by Charles Schwartz, Professor Emeritus, University of California, Berkeley
email@example.com October 23, 2000
>> This series is available on the Internet at http://socrates.berkeley.edu/~schwrtz
Contents of the Series
Part 1 - Introduction; Digging into the Wilshire Report
Part 2 - Further Problems with Wilshire's Study for the UC Regents
Part 3 - a) Unwarranted Secrecy in the Regents' Doings
- b) Trying to Evaluate the UC Treasurer's Performance
Part 4 - Questions on Safety of the Fund; Diversification; Oversight
Safety of the Pension Fund
As quoted in Part 1, from the Regents' Joint Statement of July 19, 2000:
"First, we want to assure employees that their pension funds are safe and that they will continue to be safe. Safety of the pension funds is the uppermost concern of the regents, and it will continue to be. Safety was a major impetus in deciding to undertake a comprehensive review of investment activities."
The Regents, in adopting Wilshire Associates' recommendations for a new Investment Strategy designed to Reduce Overall Portfolio Risk, claim that they have improved the safety of the pension funds by virtue of the following measures:
In this paper I examine these claims and
find that the main ones are phoney, others are dubious, and some may do
more harm than good.
Diversify Equities - by adding non-U.S. investments
Wilshire recommended, and the Regents agreed, that 7% of Equities in UCRP and GEP should be put into non-U.S. stocks. They further recommended that 1% should be in emerging markets, and 6% in markets of developed countries. As Wilshire states (page 8 of their report),
"The 0% policy allocation to non-U.S. equities for the UCRP is in sharp contrast with the asset allocation practices of other pension plan fiduciaries. The idea that non-U.S. stocks help diversify a portfolio and should be a permanent component of an asset mix policy is now almost universally accepted."This opinion has been echoed in comments I have received from a couple of correspondents; and I accept it as sound advice.
Let's check some facts.
The UC Treasurer's Office publishes its investment portfolios on the ucop web site, updated every six months. I looked at these listings, which show the stockholdings and market value for each company represented in the UCRP Equity holdings and noticed the names of a number of companies that are not based in the U. S. In order to check on the definition of "non-U.S. equity", I compared the UCRP listings with the Russell 3000 list, which Wilshire uses to define "U.S. Equity". In this way I determined that non-U.S.Equity actually amounted to 7.5% of the total UCRP portfolio as of 6/30/00. The percentage was 8.9% at 12/31/99 and 6.6% at 6/30/99. Furthermore, 1% of this was already in "emerging market" funds, just as Wilshire recommended.
How could Wilshire say that the non-U.S. component was 0%? Actually, on page 16 of their report, Wilshire does acknowledge that
"The Treasurer's Office currently uses three outside money management firms to manage approximately $0.4 billion in emerging market equities ... [which] coincidentally equals Wilshire's recommended 1% of assets target for emerging markets."But nowhere could I find any acknowledgment of the much larger amount already held in equities of developed markets (Europe and the Far East). Wilshire's Summary (on page 1) says, "The recommendation [on Asset Allocation], if adopted, would require a 10% reduction in U.S. equities and redeployment as follows: 7% to non-U.S. equities and 3% to private equity." This statement is counterfactual.
If this is merely another error, added to the many others I have previously noted in the Wilshire report, it could only arise from an extraordinary degree of incompetence or sloth on the part of that firm. (When you look at the UC portfolio listing, you do not have to be conversant with all the company names in order to recognize non-U.S. stocks; the giveaway initials, PLC, LTD or ADR are apparent to anyone.) One cannot ignore the possibility that this failure on Wilshire's part was a deliberate act intended to misrepresent the facts and mislead their client - i. e., an act of fraud.
Next, we must ask, How could the Regents not be aware that the UC Treasurer's portfolio already contained substantial amounts of non-U.S. stocks? Probably some members of the Board have never looked at the Treasurer's portfolio listing or even read the Treasurer's annual reports. But those regents serving on the Committee on Investments - and most certainly the chair of that committee - must have known this. Here, again, we need to see the Minutes of those closed meetings - when the Regents received, discussed and approved Wilshire's report.
What we can now say with certainty is that
this flagship of the "new" policy adopted by the Regents, following Wilshire's
recommendation, did not add anything new by way of diversification (safety)
to the previous investment practices of the UC Treasurer.
Diversify Equities - by including medium and smaller sized companies
This is to be achieved, according to Wilshire, by using an external index fund, based upon the Russell 3000 index, and also mandating the Russell 3000 index as the benchmark for the stocks to be actively managed by the UC Treasurer's Office.
The UC Treasurer has, in the past, concentrated its U.S. equity investments in large cap stocks (companies with a market capitalization of over $10 Billion.) Presumably some benefit is gained by diversifying into the medium and small cap stocks covered by the Russell 3000 index. But how much of a benefit is that? Wilshire is (or pretends to be) quantitative in other parts of its analysis, let's try some quantification here.
The thing to understand about diversification is this. While some fluctuations in stock prices are due to unpredictable events affecting individual companies, other fluctuations are due to large scale swings in whole sectors of the market. Furthermore, there are significant correlations between the fluctuations in different portions of the market. The documents from Callan Associates, which I mentioned in a previous installment, give some numerical data on the correlations between different asset classes. For this discussion about large cap domestic equity being diversified into broad domestic equities, Callan quotes a "correlation coefficient" of 0.96. If I understand it correctly, this means that 96% of the time, when the large cap asset class (e.g., the S&P 500) goes up (or down), the broad asset class (e.g., the Russell 3000 index) also goes up (or down) synchronously. So you don't get much benefit from diversification using this particular strategy.
And, again, let's check the facts. The
UC Treasurer's annual report for 1999 mentions that the UCRP portfolio
already has 8% in Mid-Cap U. S. Equity. So, once again, we find that
this improvement in safety, advertised by Wilshire and bought by the Regents,
amounts to no improvement at all.
Diversify management risk by using an external index fund
I think this is just the basic selling point of index funds: If stock-picking is too difficult or too unreliable, index funds will be glad to take the money off your hands. The management fee is not much at all; but the real cost is the lower rate of return you can expect, compared to what you get from a really good team of active investment managers - of the sort we have documented for the UC Treasurer's Office.
Does it make sense to split your investments, part into an external index fund and the rest left to in-house managers - as a way to hedge? I am not at all sure about this. It would seem that such decisions are best based upon demonstrated performance. Since UC had a team that consistently beat the index funds, why not use it fully?
On the other hand, if your goal were to destroy
the in-house talent and then leave index funds as the only alternative,
this salami approach could be very effective. I wonder what other experts
think about this.
Fixed Income Investments
According to the Wilshire report, the changes that it recommended for the Bond portfolios had already been agreed to by the UC Treasurer's Office, which will continue to manage these investments. Thus it appears that this topic is non-controversial.
I do note, however, that the percent of UCRP fixed income portfolio in non-investment grade bonds was only 6.3%, as of 6/30/99, well within Wilshire's recommended limit of 10%. So it is not clear that this aspect of the new policy represents any real improvement in safety. Perhaps it is just a formal codification of sensible guidelines that were already effective in practice.
In UC's official "Summary of Investment Policy
Changes" (dated August 7, 2000, from Regent Judith L. Hopkinson, Chair
of the Committee on Investments
) I find, "Maximum % in Foreign Bonds - 10%"; and the Treasurer's annual
report for 1999 says that the UCRP fixed-income portfolio contains a total
of 21.9% in foreign bonds. However, in the Wilshire report, on page
26, there is a very different statement of the new guidelines for fixed
income investments: a limit of 10% that can be invested in "non-U.S. dollar
denominated securities" or in "the sovereign debt of any individual non-U.S.
G-7 country." In this contradictory situation, I cannot tell what
this purported change really amounts to.
Prior to this year (2000), UC's Treasurer had complete responsibility for the management of investments and other financial activities of the University, carried out under the policies established by The Regents, and she would report on a quarterly basis to the Regents Committee on Investments. The decision to bring in an outside consultant and to establish some regular mechanism for external review of the Treasurer's Office by independent experts is an improvement on safety with which I completely agree as a matter of principle. (The University regularly employs outside auditors and other experts to review its business policies and practices; academic departments are subject to periodic review by panels of outside peers; etc.)
My complaint is that Wilshire Associates, The Regents' chosen consultant, has done an unbelievably lousy job in evaluating UC's investment performance and proposing alternative investment policies. Now let's look at the recent changes in oversight structure that The Regents have adopted.
First, they amended their ByLaws to make the Treasurer no longer an independent Officer of the Regents but rather a subordinate of the President:
"ByLaw 21.4a The Treasurer ... shall, subject to the direction of the President of the University, oversee the provision of all investment services to the University."
Second, they established an "Investment Advisory Committee", consisting of three regents (the President and two others from the Committee on Investments) plus outside investment experts, charged to oversee and evaluate all aspects of the investment program: Investment strategy and policies; Asset allocation; Investment guidelines; Selection of outside consultants and investment managers; Oversight of the Treasurer's Office (staffing and budgets); Review quarterly investment performance and portfolios; Recommend hiring/termination of investment managers; etc.
The result of these changes appears to be that
the position of Treasurer is stripped of primary authority and reduced
to that of a functionary. I guess this is how you push an established
professional to resign; and I imagine that this will also make it very
unlikely that they will be able to hire anyone of comparable abilities
to replace her. In other words, I suspect that by overdoing the expansion
of "oversight" they may lose a substantial portion of the top quality talent
that made this office so productive in the past. (Kill the goose that laid
the golden egg.) That would cost the University many $ billions in
the years ahead; but it would advance Wilshire Associates' own interests
- getting pension fund trustees to put more and more of their assets
into index funds.
A cartoon by Roz Chast in The New Yorker (10/16/00
page 192) is captioned "How The Old Penn Station Got Demolished". The picture
shows three officials sitting around a table. Their mood is gleeful as
- "I have an idea! Let's tear down one of the most beautiful structures in New York!"
- "And replace it with something REALLY CRAPPY!"
- "It'll take time and cost a fortune, but it'll be worth it!"
With such a long list of faults found in the Wilshire Report, the most plausible conclusion I can come to is that their review of the UC Treasurer's Office was intended to be a hatchet job.
What, then, about the regents?
Could one imagine that all of them are part of a secret plot? In
the next (and probably last) installment I'll present a theory that tries
to make sense of their roles in this story.
Readers: Keep that feedback coming.