TALLAHASSEE, Fla. -- The indexing vs. active argument is alive and well in Florida.
The Florida State Board of Administration and the State Office of Program Policy Analysis and Government Accountability are battling over the idea of indexing the fund's entire $51 billion domestic equity allocation.
The Office of Program Policy Analysis and Government Accountability, as part of its annual performance audit, released a report stating the fund could have earned an additional $612 million in the fiscal year ended June 30, 1997, and could have saved $49 million in investment management fees had it used passive portfolios instead of external management.
Meanwhile, the state board has been conducting an in-depth review of active vs. passive investment practices for more than a year. Gwenn Thomas, chief financial officer for the $83 billion fund, said the review should be completed by the end of the year and officials are more than two-thirds of the way through their analysis.
"We are certainly evaluating an increased allocation to those (passive) assets, but it would be inappropriate to put all our eggs in one basket," she said.
She declined to estimate the amount by which the passive allocation could increase until the fund's research is complete.
Ms. Thomas said this was the first OPPAGA recommendation the fund has felt strongly about, adding the fund will likely implement whatever its own research indicates is the right thing to do.
Currently, $31 billion in domestic equities is externally managed and $20 billion internally managed. Of the external assets, $19 billion is actively managed; $2 billion of the internally managed assets are active.
The fund has four external passive domestic equity portfolios run by two managers, Wilshire Asset Management, Santa Monica, Calif.; and Barclays Global Investors, San Francisco.
The fund has 18 active externally managed domestic equity portfolios.
For the state agency, performance is the main issue. The OPPAGA report cites internally and externally managed returns for the fiscal year ended June 30, 1997, of 26.58% for active domestic equity and 31.92% for passive. For the 10-year period, active management garnered 13.65% vs. passive's 14.41%. The active managers' return in the asset class trailed the fund's Wilshire 2500 benchmark of 30.28% for the year and 14.07% for the 10 years.
Tom Roth, lead analyst for OPPAGA, said the state office had done similar reviews on external managers in the past, but in this report OPPAGA made its first specific recommendation. The report mainly focuses on external active management, but in the context of looking at all domestic equity portfolios managed internally and externally.
"In this report we felt we had a longer base of experience," he said.
The agency wants the fund to manage the asset class with passive investment managers, focusing on different market capitalizations and investment styles, Mr. Roth said.
He would not comment on what would happen if the fund ignored the report, but said his office did not lobby the state board of administration and that it was up to "the officials and their principals" to make changes. He also hopes the Legislature will take a look at the passive management issue, but he wouldn't speculate on how legislators might respond.
Tom Herndon, executive director for the state board, defended the fund's position in a letter to the governor, comptroller and treasurer written in late August: "We do not believe that 100% passive equity investing is appropriate, realistic or safe!"
In a separate letter to OPPAGA, Mr. Herndon wrote that new policies covering the use of active domestic equity management strategies would be implemented during calendar 1998, as well as in other asset classes.
He also noted the fund's consultant, Ennis, Knupp & Associates, Chicago, reviewed the due diligence and agreed the fund should not place all of its domestic equity allocation into passive strategies.
In an analysis of the state report, fund officials said they were able to pinpoint some discrepancies and errors.
One problem OPPAGA's Mr. Roth does acknowledge is the returns and fees of private equity managers were included in the analysis because the state board did not separate the managers in its investment report. Fees for private equity managers tend to be higher, he said.
"We feel the general conclusions still apply," he said.
The fund has a total of 10 private equity managers that manage $1.2 billion.
Fund officials also are quick to point out OPPAGA's analysis should have compared the investment returns of active equity managers with the returns that would have been earned had those same managers' investment styles, such as small-cap value or growth, been implemented with a passively managed index fund.
In part of its annual performance audit of the fund, OPPAGA computed the rate of return for external active managers vs. that of the aggregate return of passive managers and then compared the difference to determine how much investment income the fund would have made had those assets been invested passively. The Wilshire 2500 was used as the domestic equities benchmark and managers were not split up by market capitalization. Individual managers then used their own customized investment style benchmarks.
"However, while this type of analysis (using customized style benchmarks) is essential for monitoring, it is not useful for assessing the aggregated performance of a group of managers using a particular investment approach, such as passive investment strategies," OPPAGA stated.
Mr. Herndon also asserted in his letter to OPPAGA that if the fund were to follow the agency's recommendations, there would be no risk controls in place.
"We would gain a full share of any market upside and lose a full share of any downturn," Mr. Herndon wrote.
Other large public funds have looked at the same issue and have rejected the completely passive approach, he added.
Mr. Herndon also said internal passive management was not conducted for the entire 10-year period studied, and he questioned how the agency came up with a 10-year number.
OPPAGA said it used data from the fund's 1987-1988 investment report and estimated returns for internal passively managed portfolios during that year to -6.7%.
"Our point is that, taken as a whole, the SBA's external domestic equity managers that used passive investment styles continued to outperform its active investment style managers and were paid significantly lower fees," OPPAGA wrote in a rebuttal.
Lan Janececk, chief of equities for the state fund, said the report "smacks of hindsight, and that's always an easy thing to do in the equity market."
