Pension fund giant CalPERS has
received glowing reports for the
cost savings it has achieved by
managing much of its portfolio inhouse.
While this is good news for the
fund, it might be a warning to investment
An independent report by the
Canada-based firm, Cost Effectiveness
Measurement (CEM), asserted
that CalPERS “paid less for similar services
and received cost
savings from its lower-cost implementation
style of less external asset
Compared with its peer group in the
study universe, CalPERS availed itself
of substantially less external active
management – 30%, compared with
an average of 44% for its peer group
(CalPERS is admittedly substantially
larger than its peer group). Its overall
external management costs were
lower than its peers, and even its internally
managed investment costs were
lower, although only slightly so.
Taken together, these factors allowed
CEM to assert confidently that
CalPERS is a low-cost fund.
CalPERS has focused on moving
more and more of its investment management
capabilities in-house for the
past four or five years, according to CIO
Mark Anson. The decision to take this
approach followed a shift in paradigm
‘separating the beta from the alpha,” he
said, as well as a process of analysing
where CalPERS has “competitive and
informational advantages”.
This period of analysis took place at a
crucial time in the evolution of
CalPERS . “It was coincident with
getting better pay for my in-house
investment staff,” Anson stressed.
Their remuneration is now benchmarked
to a median derived from an
extensive salary survey. Although
salaries have not yet reached this
median, they are approaching it over
time. “This is what allows me to attract
and retain quality staff,” said Anson.
“I give credit to my board. They had
the courage to recognise that we need
to pay a better wage in order to build
up an informational advantage,” said
Anson. A subcommittee on the board
addresses compensation issues, and it
monitors a “very transparent and very
precise” performance metrics system,
which ensures that pay is related to
The wages issue is a crucial determinant
of whether any fund can bring its
asset management in-house, agrees
Brian Birnbaum, principal at consultants
Ennis Knupp in Chicago. “The
only way to manage your assets internally
is to have a compensation scheme
that attracts talented people,” he said.
However, public funds are subject to
greater than normal scrutiny, and substantial
performance bonuses can easily
raise an outcry. This was the case,
for example, with the Harvard Management
Company (HMC), the inhouse
organ for the Harvard University
endowment. Its bond managers
achieved stellar results in 2003 and
2004, outperforming their benchmarks
significantly, and they received
equally stellar bonuses, outraging the
Harvard community.
“Harvard’s management always gets
criticised for its high incentive fees,”
pointed out John Casey of Casey
Quirk Acito. “But when you look at
their performance, they have done
very well for the fund.”
This spring, HMC’s bond team,
along with the president of the
endowment, announced that
they were leaving to set up on their
own, in part to get away from that kind
of close attention. And they are not the
only managers to have fled the fund –
other managers have left to set up privately,
taking their mandates with
them, so that in recent years the
amount managed internally has
decreased from 85% to just over half.
CalPERS’ fund is subject to similar
public scrutiny, but this does not deter
Anson from his commitment to internal
management. When evaluating
the management possibilities for any
asset class, Anson says, “the issue is buy
versus build. Can I attract good staff
and compensate them appropriately?
If so, then it is to our advantage to
bring management in-house, because
the costs are clearly lower. But if you
cannot build a large, experienced
team, then you have to buy.”
Today, CalPERS manages a significant
proportion of its more than
$195bn (€161bn) in assets in-house.
Just over 50% of its $125bn total
equity portfolio is managed in-house.
Looking at its domestic equities, the
way it achieves its costs savings is clear.
Of its $75bn in domestic equities,
nearly 82% is managed passively and
internally, with just the small remaining
portion farmed out for active management.
The fund also manages the
vast majority of its fixed income inhouse:
86% of its total global fixed
income of $48m, and 97% of its $42bn
in domestic fixed income, is managed
Not only is CalPERS achieving
impressive cost savings by moving
funds in-house, but it is also getting
good results. “We have demonstrated
time and again excellent outperformance
with fixed income across the
board,” Anson asserted. For 2004 the
fund was up 13.5% overall; US fixed
income was up 7.4%, easily beating its
benchmark of 6.7%. “We have also
clearly demonstrated our strengths
with the index side of global equities,”
Anson also pointed out.
The success CalPERS has had thus
far has encouraged the fund to
look further at internal management.
“We are definitely going to be
more active at exploring our competitive
advantage,” Anson stated. One
area he is actively looking at right now
is international equity enhanced
indexing strategies. In April this year,
the fund designated a pool of managers
for this area – BGI, Baring Asset
Management and JP Morgan.
CalPERS is also actively involved in
its corporate governance investments,
and recently named Dennis A Johnson
to lead the unit. It targets companies
that are underperforming because of
corporate governance or finance
issues rather than underlying industry
trends, and uses its pressure as a shareholder
to reform their practices. This
area posted the highest return for
2004, coming in at 28%; over the past
five years, CalPERS Corporate Governance
Program has earned an average
annual return of 17%.
In areas in which the internal management
has not yet established a core
competence, the fund explores the
asset class by working in conjunction
with strategic partners. For example,
CalPERS is making some private
equity co-investments for its real
estate portfolio; it is venturing to
choose properties with partners and to
embark on commingled investments.
Anson takes a cautious approach
when pulling an asset class in-house,
often by moving gradually. For example,
CalPERS recently took part of its
international equities portfolio inhouse,
taking in $5bn of an estimated
$30bn managed by State Street.
Although no fund manager is pleased
to lose assets, Anson stressed that it is
not that big a blow for State Street.
“It’s still a big mandate, and I am sure
they do not mind a little competition,”
he explained. “We are not going to terminate
the relationship.”
That said, State Street and the other
managers that are experiencing outflows
as CalPERS and other big funds
try to make cost savings by moving
more and more in-house must be
apprehensive. If CalPERS makes a success
of managing more global equities
strategies in-house, moving more and
more to internal management would
represent additional and very attractive
cost savings for them and yet
another reason to move funds away
from external managers. CalPERS’
dedicated pursuit of in-house management
is not a sign that the industry is
under threat. As one investment manager,
who handles a portfolio for the
Californian giant, pointed out:
“CalPERS is unique and what they do
is not indicative of a trend.”
Nonetheless, for the very large state
pension funds, “it is common to have
a portion managed internally”, said
Birnbaum of Ennis Knupp. “The reason
is the significant cost savings.”
Their budgets often need to be
approved by their state legislatures and
so are subject to intense scrutiny, particularly
on costs. If they manage to
replicate CalPERS’ results, and can
also achieve solid returns, they may
also look at increasing their in-house
In addition, several large corporate
funds, such as General Electric, General
Motors, and DuPont also manage significant
amounts internally. “It is most
common with the very big funds,”
pointed out Casey. “For them the economy
of scale is really a friendly thing.”
While this is not good news for fund
managers, it is a benefit for consultants,
as Birnbaum noted. “Increasingly
boards are interested in having
an independent opinion on how the
fund is doing if it is running its management
For CalPERS, this role has been
filled by Wilshire Associates for the
past 22 years, and this April, its contract
was renewed for another three.
Wilshire’s role “is to render independent
opinions on my ideas to the
board,” explained Anson, but he
stressed that Wilshire is an excellent
resource for the fund that that he has
a good working relationship with the
consulting firm, often talking
through issues, including benchmark
selections and the deployment of
internal resources, in advance of
board decisions.