U.S. pension funds have moved or planned to move a total of more than $900 million in assets to international, enhanced index portfolios over the past few months.
The Missouri State Employees' Retirement System is the latest U.S. pension fund to consider switching to investing overseas in an enhanced indexed portfolio.
A few others have made the change.
Making the move
Some moved from pure passive portfolios tracking the Morgan Stanley Capital International Europe Australasia Far East index, while others have terminated managers or reduced allocations from active managers.
* Illinois State Board of Investment terminated active international manager Cursitor-Eaton Asset Management Co. and recently hired UBS Brinson to run a $200 million international quantitative portfolio that closely tracks the fund's benchmark, the MSCI All Country World index ex-U.S.
* New York State Common Retirement System sliced off a $300 million chunk in February from its $600 million passive EAFE portfolio with Bankers Trust Co. and gave it to Barclays Global Investors to put in an enhanced indexed EAFE portfolio.
* Georgia-Pacific Corp., also in February, hired Bankers Trust to run $55 million in an enhanced indexed EAFE portfolio, taking away cash from its active international managers to fund the mandate.
The weighting of Japan in active international equity portfolios is the main reason for the switch, pension fund executives and consultants said.
Active managers over the past five years could outperform the EAFE index by underweighting Japan and overweighting Europe. Over the past year, that's changed.
In the five years ended Dec. 31, the EAFE index returned 10.5%, and 59 of 122 international managers matched or bettered that mark, according to Pensions & Investments' Performance Evaluation Report. For the 12 months ended Dec. 31, 41 of 165 managers matched or beat the EAFE's one-year return of 20.2%, according to PIPER.
International enhanced managers usually track an index's country weight but have freedom to pick stocks from outside the index.
Missouri Employees, Jefferson City, is in the process of writing a request for proposals from international managers, said Rick Dahl, chief investment officer for the $4.8 billion fund.
Funding for the potential $350 million mandate would come from its current passive EAFE portfolio with Bankers Trust, he said, although BT probably will be invited to bid for the new portfolio.
"Five years ago, Japan was about 50%" of the EAFE benchmark, Mr. Dahl said. Its weighting drove the return of the benchmark.
Now, active managers are faced with tougher odds to beat the benchmark, he said.
"The Japan bet is not going to pull as much weight as it has historically," he said. The country's lesser weighting, about 23% recently, "is going to force managers to make more than one right country call."
"If Japan turns, it's going to make it that much more difficult for managers to beat" the EAFE index's country selection, he added.
Other pension fund executives' statements echoed Mr. Dahl's. "Now that Japan is more of a 'normal weight' in the index, the disparity between the average manager and the index will be less," said Ron Schmitz, chief investment officer for the $8 billion Illinois Board of Investment in Chicago. Its new international quantitative portfolio with Brinson has a tracking error of plus or minus 2% against the fund's international benchmark, the MSCI All Country World index ex-U.S., which it adopted last fall.
"Japan has been the key for a long time," said Tony Abbott, director, benefit investments, for Atlanta-based Georgia-Pacific, with $2.1 billion in defined benefit assets. "Now, the Japanese market was the one to be in, in the first quarter, and most managers were underweight."
The Nikkei 225 in Tokyo was up 22.4% year to date through April 28, while London's Financial Times 100 was up 12.2%; and the Frankfurt Dax-30, 6.9%.
Bankers Trust's enhanced index portfolio mimics the EAFE index "on a country and sector basis," Mr. Abbott said.
Questioning the wisdom
But some active international managers question the wisdom of investing overseas with an index strategy.
"Certain markets have very attractive, unique investments. As far as EAFE, they have small or no representation," said Nicholas Reitenbach, president, Pinnacle International Management LLC, New York. Mexico and Latin America, for example, are not part of the EAFE index.
"An active manager doesn't have that EAFE fence," he said. He added, however, that enhanced indexing "was a step in the right direction" because of its active stock selection.
Relatively few money managers have the capability and the track record to run enhanced indexed portfolios. Pension officials and consultants listed Morgan Stanley Dean Witter, Sanford C. Bernstein & Co., Dresdner RCM Global Investors and State Street Global Advisors -- along with the firms recently hired as money managers -- as among the few.
Fees for enhanced indexed portfolios fall between those for passive and active portfolios. Fees for enhanced indexed portfolios of $250 million and up are usually about 25 to 30 basis points, about half of an actively managed international portfolio.
Smaller portfolios in the range of $25 million to $75 million have substantially higher fees of 40 to 55 basis points.
But concern about performance rather than fees has driven the shift. The $109 billion New York State Common Retirement Fund hired Barclays Global Investors to diversify the fund's portfolio and increase its returns, said Jeffrey Gordon, spokesman for the Albany-based fund.