currency that is and has been issued, making it a significant part of the universe,” he says.
“That is something we have looked to investigate and, if there are sufficiently well defined indices, we will customise our index to include them as well.”
In the 1990s emerging markets-debt indexes were limited to external US-dollar-denominated sovereign debt but as interest in the asset class has increased so has the breadth and depth of available indexes.
The JP Morgan family of emerging market-bond indexes contains some of the most widely used by investors.
In the 2000s JP Morgan expanded its coverage of emerging markets debt and launched local-currency Government Bond Index Emerging Market Global. This was followed by an emerging-market corporate bond.
Both local and corporate bond markets have grown strongly in recent times.
JP Morgan reports that as of the start of this year the underlying market value of its Government Bond Index Emerging Market Global Diversified (GBI-EM Global Diversified) was $864 billion.
This compares to $276 billion for its long-established external hard currency benchmark Emerging Market Bond Index Global Diversified (EMBI Global Diversified). The most widely used of its corporate bond indexes, the Corporate Emerging Market Bond Index Broad Diversified, has a market value of $213 billion.
In the two government bond indexes, the hard-currency index is distinguished by the greater number of countries it covers.
The EMBI G Div covers 44 countries, while the GBI-EM Global Diversified covers just 14 countries issuing debt in their own currencies.
Relative weights
Securities must be accessible for foreign investors, resulting in both India and China not being included in JP Morgan’s local currency index due to restrictions on foreign investment.
JP Morgan’s Corporate Emerging Market Bond Index Broad Diversified contained 336 individual issuers as of the start of 2012.
Of the three indexes, the corporate index has the greatest exposure to Asia, with a 40-per-cent weight in the index to Asian corporate securities. This compares with 29 per cent and 19 per cent for the GBI-EM Global Diversified and the EMBI Global Diversified, respectively.
Of the two sovereign bond indexes, there is not a great deal of difference in terms of regional coverage. The local-currency index contains marginally more emerging market Asia and slightly less Latin America relative to the hard-currency index.
The indexes, while broad, capture a slice of the total fixed-income universe.
By 2011 there were more than 70 countries issuing US-dollar-denominated sovereign debt and more than 45 countries issuing debt in their own currency.
As more countries issue investable debt in both local and hard currency, the number of nations included in the index is expected to increase.
Similarly, the local-currency index may include other forms of debt beyond government bonds as companies start to issue debt in their own currency in reaction to a growing local-investor base.
The corporate bond index has also shown traits of increasing diversity.
There has been a marked increase in the regional diversity in the index with corporate issuers from emerging Europe, Africa and the Middle East now making up more than 32 per cent of CEM BI Broad Diversified as of December 31 2011.
While banks remain the largest sector of the index, energy and telecom companies have expanded their market share in recent years.
JP Morgan emerging market bond indexes
| Yield | Duration (years) | Credit quality | |
| EMBI Global Diversified | 5.69% | 7.1 | Baa3/BBB- |
| Corporate EM Bond Index Broad Diversified |
5.8% | 5.2 | Baa2/BBB |
| Government Bond Index EM Global Diversified |
6.23% | 4.6 | Baa2/BBB |
Source: JP Morgan, January 2012
This paper by New York University’s Jonas Prager outlines the major changes in the financial structure as well as the focal events that characterised the 2007-2008 global financial crisis and considers the evidence for the crucial role played by misaligned incentives.
Misaligned incentives, bank mismanagement, and troubling policy implications
The Californian pension funds, CalPERS and CalSTRS, have taken a leadership role in promoting corporate board diversity, demonstrated in the launch at the NYSE this week of 3D with GMI Ratings, and membership in the Thirty Percent Coalition.
3D, which stands for Diverse Director DataSource, is a databank of pre-approved board candidates with an emphasis on highlighting people with fresh ideas and new perspectives.
The initiative is consistent with the funds’ focus on long-term shareowner value.
Anne Sheehan, director of corporate governance at the $150-billion CalSTRS, says 3D is a market solution to a supply-and-demand problem.
“As promoters of long-term shareowner value, we’ve been demanding greater diversity on the corporate boards of our portfolio companies for some time. Now we’re prepared to provide a tool to supply corporate-search firms and nominating committees with a deep breadth of quality board candidates. These professionals can not only do the job, but approach issues from diverse perspectives forged by a wide variety of backgrounds and experience, as well as by gender or ethnicity.”
Anne Simpson, CalPERS senior portfolio manager and director of global governance, says 3D is an innovative resource that opens the door to finding candidates whose fresh ideas and new perspectives can help companies generate lasting value and provide a check against the kind of ‘group think’ that played a significant role in the financial crisis.
Chair of GMI Ratings, Richard Bennett, says corporate boards work best when they reflect a diversity of perspective and experience.
“With 3D, we created an accessible resource to help companies and recruiting firms identify and recruit candidates sometimes overlooked under traditional search processes. We encourage candidates to continue submitting their credentials for review.”
GMI Ratings is an independent provider of global corporate-governance ratings and research.
It makes business sense to embrace more women
Separately the funds, as part of the Thirty Percent Coalition, sent a letter urging change to the 41 S&P500 companies that do not have any women on their boards.
The Thirty Percent Coalition is a group of pension funds, state officials, fund managers and women’s groups that is pressing for gender diversity on corporate boards.
According to reports by Catalyst, ION and Governance Metrics International, women only hold between 12 and 16 per cent of corporate board seats.
Studies have shown there is a correlation between greater gender diversity among corporate boards and management, good corporate governance and long-term financial performance.
The Thirty Percent Coalition project leader, Charlotte Laurent-Ottomane, says substantial research underscores the correlation between gender diversity, good governance and positive long-term corporate performance.
“We are urging the business community to embrace this elemental truth.”
The letter references quotas being adopted in numerous countries around the world to increase the number of women on corporate boards but proposes instead that companies in the US voluntarily embrace more ambitious diversity goals because it makes business sense.
The group has set a three-year time line by which it would like to see 30 per cent of corporate board seats held by women.
CalSTRS’ Sheehan says the group intends to follow up and engage with each of the 41 companies, asking them to “welcome women to their boards”.
“Whether it’s in dialogue with management, through shareholder resolutions or related strategies, we intend to press for change. And then we’ll move beyond the S&P500 to other companies as well. Our goal is to continue engaging companies until women hold at least 30 per cent of corporate board seats across the United States.”
Of nine board members at CalSTRS, women hold three positions, including the chair, Dana Dillon.
At CalPERS there are only two women on the board.