SACRAMENTO, Calif. - The $7 billion tactical asset allocation portfolio of the California State Teachers' Retirement System has underperformed recently and is presenting problems for Chief Investment Officer Thomas Flanigan, just as he comes up for contract renewal.
The TAA portfolio underperformed its benchmark by 850 basis points - or by more than $500 million - for the year ended June 30. The portfolio is directed by Mr. Flanigan and his internal investment staff.
(No long-term performance history is available, even though CalSTRS has used TAA for 10 years, because a formal report has only been developed in the last year to 18 months.)
Alan Emkin, a principal of Pension Consulting Alliance, Studio City, Calif., CalSTRS' consultant, told trustees the TAA portfolio is the major reason the $65 billion fund has underperformed in recent months.
Indeed, CalSTRS' performance has fallen behind that of the $100 billion California Public Employees' Retirement System, which is troubling some trustees. Longer term however, the two funds' overall performance is about even.
The tactical portfolio, called the Asset Deployment Portfolio, is supposed to outperform a passive neutral portfolio benchmark, according to Mr. Emkin's report. The benchmark is 45.5% equities, 45.5% fixed income and 9% cash.
Mr. Flanigan believes one year is too short a period to judge the performance.
The tactical asset allocation portfolio returned 2.4% for the year. The neutral portfolio returned 10.9% for the year.
The difference between the $133 million gained by the tactical portfolio and the potential $657 million from the neutral portfolio is $524 million.
Of the $524 million opportunity cost, Mr. Emkin told trustees $503 million of it resulted from "deployment decisions."
The investment staff put 90% of the assets of the portfolio in fixed income and none in equities at a time when the U.S. stock market has been producing record results.
In response to the criticism, Mr. Flanigan said he can't explain why Mr. Emkin's report on the TAA portfolio didn't include information about CalSTRS' longer-term performance for the entire fund or information about the fund's policy to seek undervalued asset sectors.
Mr. Emkin couldn't be reached to comment or to supply risk-adjusted return numbers.
Mr. Flanigan said he is disturbed with the narrow focus on the short-term performance of his TAA fund.
CIO search continuing
Meanwhile, at a recent board meeting, trustee Emma Zink expressed displeasure that Mr. Flanigan was the only candidate for CIO following a request for proposals in which 120 people made inquiries.
"I want competition very keenly," Ms. Zink told James Mosman, CalSTRS' chief executive officer. Mr. Flanigan's contract is up at the end of the year.
The board subsequently decided to find an executive search firm to make certain there were other candidates besides Mr. Flanigan.
To get candidates to compete against Mr. Flanigan, Mr. Mosman said he might have to lower the standards from what the original RFP required - seven years of investment experience and three years as a chief investment officer.
According to sources familiar with the teachers' fund, Mr. Flanigan hasn't been humble and has been reluctant to make some changes in money managers. That reluctance might have rankled some powerful people at the fund, the sources suggest. But, they say, Mr. Flanigan has a good reputation in the investment community and for someone at his compensation level, the board will have trouble finding better talent.
Performance an issue
Mr. Mosman said concern about underperformance of the TAA fund is one factor some board members cite to seek competition for the CIO post.
For the year ended June 30, the teachers' fund has fallen behind the public employees' fund, 13.2% vs. 15.3% in total performance.
But according to figures supplied by Mr. Flanigan, CalSTRS has outperformed CalPERS in annualized performance 11.9% vs. 11.6% for the 10 years ended Dec. 31, 1995. The two funds are dead even at 12.7% for five years on an annualized basis.
Mr. Flanigan said the teachers' fund has outperformed CalPERS in seven of the 10 years he has been with the fund. His investment staff has increased the funding level to 88% from 58% - which he said "was the worst in the country" when he came.
The public employees' fund can afford to take more risk than the teachers' fund because CalPERS is 100% funded, said Mr. Flanigan. "People talk about relative performance, but they don't talk about risk," he said.
Even for the 10 years ended June 30, CalSTRS is in a virtual dead heat on an annualized basis with CalPERS, 10.7% vs. 10.9%, according to Mr. Flanigan.
"We have moderately to substantially less risk than CalPERS does. The reason is because we have more bonds and they have a lot more stocks," he said.
"CalSTRS has a much more risk averse strategy."
CIO explains underperformance
Given the fund's emphasis on buying undervalued asset classes and minimizing risk, CalSTRS' portfolios are expected to underperform some other large funds for short periods, Mr. Flanigan said.
"Fundamentally what we are trying to do is push the cash flow into areas of undervaluation and away from areas of overvaluation," said Mr. Flanigan.
"You cannot take a look at this fund on a short-term, snapshot basis," he added.
In keeping with CalSTRS' adopted strategy, Mr. Flanigan has emphasized bonds in the TAA portfolio because his information tells him the U.S. stock market is significantly overvalued. The emphasis on bonds, he said, has lowered the fund's risk.
Since 1991 and the Japanese stock market collapse, he said, CalSTRS has been putting half its cash flow into international equities. Again, that was part of the board-approved diversification strategy, said Mr. Flanigan.
But in the short term, that move to put 18% of fund assets in international equities has hurt fund performance. For the three years ended June 30, the Standard & Poor's 500 Stock Index returned an annualized 26% while the Morgan Stanley Capital International Europe Australasia Far East Index returned 13.6%.
Yet, it is in the international markets where growth likely will be, he said.
Over the last three years, the remaining cash flow has been going into the TAA portfolio. The "sensitivity" of that fund has been toward valuation and globalization, said Mr. Flanigan.
"In 1994, the Fed tightened (interest rates) by the greatest margin and in the shortest period I have ever seen happen," said Mr. Flanigan.
With long bonds providing 8.25% coupons after the tightening, CalSTRS bought zero-coupon and long-coupon bonds.
"Most people don't know that long bonds outperformed stocks last year," said Mr. Flanigan. But the bond market did have a correction in the early part of this year.
Using information from asset allocation models and think tanks, Mr. Flanigan is convinced "the stock market has become increasingly overvalued."
A 'prudent, defensive' approach
He has taken a "prudent, defensive" position, he said, and lowered the total fund's risk compared to two years ago.
"The bottom line is that if something goes wrong in this stock market - and I hope it doesn't - we are going to be in a very defensive position that we think is the cautious and prudent approach," said Mr. Flanigan.
The S&P 500, said Mr. Flanigan, now has a capitalization that is nearly as great or greater than the country's gross domestic product. "That has never happened before," said Mr. Flanigan.
Last year, about $250 billion went into the mutual fund equity markets, said Mr. Flanigan. To have 10% to 15% growth next year will require about $700 billion to go into the mutual fund equity markets to sustain this growth in the stock market.
"In most people minds, this (U.S. market rise) is a speculative bubble," said Mr. Flanigan.
"Functionally, this (CalSTRS) process is meant to recognize trends - not to trade the portfolio," said Mr. Flanigan.
He said the trend-watching process has worked before. CalSTRS stayed out of real estate in the late 1980s and stayed out of the international securities market until the Japanese market collapse.
Regarding the current criticism of him on shorter-term performance, Mr. Flanigan said: "Obviously some people have an agenda here. They want to take a look at a worst-case scenario and highlight it. Nobody was here to tell everybody what a great job they did last December."