PHOENIX, Ariz. - The Arizona State Retirement System, looking for better performance and lower operating costs, restructured its international portfolio and is in the early stages of moving the management of some of its equity assets in-house.
The $10.9 billion pension system increased its international equity exposure to 14% of assets from about 9% and redistributed the assets among four of its existing managers, said C. Douglas Lemon Jr., investment officer.
Three other existing managers remain under contract in anticipation of an even higher international allocation, though they are not now managing any money for Arizona.
About three-quarters of the new $1.5 billion international portfolio is in quantitative strategies, with Axe-Houghton Associates, Rye Brook, N.J., and Wells Fargo Nikko Investment Advisors, San Francisco. Capital Guardian Trust Co., Los Angeles, is running $154 million in a Canada-U.K.-Europe active portfolio.
Mellon Capital Management, San Francisco, which had been managing $540 million in a Morgan Stanley Capital International Europe Australasia Far East Index account, continues to manage $140 million in that strategy.
The system's other international managers - J.P. Morgan Investment Management Inc., Clay Finlay Inc. and Schroder Capital Management International, all of New York - remain under contract. Mr. Lemon stressed it was a deliberate decision to keep the firms under contract while the fund tries out the new strategy.
The state Legislature last year raised the limit on international assets to 15% from 10%. Mr. Lemon has hopes it will be raised again this year to 20%. He believes that to properly represent the capital markets, international assets should be a minimum of 25% of total assets.
The Arizona system also is in the preliminary stages of bringing up 20% of its equity assets in-house, following a report from the state auditor general.
The report, which came out in September, recommended the system could reduce rising investment management costs without jeopardizing performance by moving assets in-house. Investment management costs for the system's 14 managers totaled $10.3 million in 1993 and it was estimated in the report that they would reach $15 million or more by 2004. The report recommended that once an effective in-house investment program was in place, the system should request the Legislature increase the amount beyond 20%.
Mr. Lemon said funding for the internally managed portfolio would come from the system's passive domestic core equity assets. He would not be more specific, but did say the assets would not come from the system's active managers. The staff, he said, is in the process of installing asset management software: BARRA Inc.'s Alphabuilder for portfolio construction and risk analysis, and Wells Fargo's Style-Index Global Management Analytics. The staff also will have access to Bloomberg Financial Markets databases.
The investment staff will run shadow portfolios before gradually moving the $2.4 billion in-house. It is most critical, Mr. Lemon said, to get the infrastructure set up.
In the past, the system has managed short-term cash and bond portfolios internally. None has been managed internally, however, since 1989.
The process of changing its international portfolio started with an asset allocation study and manager performance review of its six international managers by consultant Mercer Asset Consulting, Los Angeles. It was followed by an asset/liability study by the fund's actuary, The Wyatt Co., San Francisco. Mr. Lemon said the liability study was necessary to make sure the changes he was proposing would work.
The objective of the reallocation is to improve the overall performance of the fund, increase its commitment to international diversification and reduce operating costs.
The portfolio has a geographical focus with just less than 50% of the international equity assets in countries in the MSCI EAFE Index and just more than 50% in the Pacific Rim.
Mr. Lemon said that in 1992, when the system had 9% in international equities, fees and transaction costs were higher for international than for the entire rest of the fund's portfolio.
"The management costs, custody costs, and transaction costs were through the roof," he said.
As part of the restructuring, the system put $187 million in an ADR Japan/Pacific Basin index fund with Axe-Houghton, using the MSCI Pacific Index as its benchmark. The choice to use ADRs is a custody decision, Mr. Lemon said. The advantage to ADR shares is that they can be traded anytime, even if a market is closed, which gives the assets additional liquidity. There is also a savings in custody, currency transaction and stock transaction costs.
Axe-Houghton, which was managing $140 million for Arizona in an ADR EAFE index fund, received an additional $400 million it put into that strategy.
Arizona hired Wells Fargo Nikko to manage $500 million for its Country Selector Fund strategy. The assets were shifted from a core equity account managed by Wells, said Mr. Lemon.
The quantitative asset allocation strategy uses country selection, the way a domestic tactical asset allocation strategy may use stocks, bonds and cash, or stocks and cash, depending on the model. The strategy provides incremental performance by adjusting country weights based on expected returns of the 20 equity markets in the EAFE index, Mr. Lemon said. Mr. Lemon said Arizona is the first client for the program.
Mr. Lemon believes strongly in the value of quantitative strategies and said they add the most to the portfolio as a way to reduce risk.
The system's domestic TAA strategy, also run by Wells Fargo Nikko, has been a success in enhancing the total portfolio's return, he said.
The portfolio has always exceeded its benchmark, the Standard & Poor's 500 Stock Index, he said. The system has $2 billion in the strategy.