Country restrictions cost CalPERS plenty

SACRAMENTO, Calif. — CalPERS' country restrictions on its emerging markets portfolio has cost the fund 2.6 percentage points in performance since they went into effect almost five years ago, according to a staff memo.

That translates into an opportunity cost of $401 million for the $231.5 billion California Public Employees' Retirement System, Sacramento, the memo said.

Roy Schotland, a professor at Georgetown University Law Center, Washington, said the emerging markets policy looks good for politicians running for office but appears to be "costing a hell of a lot of money." CalPERS' eligible market restrictions were expanded in 2002 at the behest of then-state Treasurer Philip Angelides to include factors such as political stability and labor practices.

Mr. Schotland said he applauds CalPERS for disclosing the costs of the policy. "Now let's have a discussion on whether the policy should be modified or killed," he said.

Clark McKinley, a CalPERS spokesman, said CalPERS may be losing money in the short term by not investing in ineligible countries, but putting money into such volatile markets poses an "unacceptable risk."CalPERS uses a seven-factor model using both country and market criteria for evaluating emerging markets.

The staff memo, which is based on a draft report by investment consultant Wilshire Associates Inc., Santa Monica, Calif., shows that CalPERS has left money on the table because of the emerging-markets restrictions.

Two of the fund's three active emerging markets managers significantly underperformed similar portfolios that were not constrained by the eligible country list, according to the staff memo and the Wilshire report.

Each manager ran $1.7 billion in assets for CalPERS as of Nov. 30, the latest date for which the fund has disclosed data. All of the figures are annualized and gross of management fees.

Genesis Asset Managers Ltd., London, returned 30.7% for the period from Aug. 1, 2002, through Dec. 31, 2006, 6.2 percentage points below its unconstrained portfolio.

AllianceBernstein LP, New York, returned 36.4% during the same period, 3.3 percentage points below its unconstrained portfolio.

Dimensional Fund Advisors Inc., Santa Monica, Calif., returned an annualized 33.6%, one percentage point better than its unconstrained portfolio.

Part of the reason why DFA outperformed the unconstrained portfolio may be because the manager excludes some emerging markets from consideration because they don't have adequate investor protections.

DFA does not invest in countries that lack adequate property rights and shareholder protection, said Weston J. Wellington, company spokesman and vice president.

"Any time you constrain the opportunity set, you limit the potential for higher returns, particularly if the constraints focus on riskier areas that should compensate investors for that risk with higher returns," said Michael Rosen, principal, Angeles Investment Advisors, Santa Monica, Calif.

And there's no question that CalPERS is taking on more risk by limiting its universe of possible investments.

"As of April 2006, the permitted list excluded roughly 15% of the available market capitalization and resulted in an overweight to the more economically sensitive market sectors," the Wilshire report said.

Since April 2002, CalPERS' custom emerging market benchmark had a standard deviation of 19.5%, compared with 18.5% for the unconstrained FTSE All Emerging index, the staff memo explained. From April 2002 through December 2006, the CalPERS benchmark returned 22.8% on an annualized basis, 2.9 percentage points short of the FTSE All Emerging index.

After a two-year debate, CalPERS expanded its list of factors used in ranking emerging markets to include social issues. But board members never anticipated the outcry their actions would cause when individual countries were proposed for exclusion. Six busloads of Filipino-Americans showed up at a CalPERS meeting to protest the proposed exclusion of the Philippines from the eligible markets list. CalPERS officials then were embarrassed when they had to restore the Philippines to the list because they had relied on outdated information supplied by Wilshire officials.

This month, CalPERS made plans to drop Sri Lanka from its list of eligible emerging markets. Sri Lanka's ranking was dragged down by low scores for political stability and market regulation. CalPERS had $3.4 million invested in Sri Lankan stocks as of June 30, according to Mr. McKinley.

Sri Lanka has a month to appeal the finding before it is adopted.

Elsewhere, CalPERS officials are considering investing $300 million to $500 million in emerging markets corporate governance funds.

Staff hopes to earn an attractive risk-adjusted return as well as improve corporate governance practices at companies based in countries with substandard practices, a memo to the board said. The investments would not be limited to countries meeting CalPERS' eligible emerging markets standards.

Staff has held discussions with officials of International Finance Corp., a unit of the World Bank, to see if the two institutions could jointly pursue such investments. Staff has also started researching the Asia Development Bank's corporate governance initiatives and is interested in pursuing such strategies with other global investors, the memo said.

The staff plans to seek feedback from CalPERS' investment committee at its Feb. 20 meeting. If the response to making corporate governance investments in emerging markets is favorable, staff would return with a specific proposal at a later date.