SACRAMENTO, Calif. - Underweighting in domestic equities, which cost the California State Teachers' Retirement System an estimated $1.8 billion in returns last year, has pushed forward board member plans for an asset allocation review for the fund.
The $1.8 billion was calculated by state Controller Kathleen Connell, who called it a "loss" and blamed it on the fund's low domestic equity allocation.
What began earlier as concern over performance of CalSTRS' $7 billion tactical asset allocation portfolio grew at the February board meeting into an issue over the $68 billion fund's entire investment policy and set off heated exchanges among board members and staff.
Several board members said they want to increase the allocation to domestic equities and know more about how fund policy is guided by the Chief Investment Officer Thomas E. Flanigan. They also want to review the overall asset allocation earlier than the scheduled review in June.
Urging caution
But Mr. Flanigan criticized by board members for the conservative investment stance and continued to urge caution.
"The (domestic) stock market is dramatically overvalued," said Mr. Flanigan. "I urge you not to rush to judgment. The ship is not sinking."
Mr. Flanigan's resistance to a significant increase in domestic equities was met with some questions about whether Mr. Flanigan varied from board directives to him in the past.
While the domestic equity market returned more than 20% in 1996 - the Standard & Poor's 500 returned 22.96% - Mr. Flanigan indicated it was due for a correction. And his expectation in 1996 that bond values would be increasing didn't happen. The Lehman Government Corporate Bond Index returned 2.9% in 1996.
Board members declined to discuss how much, or when, they'd increase domestic stocks, saying they didn't want to tip their hand to other investors.
By the end of the third quarter 1996, the fund had 32.3% of total assets invested in domestic equities. (Between international and domestic stocks, the fund has 50.7% of assets invested in stocks.)
Criticizing performance
Ms. Connell deplored the fund's performance and low domestic equity exposure, saying the fund suffered a $1.8 billion "loss" in calendar year 1996.
Using her office's own calculations of comparative performance, Ms. Connell said CalSTRS would have $1.8 billion more in assets at the end of 1996 if it had performed as well as the $108 billion California Public Employees' Retirement System, also in Sacramento.
Ms. Connell said CalPERS hasn't performed all that well, either, and she also is concerned about that fund's investment performance. For calendar year 1996, CalPERS was ranked in the third quartile by the Trust Universe Comparison Service for public funds with assets of at least $1 billion, while CALSTRS ranked in the 95th percentile.
Ms. Connell - an ex-officio member of both pension fund boards - ripped what she portrayed as a CalSTRS' defensive investment strategy gone awry. She said she was "horrified" by the poor performance and contended the fund had been falling further behind all through 1996.
Ms. Connell's concerns were shared by several other vocal board members, including Natalya Smith, representing the state treasurer, and Emma Zink, chairwoman of the board.
Strong protest
Ms. Connell's remarks unleashed a strong protest from Mr. Flanigan. He said CalSTRS gained more than $6 billion from its investments last year.
A key reason for the 1996 underperformance was the lack of domestic equities in the fund's $7 billion tactical asset allocation portfolio and a relatively low allocation to domestic equities for the fund overall, a board study found.
Some board members expressed anger when the fund's consultant - Allan Emkin, consultant with Pension Consulting Alliance, Studio City, Calif. - suggested Mr. Flanigan "might disagree" with board members over allocations in the fund's TAA portfolio.
Mr. Emkin also said the total fund's actual asset allocation varied from the investment committee policy during almost all of the last 10 years.
Early in 1987, the fund had almost 52.4% of assets in domestic equities. By June 30, 1995, the allocation had dropped to a low of 30.7%, according to Mr. Emkin's report to the board.
Several board members accused Mr. Flanigan of not following their requests for an increase in the allocation to domestic equities, including in the TAA portfolio.
The board and staff also argued over terminology and interpretation of policy.
Ian Lanoff, the fund's fiduciary counsel, told the board that Ms. Connell, having worked on Wall Street, knows the term she should have used was "opportunity cost" rather than "loss" of $1.8 billion.
But Ms. Connell replied the word "loss" was perfectly correct. "Everybody on Wall Street knows that when you don't perform for a client, the penalties are severe," said Ms. Connell.
Adding to board worries, John Depew, a representative from the California Teachers Association, the state's largest teachers union, asked the board to make sure there were several good candidates to compete for the CIO's job. A selection could be made as early as April; Mr. Flanigan is one of the candidates.
Gary Lynes, CalSTRS' investment committee chairman, assured Mr. Depew that fund officials are making a strong effort to find candidates by spending $70,000 to $80,000 for executive recruitment.
Ms. Connell tried to heighten fellow members concerns by presenting additional investment calculations done by her office. She said the $1.8 billion is twice as much money as the financially hard-pressed state of California paid into the pension system in 12 months in 1996. The $1.8 billion is particularly severe, considering how much money could have been gained by reinvesting the money, she said.
Ms. Connell based her investment figures on a fund-to-fund comparison. She said for the year ended Dec. 31, 1996, CalSTRS' investment performance was 301 basis points lower than CalPERS'. CalSTRS returned 9.87%; CalPERS, 12.88%, she said.
Ms. Connell said if CalSTRS had done as well as CalPERS over the last three years, it would have an additional $2.3 billion.
Two years of complaints
Ms. Connell noted she has been complaining about CalSTRS performance for two years, and it has only continued to decline.
Mr. Flanigan, however, said CalPERS has a much higher level of funding than CalSTRS and takes the greater risk that comes with equity investments.
"You have to look at risk," Mr. Lanoff cautioned the board.
Mr. Flanigan said past board policy has been to tilt away from overvalued areas of the market and move toward undervalued areas.
Judging a fund's performance on the basis of one year is "too short" a time, said Mr. Flanigan.
Ms. Zink, who chairs the board, said she was inclined to terminate the TAA portfolio, which is directed by Mr. Flanigan with help from staff, external research and information from outside TAA managers. Mr. Emkin said the TAA portfolio accounted for about one-third of the performance lag between CalSTRS and CalPERS.
Ms. Zink also challenged Mr. Flanigan's denial that she suggested he increase the amount of equities in the tactical asset allocation fund. "I made it clear some time ago," she said.
"I don't remember that," said Mr. Flanigan.
But Mr. Lanoff noted Mr. Flanigan can't make changes based on individual board member requests. He said the CIO must act on the direction of the board as a body.
