Some pension funds are intensifying their monitoring of how closely their active equity money managers are adhering to their investment styles, and how the manager styles interact with each other.
Such scrutiny, some pension executives and consultants believe, offers the best hope for improved active equity performance - particularly as some domestic managers struggle to outperform indexing.
One reason for the increased interest: Pension executives and consultants now realize part of the blame for active equity performance that lags the indexes might rest with them.
No statistics exist on the number of investors moving in this direction. But several funds are considering, or already have taken, action:
The $80 billion California State Teachers' Retirement System, Sacramento, is considering a "radical change" in the fund's monitoring process, said Patrick Mitchell, chief investment officer. The fund would use new software to monitor more closely investment styles of its equity managers compared to the target benchmark, and to monitor risk parameters of managers.
The $2.4 billion pension fund of Southern California Gas Co., Los Angeles, is considering licensing software that, among other features, will permit closer monitoring of active equity money management, said T.W. Hatten, pension investment manager. He said other pension funds are looking more closely at manager structures, but he wouldn't identify them.
The $25 billion Oregon Public Employes' Retirement System, Salem, monitors managers' stock trades daily. Managers seen as varying from their defined investment styles are called on the carpet.
Roland M. Machold, director of the $56 billion New Jersey Division of Investment, Trenton, said he does extensive internal monitoring and uses three consultants - New England Pension Consultant, Cambridge, Mass.; Callan Associates, San Francisco; and INDATA, New York, to help.
The $68 billion Florida State Board of Administration, Tallahassee, uses style analysis that predicts how equity managers will perform together. Tom Herndon, executive director, said his money managers tell him more pension funds are conducting similar analyses of manager structures.
At the University of California at Berkeley, Oakland, the $28 billion retirement and $3.5 billion endowment funds also scrutinize active equity investment structures and use predictive style analysis tools. Pat Small, treasurer, said fund officials are preparing a search for significant upgrades in software technology that can improve that analysis.
The $2.7 billion Sacramento County (Calif.) Employees' Retirement System has begun a study on more closely aligning active equity managers as a group with the fund's performance benchmark.
The pension consulting firm RogersCasey Sponsors Service, Darien, Conn., has adopted, for all of its 150 clients, an analysis approach that predicts how equity managers will function as a group.
About 60 investors are licensing Compass software for such analysis from Wilshire Associates, Santa Monica, Calif. They include: the $7.8 billion World Bank, Washington; the Abu Dhabi Investment Authority, Abu Dhabi, United Arab Emirates; and the $8 billion General Board of Pensions and Health Benefits of the United Methodist Church, Evanston, Ill.
Sharing the blame
Fund executives and consultants group or structure the fund's managers.
Unless the manager group is sharply defined and measured, the managers interacting with each other can be making unintended investment bets.
That can result in a "negative surprise" in performance, said Allan Emkin, a principal with Pension Consulting Alliance, Studio City, Calif.
A pension officer can believe he or she has structured the active equity stable for a particular bias, such as small capitalization or growth. But, individual money managers can change investment approaches relatively quickly, and sometimes be unaware of it themselves, said Lisa Stanton, a managing director at RogersCasey.
What happens is called a "misfit risk," said Ms. Stanton. An often hidden misfit exists between the bet the money managers are making in the aggregate and the target portfolio identified by fund officials.
Consultants are providing software - unavailable even five or six years ago - that can provide statistics and tracking errors, said CalSTRS' Mr. Mitchell.
The California fund is considering about $30,000 in additional software from Vestek Systems Inc., San Francisco, or BARRA Inc., Berkeley, Calif.
Some take rear-view approach
Forward-looking analysis software can predict the volatility of manager portfolios individually and as a whole, and provide other risk data, said Ms. Stanton. But many pension funds still take a "rear-view" approach to defining manager styles based on historical numbers, she said. And a manager's past style is no guarantee of its style in the future, said Ms. Stanton.
New Jersey's Mr. Machold said even with lots of help, trying to monitor investments is a struggle for pension funds.
He said preliminary consolidated performance reports are sometimes "full of errors," and can be off by half a percentage point or more.
He said there are problems in comparing equity portfolios, and with definitional problems in comparing different types of equity portfolios, like small-cap stock portfolios.
Mismatches might be partly to blame for the trailing performance of active domestic equity money managers vs. commonly used benchmarks.
For the three years ended June 30, 80% of the 1,424 domestic equity managers in the Trust Universe Comparison Service managed equity portfolio universe performed below the Standard & Poor's 500 Stock Index's compound annual return of 28.33%, according to TUCS data. For five years, active domestic equity managers' performance was close to the S&P 500. The median manager returned an annualized 19.66%, vs. 19.74% for the S&P.
Meanwhile, pension fund reliance on passive money management is increasing, noted Richard Ennis, chief executive officer of Ennis Knupp & Associates, a Chicago pension consulting firm.
Many active managers, and some pension executives, believe in a down market, active equity could pull ahead of passive management. Whether that happens, many pension officers believe their best performance from active managers as a group will come from close monitoring.