THE GREAT THING
about having stable employment is that when you do your job well, you get paid, and when you don't, you still get paid. Not surprisingly, that payment scheme can lead to unmotivated workers they're in the office, but really just going through the motions. But what if you got compensated only for superior work and mediocre work meant no paycheck?
California Public Employees' Retirement System, or Calpers, the nation's largest public pension fund with assets totaling nearly $247 billion (as of July 31), is considering such a pay system for its money managers. Roger Edelen, assistant professor of finance at Boston College whose research focuses on institutional investing, thinks it could have big advantages for Calpers and other institutional investors.
Dissatisfied with its portfolio's performance, Calpers is seeking to double the active return of its $150 billion Global Equity asset portfolio, which constitutes 66% of total assets in the pension fund. This week Calpers's investment staff presented to its board this simple pay scheme: Pay the fund's global stock managers a fee only if they outperform their benchmark index and nothing if their returns fail to beat the index.
Many public pension funds use a fee structure that rewards money managers with additional fees for outperforming their benchmarks. But they also include at least a minimal fee paid regardless of performance.
"Under this scenario, the managers would get paid only for alpha generation," Calpers's chief investment officer wrote in a memo to the investment committee. Alpha is a term asset managers use for the amount by which they beat the market's return, which they call beta.
The big advantage to this kind of setup: It gives the manager added incentive to beat the market and allows Calpers to make clear-cut distinctions between the alpha- and beta-generating portions of its portfolio, says Edelen.
"I think what Calpers is looking for is the 20% alpha," says Edelen. "They're saying we don't want a closet indexer" the investing equivalent of phoning it in. "I think what they're trying to do is separate the icing on the cake from the cake itself," he says.
SmartMoney.com spoke with Edelen about Calpers's proposal, what it might mean for the pension fund industry and if this fee structure would lead fund managers to take on too much risk.
SmartMoney.com: What do you think Calpers is trying to do with this fee scheme?
Roger Edelen: I think Calpers likes to think about their overall portfolio, say 80% is the index, and then 20% would be alpha. If the manager is collecting fees but is basically just indexing, if they had a performance scheme like this, it's going to cause managers to say, "If I am paid to provide alpha, I'm going to be more aggressive." That would help Calpers separate indexing from alpha generation. Whereas now, they might be paying [the managers] for alpha generation but they're just tracking the index or benchmark.
But on the other hand, the thing you've got to worry about is the idea of, "I don't lose money if I lose, I just don't get paid." They have a lot more upside than downside. On the upside, they can make an arbitrarily large amount of money, which might also mean they would take on risk. It's sort of heads I win, tales I don't lose. Maybe half the time you make money, and the other half, well, whatever. That's the incentive the money manager gets. That is obviously passing free money to the money manager. Calpers would have to weigh that advantage against the disadvantage.
SM: Would this type of system encourage the managers to take on excess risk?
RE: There are ways Calpers can deal with this. They can look at the portfolio to see if the manager is taking on excess risk. That's a little bit tricky. That's the one thing they would have to consider to see if they're getting any payoff for this.
I think this makes sense in a controlled setting. Suppose Calpers wants 80% [of its portfolio] to be tracking the index. I'm sure they're not going to put this performance scheme on the indexed assets. This scheme would only apply to the 20% alpha. Your typical large pension fund has a portion carved out that is trying to capture the market. They will hire a manager whose sole purpose is to capture beta which is a fancy word for an index fund. You put money in an index fund, the fees are the bare minimum and you have complete control over that.
SM: So Calpers is willing to pay more for more aggressive investing?
RE: I think what Calpers is looking for is the 20% alpha. They're saying we don't want a closet indexer. I think what they're trying to do is separate the icing on the cake from the cake itself. It definitely has an advantage. It has a disadvantage as well. In the case of Calpers, I would suggest the advantage is big. The cost of paying a closet indexer is pretty high. It definitely comes down to this question of you have your whole pie, the whole portfolio, and you're carving out a piece. With this piece we'll play a game at trying to beat the market. With the rest of the portfolio, we're just going to do indexing. At places like Yale, which has been in the news recently, if they have a fund, a pool of money big enough and enough prowess and prestige that they can get access to really good alpha players, I think it makes sense to devote a good chunk of the portfolio to that.
SM: If it's successful here, do you think other big pension funds will want to follow suit?
RE: This basic notion of separating out alpha from the beta is a good one. It's a good disciplining tool. If you think people can beat the market, this is an explicit statement of how far you're going to do that. It's an interesting strategy and makes some sense. I do think it would be portable to other pension funds.
SM: What are other possible downsides to what Calpers is considering?
RE: The big issue is what we academics call risk shifting. You want to induce the manager to take the right risk good bets but you don't want them to take on risk for the sake of risk. That's the downside to these schemes....
It certainly makes sense, particularly in a setting like the institutional world where money is pretty stable. And if you're kind of playing golf instead of working and collecting the fee, that can be pretty costly to Calpers. If I know you're doing it for your own wealth, I can trust you'll try hard. I assume they'll try to monitor that carefully. In the case of Calpers or another institutional setting, they can directly deal with the money manager, and look at the portfolio and ask specific questions about specific holdings: Why did you do this trade? How does this fit? You can't really do that with a mutual fund. I think that's possibly what Calpers has in mind for protecting itself.