The California Public Employees' Retirement System not only thinks it can beat the market, it thinks it can beat active management firms - and it thinks it can do it on the cheap.
Its plan to move some of $47 billion run by outside money managers to in-house management deserves tough scrutiny and skepticism.
In short, the proposal is predicated on several notions that may or may not be correct.
One is that it can assemble a team of portfolio managers who can beat both the market and other active managers.
Another notion is that it can keep the compensation level of internal portfolio managers down without hurting investment performance through turnover of staff who, because of their success, may leave for more lucrative remuneration in the private sector. Because CalPERS is toying with the idea of using an in-house quantitative discipline, its thinking is that it can easily attract new professionals to manage the investments without hurting performance.
But these notions raise several issues.
One is whether the system can recruit highly talented people in the first place. Another is whether it can refresh the quantitative models adequately. The market is too dynamic for any model to work without adjustments for changing conditions and new information, and also without imitators of any CalPERS success undercutting its potential excess returns. It's doubtful new staffers can easily step in and quickly perform the task.
Other issues to consider include the costs of operating the in-house staff compared with the costs of external managers. And will the internal managers be scrutinized with the same rigor and consequences - meaning subject to immediate dismissal - as outside managers? CalPERS may not be able to readily disband an in-house operation, in part because of the unintended political implications for the CalPERS officials who established the unit.
Before moving to in-house active management, the system needs to re-evaluate its existing active managers, with which in general it apparently is dissatisfied. Otherwise, why would it entertain serious thought of moving some active management in-house? It needs as well to assess its active manager search process.
A would-be move to in-house management has significance beyond just beating benchmarks. It would remove a layer of fiduciary responsibility now carried by the external managers, an especially telling loss in an increasingly complex investment market.
The impetus for the move to in-house management may come from Robert Boldt, who joined the system late last year and who may desire to apply his extensive money management experience - he spent a decade with the interesting yet enigmatic Concord Capital Management, which was known for its thematic approach to investment management.
It's one thing to manage bonds and indexed equity in-house as CalPERS does now for $64.1 billion. But to successfully manage active equities requires a higher skill level; it's the holy grail of the investment culture.
All in all, external management should get no free pass.
Keith A. Ambachtsheer, president of Cost Effectiveness Measurement Inc., Toronto, in a study a few years ago found returns of external management only slightly better than internal managers, yet found the cost of the former was much higher than the latter.
A CalPERS test could prove or disprove these findings.