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The Big Giveaway Begins -- With So Many Questions
The Regents have launched the first
phase of their Multiple External Manager Strategy for domestic equity
A selection is now in progress for Small Cap investment companies who will
share about $1 billion in UC funds. Here I review the information that
UC officials have made public; and I also raise many questions about
issues that have been overlooked (or kept secret.)
In earlier issues (starting with Part 13) I raised questions about whether the UC Regents' hired experts (Treasurer David Russ and investment consultant Wilshire Associates) had been competent and objective in their evaluations of the past performance of UC's internal investment staff and I also questioned the wisdom of their recommendation - approved by the regents in secret session last November - to shift $13 billion in stock-holdings to an external index fund for subsequent distribution to external money managers. The implementation of this big giveaway has been slow, as Treasurer Russ gradually assembled a new staff in his office to be the managers-of-managers. At the August 26 meeting of their Committee on Investments, the regents were given two reports: one in Open Session ("External Manager Search Process and Personnel") and another in Closed Session ("Investment Strategy: Funding of External Managers").
I'll first summarize what is available from the public documents, then go over many questions that have been either overlooked or deliberately hidden from public view (why?).
The Overall Plan
Here are the main points of the plan as presented to the regents on August 26. The first search is for Domestic Equity Small Capitalization investment managers. For an estimated total of $1.0 Billion, five to eight managers will be selected by an RFP (Request for Proposals) process starting Fall 2003, with funding to extend through early 2004. Subsequent RFPs will be for Large Cap Domestic Equity (estimated $5.2 Billion) and International Equity ($1.6 Billion.) Both the Treasurer and Wilshire Associates will be responsible for the manager selection. That process will involve both quantitative and qualitative evaluations of the submitted proposals and site visits with the finalists. [I note that the stated Manager Evaluation Process includes , "Examine past investment returns to determine risk-adjusted out-performance of appropriate benchmarks and peer groups." Much of my previous criticisms of the UC Treasurer and Wilshire was that they failed to conduct any such "risk-adjusted" evaluation when they looked at the past performance of UC's internal investment staff - and recommended their wholesale termination.] The new plan envisions quarterly reports to the Regents on the performance of the individual external managers, with their success (or failure) to be measured over a 3 to 5 year cycle.
The Small Cap RFP was posted on the UC Treasurer's website September 16 (www.ucop.edu/treasurer) containing detailed instructions for all applicants; and a set of Questions and Answers was posted shortly after that. The deadline for submission was October 17; and so I presume the internal evaluation process is now underway.
What follows is my
a list of topics that appear to be absent or inadequately presented in
these public documents. How do I (an admitted amateur in this highly
field) know how to spot something that is missing? I use as a reference
the information provided on the website of CalPERS, the nation's largest
public pension fund which has most of its actively managed investments
with external management firms. I also read the daily newspaper, which
carries stories about unfolding scandals on Wall Street.
The quarterly performance reports from the external investment managers will certainly have to be made public by UC, along with a lot of other information (as CalPERS does). The Regents need to have a clear understanding of their obligations to keep employees, retirees and the public well informed (under law and under their fiduciary responsibilities); and the RFP applicants should be well informed of those issues from the beginning. Let's have no repeat of the recent disclosure battle over private equity investments.
Apparently, UC does not provide a sample contract for applicants (or you and me) to see. Certainly the final contracts, after any negotiations are completed, will be public records. Why not set out UC's "rules of the road" in advance?
At present, UC has offered no guidelines as to
what management fees (fixed fees and incentive fees) it considers
applicants are merely asked to submit their bids. In an earlier paper (Part
16) I presented some data on CalPERS' payments of management fees; and
the numbers there looked surprisingly large - almost as large as fees paid
by retail customers in mutual funds. See Table 1, below, reproduced from
|Fiscal Year (ending 6/30)||2002||2001||2000||1999||1997|
|Total Amount Managed||10||12||13||12||9||$Billion|
|No. of Ext. Managers||16||21||16||11|
|Ext. Management Fees||77||40||--||18||8||$Million|
Data from Annual Investment Reports, available online from CalPERS (some
of these concerns, UC Treasurer David Russ gave an interview to Professor
Larry Waldron, who then reported it in the May issue of Berkeley Emeriti
Times. According to Waldron, "Treasurer Russ stated that management
fees would be far less than some that have been quoted. UC is a big player,
and managers will be eager to have its business." If bigness is the key
to low management fees, how does Russ explain the CalPERS data?
In addition to management fees, there is the issue of commissions paid to brokers on stock purchases and sales. This also needs a lot more attention.
In Table 2, below, is
data from CalPERS on the volume of transactions (stocks bought and sold)
and the commissions paid on those transactions for all of their externally
managed equities (both domestic and international). WARNING: This
data can be very disturbing if taken at face value. The huge volume of
transactions in several years suggests a gross excess of churning; the
figure for commissions paid in 1997 is incomprehensible. My several
to get some explanation of these numbers from CalPERS staff have been
Assuming there is some sensible explanation for those excesses, the data
shown for Total Commissions Paid in recent years (amounting to about 0.2%
of assets) is still significant.
|Fiscal Year (ending 6/30)||2002||2001||2000||1999||1997|
|Total Amount Managed||18||18||--||39||32||$Billion|
|Volume of Transactions||224||3||--||479||208||$Billion|
|Total Commissions Paid||35||30||--||18||3,135||$Million|
Data from Annual Investment Reports, available online from CalPERS (some
One special aspect of
commissions is the possibility of large transition costs when this program
is first set up or when there is a change of managers. UC's available
give no clue on what to expect in this regard.
This is an arrangement whereby the client (UC) tells its external managers to do their stocktrading through a selected broker, with some pre-arranged discount rate of commissions. The RFP asks applicants what they are used to in this regard but indicates no plans or preferences on UC's part.
Soft Dollar Arrangements
This is the ambiguous (but legal) practice whereby a broker charges large commissions to select investment managers and then offers a kickback in the form of various investment "services". This topic, also, is merely mentioned in the RFP with no indication of any preferences which UC may have about this practice. CalPERS has a detailed policy on Directed Brokerage and Soft Dollars; and some investment companies explicitly shun the Soft Dollar business because it is hard to be sure (and hard to reassure clients) that everything is being done fairly. The Regents need to have a full and open examination of these, and other, dubious practices in the commercial investment industry.
Open vs Closed Process
In the interview with Professor Waldron, cited above, we are told that Treasurer Russ stated "that he would be very much in control, choosing managers in an open process." [Emphasis in original.] However, according to the plan presented at the August 26 regents meeting, the manager selection process will be entirely closed, with the identity of the chosen managers made public only after they have been contracted and funded.
Conflict of Interest
There ought to be some clear protocol by which the UC staff vets any proposed investment contract for possible conflicts of interest. This applies not only to UC officials (regents, et al) but also looks at potential conflicts of interest within and among the investment management companies. This is now a hot topic in newspaper stories.
The latest round of Wall Street scandals,
by New York's AG, Eliot Spitzer, concerns market games played by mutual
funds, big investors, consultants and other industry intermediaries --
market timing, late trading, fast trading, etc. -- which may violate the
law, or merely violate company policy, or may merely rob the majority of
client investors for the enrichment of special parties. One large firm
recently caught up in these scandals is Putnam, which turns out to be one
of the major firms used by CalPERS as an external manager. Here, again,
the Regents ought to develop, in advance, a clear set of stringent policies
applicable to any firms with which it may contract. UC should write its
ethical performance standards into any investment contracts, with explicit
penalties for any later infractions. This will be not only an act of good
citizenship (helping to clean up an infected industry on which many people
rely) but it also protects UC's own financial self-interest.
The Story on Wilshire Associates
This story first appeared in Money magazine (October 2003), titled, "The Great Mutual Fund Rip-Off", and has been followed by stories in several newspapers. One of the firms found to have skimmed millions of dollars from mutual funds via "fast trading" activities is UC's own investment advisor Wilshire Associates.
Here is how some of the schemes work. Mutual funds set the price of their shares at the close (4pm) of each market day. Significant news affecting particular stocks is typically released after market closings. So if a player can anticipate that the price of a mutual fund share will rise (or fall) at the opening of the next day's market, he could make a sure bet by buying (or selling) at the former day's price. To prevent this abuse, respectable mutual funds forbid such "late trading" activity or place a stiff penalty on related "fast trades". Now it turns out that some mutual funds have allowed certain insiders and also certain outsiders to engage in such illicit profiteering.
Today's headline in the New York Times, "Mutual Fund Accused of Fraud in Rapid Trading by Managers - Suits Are the First in a Widening S.E.C. Inquiry", leads into the story of Putnam Investments, a $272 billion money management firm. "The S.E.C.'s suit contends that a total of six Putnam employees, ... reaped gross profits in excess of $1 million in their personal trades", described as "quick in-and-out trades", even though the stated company policy forbade such activity.
By comparison, the Money Magazine story says that Wilshire Associates' chief executive, Dennis Tito, cooked up a scheme that led him to invest $100 million in rapid trading of several mutual funds, providing more than 100% return per year with very little risk. How did he manage to circumvent the funds' policies and penalties that are designed to prevent just such churning? Apparently, it was done with the funds' willing cooperation. As the writer, Jason Zweig, tells it:
"Wilshire would not respond to my inquiries in further detail, but disturbing questions remain. Was it a conflict of interest for fund companies - who knew that Wilshire might (or might not) recommend them when its clients searched for money managers - to let Wilshire yank $10 million a day in and out of their funds?"Now, Wilshire, as UC's investment consultant, will be at the center of decisions on which external investment managers will get UC's money. If you were a regent, what would you say about this?
Conclusions and Recommendations
It is likely that at least some of the issues I have noted above have been discussed with the Regents in Closed Sessions. (It would be even more shocking if they were not.) But why should those discussions of investment policy be kept away from public eyes and ears ?
One small sidelight of the recent litigation (see Part 18) was an amicus brief submitted by AARP, which stressed the fiduciary responsibility of the Regents, as trustees of the pension fund, to provide full information about their activities to the plan beneficiaries, employees and retirees. Those are precepts that stand in addition to the state's Open Meetings law and Public Records law.
Perhaps the lowest point in those proceedings occurred when UC's lawyers delivered a pile of documents to our lawyers, documents from the UC Treasurer's office which had been requested months earlier and had only recently been "found." Inexplicably, there was a yellow post-it on the cover page of one of those documents, bearing the handwritten message: "Too complicated David does not want to disclose ". Hopefully, when the lawsuit is finally settled (they are still appealing the judgments against them) we shall see some improvement in the behavior of the Regents and their staff.
The several questions about ethical standards, potential conflicts of interest, soft dollar arrangements, etc., are issues that require the UC Regents to first set out policy guidelines and then present those to applicants for the external manager jobs. As things now stand, it will be up to UC's staff (Treasurer Russ and his assistants, with advice from Wilshire) to make the decisions. How will they choose to balance the relatively good ethical standards of one applicant against the relatively low fee proposal of another, against other disparate virtues (or the lack thereof) among the many RFP respondents?
My Recommendations: This giveaway program of money going to outside investment managers should be put on hold until all the above questions are fully aired and resolved by The Regents. I also believe that Wilshire Associates' role in UC's investment program should be suspended until the questions about their conduct are completely resolved. Prudence, I believe, requires nothing less.