Along with all my other exciting duties, I’ve taken on the role as the manager of the PERA Project for the Independence Institute’s Fiscal Policy Center. It’s an astonishing amount of material to become acquainted with, but I’m starting with the most recent Comprehensive Annual Financial Report, from 2010 (the 2011 report won’t be ready until July, for some reason).
Most funds try to achieve some level of diversification within their target investments. This is true even for narrow, industry-specific funds, but is clearly true for larger, broad-based funds like a retirement fund, whose primary goal needs to be capital preservation and conservative growth.
In PERA’s case, they divide their investments into five asset classes: stocks, bonds, real estate, commodities, and alternative investments. While there’s some correlation among these, they are true asset classes, meaning that they really do respond to different economic conditions and stimuli. While a generalized, panicky flight for the exits would affect them all, for the most part, these investments don’t move in tandem.
However, the benchmarks against which PERA measures its performance are another matter, and may be setting the fund up for diminished returns.
The benchmarks themselves are not only highly correlated, in several cases, they’re just the same as each other:
| Global Benchmark | |
| DJ US Total Stock Market Index | |
| MSCI ACWI ex-US Index | |
| Fixed Income Custom Benchmark | |
| Barclays Capital Universal Bond Index | |
| Barclays Capital Long Gov’t Credit Index | |
| Alternative Custom Benchmark | |
| DJ US Total Stock Market Index + 3% | |
| Real Estate Custom Benchmark | |
| NCREIF Open-end Core Fund Index + 1% | |
| Opportunity Fund | |
| DJ US Total Stock Market Index | |
| MSCI ACWI ex-US Index | |
| Fixed Income Custom Benchmark | |
There are some questions here. First, the “Opportunity Fund” is currently invested in timber and raw materials. Surely there must be commodity indexes that would be more reflective of the fund’s style. A mixture of equities and fixed income indices doesn’t seem to bear any relationship to the fund’s investments.
Second, fund managers are judged in part by how well they track or beat these benchmarks, PERA is potentially setting up incentives to invest in assets that are reflected in those indices, throwing away the benefits of diversification. The Opportunity Fund, for instance, is being judged on what amounts to a combination of the Global and Fixed Income Benchmarks. It may be in commodities or timber now, but it could well end up migrating to investments that track those other two funds.
The Alternative Investment Fund is the most problematic; in essence, it’s just being held to the US stock market plus 3%. But look at its portfolio: private equity, venture capital, and distressed debt. Those investments don’t necessarily peak at the same point in the business cycle as vanilla equities. The difficulties and dangers of benchmarking alternative investments, which are often illiquid and lacking in direct peers, have been noted before. But there are any number of hedge fund indexes available for them to use. Surely some basket of those would be more reflective of the fund’s actual and intended holdings.
I’ve only just noticed this, and to be fair, I don’t have any evidence that it’s actually affecting investment decisions. Moreover, it’s a second-order effect. Obviously, this isn’t as bad as if the asset classes themselves were highly-correlated. But it’s possible that PERA is creating investing incentives that could come back to bite them in bad years, and cost them valuable basis points in normal years.
