Four large public funds are adding to their actively managed non-U.S. investments, a trend that could lead to new opportunities for active managers of non-U.S. assets.
The California State Teachers' Retirement System, Sacramento, decided to shift $3 billion to active foreign equity managers and end its heavy emphasis on passive foreign stock investing. CalSTRS is making the change because its active managers have clobbered passive investment returns in recent years.
At the same time, three of New York City's pension funds are raising their allotments to non-U.S. equities, for a total new commitment of nearly $2.5 billion. Funding will come at least partly from reducing each fund's target allocation to domestic equities.
When the allocations are funded, most likely by the third quarter, the city's employees', fire and police funds will have total non-U.S. equities investments of more than $8 billion.
The moves are part of an increasing shift toward active foreign equity money management among U.S. pension funds, according to Inga Sweet, in the international consulting services division of Callan Associates, San Francisco.
The trend should mean significant new business for active managers. The Morgan Stanley Capital International Europe Australasia Far East markets have $6 trillion in market capitalization, a primary target for pension funds placing money internationally.
Ms. Sweet said, "There has been a very consistent trend" toward active foreign equity money management by all types and sizes of pension plans.
Some plans are taking large gains from U.S. equities and putting some of the money into active foreign equity management as they rebalance plan asset allocations, she said.
Not all money is going to active foreign equity. Some large plans continue to put foreign equity assets in passive management to complement their active strategies, Ms. Sweet said. Other plans with highly restrictive strategies, such as nuclear decommissioning trusts, use passive management for foreign equity.
But, overall, she said, "Plan sponsors have embraced an active approach when it comes to non-U.S. equities."
5 NEW MANAGERS
CalSTRS alone plans to add four or five new managers as contracts for its existing nine active and two passive foreign equity managers are about to expire. The fund, which has $20 billion in foreign equity, is preparing an RFP for the 16-manager lineup. The system plans to send out the RFP for active foreign equity managers in August.
CalSTRS intends to put 70% of its active foreign equity money in EAFE markets and 30% in regional markets.
Among the New York funds, the $37.4 billion New York City Employees' Retirement System hired seven additional active international equities managers. Five of those managers also were selected by the $15.2 billion New York City Police Department Pension Fund, which also increased allocations to three existing managers.
The $5.6 billion New York City Fire Department Pension Fund chose two new foreign stock managers (including one hired by both the fire and employee funds), raised allocations to two existing managers and terminated one. All 14 new portfolios will be broad international equities portfolios.
The NYCERS fund is raising non-U.S. equities holdings to 13% of assets from 10%; it will have $4.8 billion in foreign stocks. The police fund is increasing its non-U.S. stock allocation to 19% of assets from 13.2%; it then will have $2.8 billion in foreign equities. The fire fund's international equity exposure will increase to 12% of assets from 9.7%; it will have $656 million in that asset class.
In each case, new commitments followed asset allocation studies, said Donna Anderson, chief investment officer for New York City's five pension funds.
NYCERS' newly chosen international managers bring to 12 its stable of non-U.S. equity managers. The newly selected firms are: Rowe Price-Fleming International Inc., London, $600 million; Oechsle International Advisors, Boston, $150 million; Putnam Investments, Boston, $150 million; Sprucegrove Investment Management Ltd., Toronto, Ontario, $190 million; Delaware International Advisers Ltd., London, $190 million; Bank of Ireland Asset Management, Dublin, Ireland, $190 million; and Invista Capital Management Inc., Des Moines, Iowa, $35 million.
Funding will come from reducing NYCERS' passively managed non-U.S. equity portfolio. The fund also will drop its U.S. equity allocation target to 55% from 60%, Ms. Anderson said. The fund has no plans to terminate any U.S. equities managers.
Managers hired by the Police Department fund are: Delaware International, for a $100 million portfolio; Oechsle and Putnam, $100 million each; Rowe Price-Fleming, $200 million; and Invista for $35 million. The fund increased its international equities allocations to GE Investments, Stamford, Conn., by $150 million, to $225 million, and the Bank of Ireland by $65 million, to $352 million. The passive component handled by Barclays Global Investors, San Francisco, will be raised about $96 million, to $840 million, Ms. Anderson said.
Funding will come from reducing its target U.S. equity exposure to about 45% from about 60%, Ms. Anderson said.
Non-U.S. equities managers selected by the Fire Department fund are: GE, for about $58 million, and Invista, $25 million. Existing managers Scudder, Stevens & Clark, New York, and Bank of Ireland will receive additional allocations of $30 million and $40 million, respectively. Those will bring Scudder's total foreign stock allocation from the fund to $91.2 million and the Bank of Ireland's to $91.4 million.
The changes will be funded by trimming domestic equities (mostly passively managed) to about 50% of total assets from 60% and terminating Alliance Capital Management, New York, which handled a $35.6 million non-U.S. stock portfolio. Alliance's termination is due to a loss of key investment personnel, Ms. Anderson said.
It's hoped these new and expanded portfolios "will be funded by the third quarter, pending completion of the contracting process," she said.
PASSIVE MANAGERS LOSE
The CalSTRS move will be a loss for the passive foreign equity managers that have run 65% to 70% of the system's foreign equities: Barclays Global Investors and State Street Global Advisors, Boston.
The fund's performance reports demonstrate what is driving interest in active foreign equity management. For the three years ended March 31, the system's active foreign equity managers outperformed passive returns by 439 basis points, annualized, said Pat Mitchell, chief investment officer for the $86.5 billion fund.
During the three years, CalSTRS' active foreign equity money managers scored an annualized investment return of 10.4%, vs. 6.1% for the EAFE index.
The asset shift represents a move to a 50-50 split between active and passive foreign equity management. The system could decide to further increase the percentage under active management, Mr. Mitchell said.
For CalSTRS, the move to greater active foreign equity money management might come too late to get as broad an investment performance spread of active over passive money management as it could have had recently.
Mr. Mitchell said he has doubts the investment return spread of 430 basis points annualized of active over passive money management will continue. But, he said, he expects CalSTRS' active money managers will outperform the EAFE index by 150 to 250 basis points per year.
CalSTRS' emphasis on passive foreign equity management came during former chief investment officer Tom Flanigan's administration. Mr. Flanigan reasoned, as have some other pension officers, that CalSTRS and other large funds become closet index funds if they emphasize active over passive money management in foreign equity.
"I don't believe that," Mr. Mitchell said. He said active managers have been successful in picking regions to emphasize. For example, many managers underweighted economically troubled Asia relative to the EAFE index to improve their investment returns, he said. However, within developed countries, markets are relatively efficient, making it more difficult to beat an index.
Some funds have even greater emphasis on passive foreign equity money management than CalSTRS has had.
According to Pensions & Investments' 1997 survey of the largest 200 pension funds, $48 billion Ford Motor Co. pension fund, Dearborn, Mich., had $2.15 billion in foreign equity as of Sept. 30, all of it indexed. No one at Ford could be reached for comment on the strategy.
The State of Michigan Department of Treasury, Lansing, passively manages all of its $2.2 billion in foreign equity. But it has only 5% of its assets in the asset class and that indexed return is achieved through swap agreements, said Richard Holcomb, head of quantitative analysis at the Michigan Treasury. If the fund expands its foreign equity allocation, it will look at using active money management, Mr. Holcomb said.
But the $140 billion California Public Employees' Retirement System, Sacramento, isn't convinced the emphasis on active management of foreign equity is the right strategy for very large funds.
CalPERS has so much money that it could be a closet index fund it if emphasized active foreign equity money management, said Brad Pacheco, a spokesman for the system, which passively manages about 70% of its foreign equity assets. The remainder is actively managed.
CalPERS has active foreign equity money managers that do add value, he said.
But, Mr. Pacheco said, active foreign equity management fees are much higher than passive and transaction costs for active trading are higher.
Passive foreign equity management has substantial advantages over active management, said J.S. Parsons, a managing director for equity management and trading with Barclay Global.
With passive foreign equity management, investors get the market's investment return at the market level of risk, not greater risk than the market, he said.
Investors using active foreign equity management might not be compensated adequately for the risk they take, Mr. Parsons said.
Active managers charge relatively high fees, he said, and it is hard to pick the stocks in any one market that will provide strong investment returns.
But Mr. Mitchell said his study shows his active managers will provide a higher return at a lower-than-market risk level. He said active foreign equity managers are adding value not by picking stocks, but by picking regions to invest in.
CalSTRS' existing active foreign equity managers are Capital Guardian Trust Co., Los Angeles; Chancellor LGT Asset Management Inc., New York; J.P. Morgan Investment Management Inc., New York; Lazard Freres Asset Management, New York; Morgan Stanley Asset Management Inc., New York; Oechsle; Schroeder Capital International, New York; and State Street Global.