HARRISBURG, Pa. — The Pennsylvania Public School Employees’ Retirement System, one of the first retirement systems to adopt a dedicated emerging manager program, is revamping its underperforming program to generate higher returns while grooming a new crop of managers for its primary pool of retirement assets.
The $62 billion system will increase the size of its emerging manager program to $1 billion from roughly $600 million, while also accessing a broader universe of emerging firms, said Alan Van Noord, chief investment officer.
The original program, hatched in 1995, limited PennPSERS to investing with emerging managers who were either based in the state of Pennsylvania, or were minority- or women-owned. The program also restricted PennPSERS from investing in asset classes other than traditional long-only equities or fixed income.
The revamped program will include emerging managers across all public market asset classes as long as they each run no more than $1.5 billion in total assets, and the maximum number of emerging managers the system may use will be increased to 25, from 20. The system will now “give preference” to minority- and women-owned managers, as well as firms based in Pennsylvania, but will not limit itself to those firms, said Mr. Van Noord.
“We found that the opportunity set we had originally created was a little too small,” said. Mr. Van Noord. “We needed a larger opportunity set to generate good alpha. … And by expanding it, we have opened up the opportunity set tremendously to do just that.”
Because of the limitations, PennPSERS’ existing emerging managers program underperformed its custom benchmark by more than 450 basis points for the year ended March 31, producing a 6.04% return. Over the three- and five-year periods, it returned an annualized 10.54% and 7.58%, respectively, underperforming the custom benchmark by 84 basis points and 85 basis points.
Ongoing reviews
The system will continue to use the 17 emerging managers in its current program — most of which run domestic equity portfolios — but will review these firms on an ongoing basis, Mr. Van Noord said.
He added that while the retirement system will have more latitude to select emerging managers, all firms must have at least a three-year track record and none will be given more than $75 million to manage.
Also, an emerging manager will not be permitted to stay in the program if assets under management exceed $3 billion at any point after the firm is hired. At this point, Mr. Van Noord said, the retirement system will evaluate whether the firm should manage portfolios for the fund’s primary pool of assets.
“The emerging manager program is like a think tank, or a testing mechanism, in a way,” said Mr. Van Noord. “There might be some strategies, whether it’s long-only or long-short, that we would like to test live and we feel that we can do it in this particular program.”
The expanded emerging managers program at PennPSERS is more consistent with programs of other major retirement systems such as the $241.7 billion California Public Employees’ Retirement System and the $162 billion California State Teachers’ Retirement System, both in Sacramento.
CalPERS has roughly $2 billion in its two emerging managers programs, and officials recently said it could expand one of its programs to include 130/30 and other alternative strategies. CalSTRS has about $1.6 billion with emerging managers in both traditional and alternative investments.
“It’s a totally different environment for public retirement systems now than it was several years ago,” said Clayton Jue, president and chief investment officer of Leading Edge Investment Advisors LLC, a manager-of-emerging-managers firm in San Francisco. “Right after the bear market, people started to look for new sources of alpha, and retirement systems began to realize just how consistently smaller managers can outperform.”
Mr. Jue said a Leading Edge study conducted last year of emerging managers’ overall performance showed they handily outperformed larger managers. Examining a range of 3,100 active domestic equity strategies from 1,200 firms of varying sizes, Leading Edge found that managers with $1 billion to $2 billion in assets produced a median excess return of 5.65% against the S&P 500 for the five years ended Dec. 31, 2005. Firms managing less than $500 million generated a median excess return of 5.46% vs. the S&P 500 in the same time period. In contrast, firms with more than $10 billion produced a median excess return of 4.08% vs. the S&P 500 during the same five years.
More data, more programs
As more performance data has become available on smaller, lesser-known firms, more public retirement systems are taking notice and carving out dedicated emerging manager programs. The $107 billion Teacher Retirement System of Texas, Austin, just last month announced it would implement a $1.5 billion emerging manager program in the next several years.
In addition to expanding the universe of managers it may access, TRS officials stated they are drawn to emerging managers because the firms can be more nimble and invest in niche markets. By using firms with smaller amounts of assets to invest, the system “is able to effectively access smaller markets with potentially more attractive returns,” T. Britton Harris IV, chief investment officer at TRS, wrote in an e-mail response to questions about the program.
Also, because these firms are smaller and “more focused,” Mr. Harris said there can often be an “increased sense of urgency to create strong results, and thus a higher alignment of interests.”
