SACRAMENTO, Calif. - California State Teachers' Retirement System board members last week OK'd internal management of a $1 billion S&P 500 index fund.
Although the initial allocation is small - CalSTRS has $80 billion in assets - the index fund could control substantially more after a 12-month board review.
The money will come from Barclays Global Investors, San Francisco, which manages an $18.3 billion S&P 500 fund for the teachers fund. BGI also manages a $6.4 billion extended market (Russell 3000 index minus the S&P 500) index fund for the fund.
It is the first time CalSTRS has done internal equity management, and the fund staff is still studying the possibility of some form of active equity internal money management.
Funding of the internal index fund should come in March.
If it is a success, Patrick Mitchell, chief investment officer, expects the internal S&P 500 index fund eventually will control as much as 50% of its total equity index assets.
However, he said the amount is up to trustees, who also must approve policies and procedures in operating the fund.
A staff study of other large public funds that manage equity assets in-house found they typically manage 70% of their indexed money in-house.
By keeping an external S&P 500 index manager, CalSTRS hopes to foster competition between its internal staff and BGI, said Mr. Mitchell.
An internal CalSTRS report proposing the in-house fund said the CalSTRS internal index fund might be able to outperform the BGI S&P 500 fund. The study said the in-house index fund will have a trading advantage because it won't impose on the internal fund staff the same trading rules it imposes on BGI.
For example, the internal fund won't have to buy a stock that is added to the S&P 500 within the close of business on the day it is added, as is required under BGI's contract, Mr. Mitchell said.
On average, the price of a stock being added to the S&P 500 rises 3% to 5% between the time the addition is announced and the day the stock is added, said Mr. Mitchell.
According to the staff study, the domestic equity portfolio managed by BGI underperformed its S&P 500 benchmark by 13 basis points on an annualized basis for the two years ended June 30.
BGI officials, according to the CalSTRS staff study, contend the tracking error is much smaller when cash flows are included in calculating performance numbers.
"The investment objectives of CalSTRS call for the best possible tracking performance," said Larry Tint, chief executive officer of Barclays' Americas division.
"We've developed proprietary trading technology and techniques for minimizing tracking error and trading at the lowest level of transaction costs."
He wouldn't comment on CalSTRS in-house passive equity management plans.
BGI, under its contract with CalSTRS, isn't allowed to re-invest dividends from the stocks it manages until the end of the month. However, the cash flows only amount to about one-tenth of 1% of index fund assets, said Mr. Mitchell.
The staff study noted a difference of even one basis point is huge: on a hypothetical $25 billion portfolio it would be approximately $2.5 million annually.
Advantages to in-house trading, the staff contends, are:
CalSTRS would have control over the commission streams that result from trades, with which staff could purchase resources, such as new technology.
Additional resources used internally could improve planning and execution in manager transitions, rebalancing, funding of managers and terminations.
Costs connected with internal rebalancing could be reduced.
A staff-run index fund would have greater alignment of interests with CalSTRS.
A combination of internal and external passive index funds would create a competitive environment.
The pension fund's consultant, Pension Consulting Alliance, Studio City, Calif., backs the staff recommendation to begin in-house indexing.
In a report to the board, PCA said if the staff can reduce BGI's tracking error, the fund could make significant savings. But the report warned the staff will have a learning curve in running an index fund, and there is potential for a costly increase in tracking error until the staff gains experience.
Steve Nesbitt, a senior vice president at Wilshire Associates, Santa Monica, Calif., said the cost of running an index fund in-house or externally is "about a wash" for very large funds.
Barclays charges CalSTRS only two-tenths of one basis point on the $18.3 billion S&P fund.
Sources say Barclays' fee for CalSTRS is one of the lowest possible. It doesn't include securities lending.
But there are benefits to running an index fund in-house, said Mr. Nesbitt.
Internal management offers more direct control over securities lending, and might increase income from lending, said Mr. Nesbitt, referring to internal management in general.
"Our general feeling is the combination of proxy voting and securities lending control may tip the balance in favor of internal management," said Mr. Nesbitt.
But, he said, while an internally run fund doesn't have to blindly follow index fund changes, an internal fund can lose money by not following those rules.