The idiosyncratic fund management style of California's mighty Calpers
With some $86 bn in assets under management, California Public Employees Retirement System (Calpers) has long been the largest and most influential public pension plan in the US. Its size has been one of the factors behind its peer group clout on the investment management side and its leadership position in the sensitive area of corporate governance. The irony is that Calpers' activism on governance issues sits alongside a management style which is relatively passive.
By any measure, Calpers is growing fast. At the end of 1983, it managed some $21 bn in assets. By 1990, that number had risen to over $57 bn. Now there seems little doubt that the pension scheme is set to become the first US public fund to hit the $100 bn mark; and that it will do so before the end of the century. With that kind of growth expected, the influence of Calpers will grow even stronger in the years ahead.
A defined benefit retirement scheme, managed for around a million state, local and school employees in California, Calpers is responsible for providing benefits based on years of service, age and final compensation. Making sure a million Californians have a balanced and safe package to retire with is a responsibility not to be taken lightly, and Calpers' 13-member Board of Administration is a rare bird in the jungle of investment management. Six boardmembers are elected by membership groups, two serve by virtue of elected office and five are appointed by the state governor and/or the legislature.
Unlike traditional public pension fund boards, known for being willing to rubber-stamp staff investment recommendations, the Calpers' board is unusually involved in its strategy. California began to reverse the pattern of passive involvement in the investment process in 1985 when the state legislature introduced a concept called 'release time'. This meant that state employees elected to the Calpers board could be paid full-time salaries, even though they were only expected to spend a quarter of their time working on Calpers matters.
This Calpers approach to a hands-on board clearly mirrors its well-publicised efforts to convince corporate directors to adopt similar standards at their own companies. The board's involved investment approach has resulted in a dynamic public fund investment strategy.
'Our objective is to obtain the highest possible returns with the lowest possible risk,' says Chuck Valdes, a board member and head of the investment committee. 'This is done in a number of ways. In fact, we have most investment styles represented in the portfolio. We have value, growth, small-cap and so on. Some fund managers are top-down style, others bottom-up. It is not a concerted effort to diversify by style, but that is undoubtedly what results.'
This flexible management view has resulted in a certain amount of innovation. For instance, Calpers was one of the first funds to index a significant part of its portfolio, and passively-managed funds now account for more than a quarter of the entire portfolio. The challenge now is to come up with a new aggressive asset mix, which is deemed necessary if Calpers is to avoid underfunding problems. While cashflow does currently cover payments to beneficiaries, Calpers forecasts that this will not remain the case in future decades unless the investment performance makes up the shortfall.
In order to produce the necessary returns, Calpers may look to index an even greater proportion of its equity assets. 'Over time, there are no money managers we know of that can consistently beat the index while still providing added bottom-line value,' says Valdes. 'We continuously review this question. If indexing beats active management over time, how much longer do we want to keep our active managers? Indexing is relatively inexpensive. There are no fees to speak of, as we do it internally; and while we continue to make tracking adjustments, we are not constantly buying and selling.'
Nevertheless, the actuarial numbers show that Calpers must guard its investment returns if it is to meet its pension payroll in the next century. In tune with this more aggressive view, the Calpers board announced an increase in equity allocation last December. The proposals will take equity from some 49 per cent to 63 per cent of assets over the next year or two.
The numbers associated with such a move are big. Taking the current asset total of $86 bn, that would involve the equity portfolio growing by some $12 bn over that period, from $42 bn to $54 bn. Meanwhile, international equity allocation would move from 12 per cent of the total equity portfolio to 20 per cent, entailing on the basis of today's funds a $5 bn growth in the non-US portion of the equity portfolio, from some $5 bn to over $10 bn. On the fixed-income side, Calpers' investment allocation will stay flat at 4 per cent.
The new asset allocation constitutes an aggressive bet. According to a survey by Greenwich Associates, the average equity holdings for public funds is 40 per cent, for corporate funds it's almost 50 per cent. International equity and fixed-income allocations average 9.5 per cent for corporate funds and 11.1 per cent for public funds.
In the past, less than optimal asset allocation has dragged down performance. Big real estate and international holdings, when those markets were not doing well, and lower holdings of US equities when the market was booming, have depressed Calpers' overall performance. Median public fund performance was 14.1 per cent and 1.7 per cent in the years ending June 30, 1993 and June 30, 1994, according to a Wilshire Associates study. Calpers barely beat the median with 14.2 per cent and 2.5 per cent. And in the year ended June 30, 1994, Calpers' US equity portfolio earned 1 per cent while the S&P 500 posted a 1.4 per cent mark. Moreover, the 22 per cent of Calpers' portfolio that is indexed to the Wilshire 2500 actually did worse than the index, because the fund was South Africa-free up until first half 1994.
The board of administration has sole responsibility for the management of Calpers' assets. The board's investment committee, along with management and staff, works under a comprehensive set of guidelines for carrying out the investment programme's daily activities. Asset allocation, as detailed above, is perhaps the most important component of Calpers' investment strategy. The board approves a target asset allocation with range guidelines for each asset class.
The strategic asset allocation provides the basis for long-term asset allocation targets for each asset class. Then, within each asset class, ranges are included in the investment policy to provide flexibility to take advantage of market opportunities, relying on information received from staff, research services and money managers. This forms the tactical asset allocation, which allows shifts between classes to exploit rapid market moves.
The securities analysis and research unit provides in-house research, analysis and recommendations in the areas of fixed-income, equity, private equity, real estate and corporate governance to assist in making investment decisions. The research unit also provides the initial screening, analysis and recommendations regarding underperforming companies for Calpers' renowned governance activities.
In total, investment staff comprise 60 professionals who manage the domestic fixed-income and indexed domestic equity portfolios, which account for roughly two-thirds of Calpers' total assets. The fund is currently considering managing some of its international passive assets in-house as well, but its penchant for quantitative methods for portfolio management and its use of computer systems for electronic trading allow it to run on a relatively small equity portfolio staff. Of the domestic equity investments, some 80 per cent are internally-managed in an indexed portfolio designed to provide returns matching the Wilshire 2500 Index.
Domestic equity investments total $21.7 bn or 27 per cent of Calpers' total. When the fund abandoned the prohibition on investments in companies with exposure to South Africa, its holdings were increased in pharmaceutical, oil and chemical companies to meet the increased weightings in the universe. About 19 per cent of the domestic equity portfolio is managed by 14 external managers whose purpose is to beat the S&P 500. Moreover, the selection of external managers affords the board the opportunity to acquire portfolio management expertise not internally available.
On the fixed-income side, at the end of fiscal 1994 the domestic bond portfolio was valued at $25.6 bn or about 37 per cent of the total fund. It is actively managed by internal staff to generate maximum total return on a long-term basis. Domestic fixed-income assets are highly diversified, with 34 per cent of bonds invested in corporate issues; 30 per cent in US Treasury and agency issues; 24 per cent in pass-through bond mortgage securities; 8 per cent in commercial real estate mortgages; and 4 per cent in member home loans.
On top of a strong hand in asset allocations, Calpers has established a set of overall investment objectives for its portfolio. First, the total portfolio must return 4 per cent over the assumed rate of inflation. The internal equity index portfolio must achieve a return equal to the Wilshire 2500, plus or minus 50 basis points. As for fixed-income instruments, they must return in excess of the Salomon Large Pension Fund Fixed-Income Index. For equity real estate, returns must represent a real rate of 5 per cent.
In terms of externally managed assets, each manager has specific performance goals, related to investment style, which are well-established and built into their contracts. External managers are given a complete set of rules and policies with respect to what they may invest in. For example, on the international side, active managers may only be allowed to invest a certain maximum percentage in emerging countries.
Alternative asset investments include a spectrum of opportunities covering corporate restructuring, later-stage venture capital and special situations. The board has allocated 3 per cent of the fund for investment in alternative assets, or some $2.5 bn; and it has approved a 2 per cent portfolio allocation to private equity investments. Commitments in this area include investments in Enron Corp ($250 mn), Wright Medical Technology ($60 mn) and Comcast Corp ($250 mn). In both alternative assets and private equity, the investments are typically long-term positions that are expected to provide significant returns over periods of five years or more. In the case of Comcast, its management made a presentation directly to the board.
'The Comcast deal was a large private equity transaction, and the board wanted to hear from the parties requesting the partnership,' says Valdes. 'The board has ultimate investment responsibility for all investment decisions. While we delegate a great deal to staff, we have not delegated in the area of alternative investments because of the size and nature of investments involved.' At the moment, Calpers is widely rumoured to be considering a stake in DreamWorks SKG, the entertainment venture led by Hollywood moguls, Steven Spielberg, Jeffrey Katzenberg, and David Geffen.
'Once we have decided on asset allocation, we delegate 90 per cent of the authority to make equity decisions to staff and external managers,' says Valdes. 'But as a board we do not get involved in deciding which companies to invest in. Even Comcast was brought to our attention only after our professional staff and consultants had decided to recommend that we invest. While we have the authority to decide not to invest in staff recommendations, that rarely happens.'
Therefore, a listed company thinking of attracting Calpers money would do better to contact one of the external equity or debt managers. 'Virtually everything we do in-house is indexed,' notes Valdes. 'The only areas where company marketing representatives come before our staff is in the alternative investment area. So, if a company wants to interest Calpers in being the owners of more shares than we might already own as part of the index, they would have to go to our active managers.'
Calpers' global investment programme is managed exclusively externally, using 15 investment managers. Some eleven of these managers are for equity, including an international equity index fund and two global asset allocators; the remaining four are international fixed-income managers. Apart from the two global asset allocators, the global managers may not invest in US securities.
In the global arena, many managers will buy and sell directly through foreign exchanges, rather than via ADRs. 'Sometimes we authorise ADRs, sometimes not,' says Valdes. 'Often ADRs are used to change the style a manager has suggested they would be engaged in. At one point, we did not allow investments in East Germany or Czechoslovakia. But we found some managers were using ADRs to effectively invest there. If a manager is going to use ADRs, they have to make sure it is within the mandate we have given them.'
Calpers on Corporate Governance
No investor better personifies the corporate governance movement than Calpers. From middle America to the Japanese islands, Calpers has led the activist trend among pension and institutional investors. Over the past eight years, its very public activities have highlighted the growing role shareholders are taking in portfolio investment, and its innovative governance policies have helped create a state of affairs in which few public companies can afford to ignore the desires of restive investors.
Calpers has focused efforts on stirring up the boardroom because it believes good corporate governance boosts shareholder value. Several studies have shown that corporate or governmental actions limiting management's accountability are linked to reduced share prices. Meanwhile, an empirical study by pension consulting firm Wilshire Associates concluded that Calpers' past activism has not only been justified, but has yielded some impressive results.
For Richard Koppes, general counsel at Calpers, it all boils down to an issue of accountability, and this issue has no international boundaries: 'In America, we have now passed from the era of the imperial CEO to one in which boards are much more active in overseeing management. That basic fact of life is going to come about in all companies around the world.'
Over the years, Calpers has gone through waves of governance policy. First, the Dale Hanson team took an aggressive activist stance. After considering the results, the scheme went through a period where it preferred to push home its point behind closed doors. When this strategy stalled, Calpers turned to a mix of activism and persuasion.
Today, Calpers is determined to direct its activities toward three broad types of issues: those which impair the ability of shareholders to select the best directors; those restricting the ability of a company's directors to supervise managers; and those in which the interests of the shareholders and managers or directors may not harmonise.
Backing up this view, Calpers has added a research side to its governance activities. Each year since 1990, Calpers has targeted a number of underperforming companies for various shareholder initiatives. The 1995 list is comprised of nine companies which rank among the 50 worst performing stocks in the pension fund's 1,200-company portfolio. The naughty nine include Boise Cascade Corp - a four-time offender - and Navistar International Corp, which has made the list two years running.
Another Calpers survey looks at the 300 biggest US companies. The results have shown that more than half of the Top 300 have adopted corporate governance guidelines designed to bolster board independence. Calpers gave high marks to 86 businesses for restructuring governance practices, including IBM, Allied Signal, BankAmerica and Union Carbide. However, some 88 companies received a failing grade for not responding or brushing off the subject.
Calpers uses a two-tier approach in its efforts to implement governance reforms in underperforming companies. Tier one focuses on ten (reduced to nine in 1995) companies - that may be the object of a shareholder proposal. Tier two companies (26 in 1995) are subject to heightened scrutiny and may be downgraded to tier one the following year.
This season Calpers' proxy initiatives concentrated on eliminating staggered boards, with some success. Its proposals to de-stagger boards at Oryx Energy and Boise Cascade secured 56 per cent and 44 per cent of the vote, respectively; and it withdrew a similar proposal at Navistar, after a satisfactory meeting with the new CEO. (Since then the company has adopted a lead director concept.)
Satisified that its actions have made a difference in corporate America, Calpers has tried to apply the same principles to its worldwide investments since 1989. It has worked hard to surmount the difficulties in international proxy voting and has learned more effective methods of communicating its message with foreign managements.
Now, Calpers is considering taking its corporate governance programme beyond the national scene. 'We vote our international proxies and sometimes we go against management,' says Koppes. 'However, we don't have any major follow-up programme as in the US. The Calpers board will grapple with this issue, and we hope to have a decision early 1996. It is a question of whether the cost and staff time are worth it. It is one thing to be active in the US, but another when you have to make a long trip.'
If, nevertheless, it decides to take this course, it would entail publicly identifying poorly performing companies, seeking meetings with chairmen and independent directors and, where necessary, developing shareholder proposals.
Calpers may be leading this charge, but it is not alone in taking the governance crusade overseas. According to the Investor Responsibility Research Center in Washington, US institutions voted 24 per cent of their foreign stock in 1991, nearly 50 per cent in 1992 and an estimated 71 per cent last year.