Before you start
AI can't OCR these pictures, so I had to save everything as JPEG and then use my iPhone to copy the text from each individual picture, because my laptop wouldn't recognize most the of the text, so I needed multiple devices to make this information accessible to AI.
A link to PERAC audits for anyone interested
https://www.mass.gov/lists/retirement-board-audit-reports
Links to all available Massachusetts state audits.
https://www.mass.gov/lists/all-audit-reports-2011-to-today#2025-
Link to everyone that accessed prosper from 1-15-2020/10-2025
https://ultimateworldfinancialmap.blogspot.com/2025/12/prosperfinancialvendoruseraccessv1.html
PERAC annual reports
https://www.mass.gov/doc/2020-annual-report-full/download
https://www.mass.gov/doc/2021-annual-report-full/download
https://www.mass.gov/doc/2022-annual-report-full/download
https://www.mass.gov/doc/2023-annual-report-full-0/download
https://www.mass.gov/doc/2024-annual-report-full-0/download
PRIM reports, summary's and minutes
Links to stuff I copied from the PRIM site for AI
https://ultimateworldfinancialmap.blogspot.com/2025/12/prim-info-for-ai.html
Link to all PRIM reports, summary"s and minutes
https://www.mapension.com/records-of-interest/
Link to more emails between PERAC and myself, plus emails between PERAC and vendors. that's how my AI noticed the issues with this system.
Public_Records_Request–PERAC_Investment_Records_2024–2025 part 2
https://ultimateworldfinancialmap.blogspot.com/2025/12/publicrecordsrequestperacinvestmentreco_22.html
Public_Records_Request–PERAC_Investment_Records_2024–2025 part 3
https://ultimateworldfinancialmap.blogspot.com/2025/12/perac-records-request-part-3.html
Beneficiaries of the Massachusetts State Employees' Retirement System (MSERS) and the Massachusetts Teachers' Retirement System (MTRS). Updated monthly. Retirees of municipal, county or regional entities as well as educators who retired from the Boston Public Schools are not listed here. For that data, please contact the applicable local or regional retirement system directly.
https://cthrupensions.mass.gov/#!/year/2025/
https://cthrupensions.mass.gov/#!/year/2025/
Memo's and other complacency paperwork I was sent.
PERAC
COMMONWEALTH OF MASSACHUSETTS
DOMENIC J. F. RUSSO, Chairman
PERAC Memo # 51 / 2012
PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
JOSEPH E. CONNARTON, Executive Director
Auditor SUZANNE M. BUMP | ALAN MACDONALD | JAMES M. MACHADO | DONALD R. MARQUIS | ROBERT B. McCARTHY | GREGORY R. MENNIS
All Retirement Boards
JanepliE.Comas
МЕМORANDUM
TO:
FROM:
RE:
DATE:
Joseph E. Connarton, Executive Director
Chapter 32, Section 23B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
Chapter 176 of the Acts of 2011 inserted Section 23B into Chapter 32 of the General Laws. That
section delineates a specific procurement process to be followed by retirement boards when
seeking certain services. It also mandates that contractual terms relative to fiduciary status,
indemnification, and disclosure be incorporated into contracts for “investment servicе
providers".
In order to provide guidance to retirement boards, attorneys, investment consultants and
managers (particularly general partners in the context of partnership or trust agreements) the
Commission sets forth the following as to the provisions of Section 23B relating to fiduciary
status, indemnification and disclosure.
Chapter 32, Section 23B requires that contracts entered into by retirement boards include and/or
exclude certain terms and conditions. Specifically these include terms:
"(a) stating that the contractor is a fiduciary with respect to the funds which the contractor
invests on behalf of the retirement board; ... (c) requiring the contractor to annually inform the
commission and the board of any arrangements in oral or in writing, for compensation or other
benefit received or expected to be received by the contractor or a related person from others in
connection with the contractors services to the retirement board or any other client; (d) requiring
the contractor to annually disclose to the commission and the retirement board compensation, in
whatever form, paid or expected to be paid, directly or indirectly, by the contractor or a related
person to others in relation to the contractors services to the retirement board or any other client;
and (e) requiring the contractor to annually disclose to the commission and the retirement board
in writing any conflict of interest the contractor may have that could reasonably be expected to
impair the contactor's ability to render unbiased and objective services to the retirement board."
FIVE MIDDLESEX AVENUE,SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
PERAC
MEMORANDUM - Page Two
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
Indemnification
The statute also requires that the contract include terms "... (b) stating that the contractor shall
not be indemnified by the retirement board ...". Thus the applicability of any such
indemnification clause to a retirement board is prohibited.
It is important in this context to review relevant terms as defined in Section 23B.
The prohibition states that the "contractor shall not be indemnified" by the board. The definition
of contractor is "a person having a contract with a retirement board."
As a result the prohibition on indemnification runs to the person providing the services to the
retirement board. Section 23B defines a "person" as "a natural person, business, partnership,
corporation, union, committee, club or other organization, entity or group of individuals."
A contract is defined in Section 23B as "an agreement for the procurement of services, regardless
of what the parties may call the agreement."
The statute does not define "indemnification".
Applying this to the investment management context requires an assessment as to how this law is
given effect under the legal structure governing the relationship between the retirement board
and "contractor".
In the separate account context the inclusion of this term and others required by Section 23B is
straightforward. The investment manager is the contractor, the investment management
agreement is the contract, and that contract must contain the terms required by Section 23В.
In the context of limited partnerships and similar legal entities the retirement board or system
becomes a limited partner or other similar party and, through that vehicle, another party (often
the general partner or an affiliate) contracts to manage assets of the limited partners including
those of the retirement board or system.
In the limited partnership, trust and mutual fund context the application of the statutory terms is
required but the manner in which that is accomplished is different. In the absence of the
necessary terms being in the partnership or trust agreement the normal method of establishing
unique terms for one investor is through a legally binding contractual agreement referred to as a
"side letter". In the event that the partnership agreement does not comply with the statute, the
23B mandatory terms relating to fiduciary status, indemnification and disclosure must be set
forth in such an agreement between the retirement board and the contractor.
MEMORANDUM-Page Threе
TO: All Retirement Boards
FROM:
RE:
DATE:
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
It is particularly important to note that the indemnification exclusion relates to the contractor or
general partner in the limited partnership situation because it is the general partner that is providing services to the retirement board and not the limited partnership itself. Thus, although
the law prohibits the retirement board from indemnifying the "contractor", in this case the
general partner, it does not prohibit the retirement board in its capacity as a limited partner from indemnifying the limited partnership.
Recently the Commission addressed this issue with a Board and its attorneys and the following
language in the side letter was deemed to comply with the statute:
"Section 3(a) of the Investment Manager and Subscription Agreement of (the
"Subscription Agreement") is deleted in its entirety and the Manager hereby waives all right to
indemnity by that it would otherwise be entitled to under the terms of the LLC
Agreement, Confidential Placement Memorandum, and/or Subscription Agreement."
A second issue that arises in the context of these investment vehicles and indemnification is how
to address liabilities that result from the misfeasance or malfeasance of a limited partner when
that limited partner is a retirement board. In making these investments retirement boards provide
various assurances to the other limited partners as well as the general partners relative to the
status of the retirement board, its legal ability to make the investment and other issues.
Responsibility for liability to the partnership or general partner arising from the retirement board
making inaccurate or misleading assertions as to these matters or a failure of the retirement board
to meet it obligations under the agreement is not the type of "indemnification" that the statute
prohibits.
Again we recently addressed this issue and the following language was deemed satisfactory:
"(a) Section 3(b) of the Subscription Agreement is deleted in its entirety and replaced
with the following:
Notwithstanding anything to the contrary in the LLC Documents, the client
hereby agrees to indemnify, to the fullest extent permitted by law, the LLC, within the meaning
of Section 15 of the Securities Act of 1933, as amended (the "Securities Act"), against any and
all losses, claims, damages expenses and liabilities, including, but not limited to, any reasonable
investigation, or reasonable legal or other reasonable expenses incurred in connection with (i(
any false representation or warranty made by the Client, or breach or failure by the Client to
comply with any covenant or agreement made by the Client, in the LLC documents or in any
other document furnished by the client to any of the foregoing in connection with this transaction
or (ii) any action for securities law violations instituted by the Client which is finally resolved by
judgment against the Client. The Client also agrees to indemnify the LLC, to the fullest extent
permitted by law for any and all costs, fees, and expenses resulting from the Client's assertion of
MEMORANDU M - Page Four
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
lack of proper authorization to enter into this Agreement or perform the obligations hereof
because such Client is acting as agent, representative or nominee for a subscriber."
Disclosure
As cited above Section 23B also mandates that contractors provide annual disclosures to the
retirement board and PERAC. Under separate cover guidance will be provided in that regard. In
this memo we are addressing the meaning of that requirement in the context of contract
agreements, particularly the arrangements outlined above.
The disclosure requirement required by statute states "(d) requiring the contractor to annually
disclose to the commission and the retirement board compensation, in whatever form, paid or
expected to be paid, directly or indirectly, by the contractor or a related person to others in
relation to the contractors services to the retirement board or any other client;"(similar language
appears in (c)).
The primary concern in this regard is the meaning of the term "...any other client". PERAC
believes that the statute did not intend that every possible arrangement relating to all public,
private, and individual clients of a contractor be disclosed. It is the position of the Commission
that the statutory requirement to disclose the noted compensation "...in relation to the
contractors services to ... any other client" can be met by disclosing such compensation in
connection with the investment being made by the other clients in the same product or for the
same service in which the retirement board is investing. For example, if the retirement board is
investing in Venture Capital Limited Partnership V, compensation paid in relation to the
retirement boards' investment and the investment of others in that partnership must be disclosed.
The identity of the other client need not be disclosed.
In addition the statute uses the term "related person". The Commission interprets that phrase in a
manner that is generally consistent with the definitions included in the SEC ADV Glossary of
Terms. Applying that here results in a "related person" being any affiliate or any person that is
under common control with the contractor. Section 23B defines a "person" as "a natural person,
business, partnership, corporation, union, committee, club or other organization, entity or group
of individuals.". "Control" means the power, directly or indirectly, to direct the management or
policies of a person whether through ownership of securities, by contract or otherwise.
MEMORANDUM - Page Five
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and Fiduciary Duty
October 18, 2012
Fiduciary Duty
Finally the Commission has addressed the issue of the Fiduciary Representation in the context of
these arrangements by finding that the following is deemed satisfactory in a side letter:
"The Manager hereby represents and warrants to, and agrees with , that the
Manager, and any investment advisor employed in connection with this Fund, is a fiduciary with
respect to the Fund, which includes the assets invested by _, and will discharge its duties
to the Fund, including the assets invested by _, with the care, skill, prudence anp
diligence under the circumstances then prevailing that a prudent person acting in a like capacity
and familiar with such matters would use in the conduct of an enterprise of a like character and
with like aims and investment policies."
Retirement boards should carefully review partnership agreements, trust agreements and other
similar investment vehicles to discern if the terms of such agreements run afoul of Section 23B.
In such instances the retirement board may wish to explore the possibility of negotiating a side
letter with the general partners or other similar entities that bring the contract between the
retirement board and the contractor into compliance with the law.
COMMONWEALTH OF MASSACHUSETTS
DOMENIC J. F. RUSSO, Chairman
PERAC Memo # 51 / 2012
PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
JOSEPH E. CONNARTON, Executive Director
Auditor SUZANNE M. BUMP | ALAN MACDONALD | JAMES M. MACHADO | DONALD R. MARQUIS | ROBERT B. McCARTHY | GREGORY R. MENNIS
All Retirement Boards
JanepliE.Comas
МЕМORANDUM
TO:
FROM:
RE:
DATE:
Joseph E. Connarton, Executive Director
Chapter 32, Section 23B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
Chapter 176 of the Acts of 2011 inserted Section 23B into Chapter 32 of the General Laws. That
section delineates a specific procurement process to be followed by retirement boards when
seeking certain services. It also mandates that contractual terms relative to fiduciary status,
indemnification, and disclosure be incorporated into contracts for “investment servicе
providers".
In order to provide guidance to retirement boards, attorneys, investment consultants and
managers (particularly general partners in the context of partnership or trust agreements) the
Commission sets forth the following as to the provisions of Section 23B relating to fiduciary
status, indemnification and disclosure.
Chapter 32, Section 23B requires that contracts entered into by retirement boards include and/or
exclude certain terms and conditions. Specifically these include terms:
"(a) stating that the contractor is a fiduciary with respect to the funds which the contractor
invests on behalf of the retirement board; ... (c) requiring the contractor to annually inform the
commission and the board of any arrangements in oral or in writing, for compensation or other
benefit received or expected to be received by the contractor or a related person from others in
connection with the contractors services to the retirement board or any other client; (d) requiring
the contractor to annually disclose to the commission and the retirement board compensation, in
whatever form, paid or expected to be paid, directly or indirectly, by the contractor or a related
person to others in relation to the contractors services to the retirement board or any other client;
and (e) requiring the contractor to annually disclose to the commission and the retirement board
in writing any conflict of interest the contractor may have that could reasonably be expected to
impair the contactor's ability to render unbiased and objective services to the retirement board."
FIVE MIDDLESEX AVENUE,SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
PERAC
MEMORANDUM - Page Two
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
Indemnification
The statute also requires that the contract include terms "... (b) stating that the contractor shall
not be indemnified by the retirement board ...". Thus the applicability of any such
indemnification clause to a retirement board is prohibited.
It is important in this context to review relevant terms as defined in Section 23B.
The prohibition states that the "contractor shall not be indemnified" by the board. The definition
of contractor is "a person having a contract with a retirement board."
As a result the prohibition on indemnification runs to the person providing the services to the
retirement board. Section 23B defines a "person" as "a natural person, business, partnership,
corporation, union, committee, club or other organization, entity or group of individuals."
A contract is defined in Section 23B as "an agreement for the procurement of services, regardless
of what the parties may call the agreement."
The statute does not define "indemnification".
Applying this to the investment management context requires an assessment as to how this law is
given effect under the legal structure governing the relationship between the retirement board
and "contractor".
In the separate account context the inclusion of this term and others required by Section 23B is
straightforward. The investment manager is the contractor, the investment management
agreement is the contract, and that contract must contain the terms required by Section 23В.
In the context of limited partnerships and similar legal entities the retirement board or system
becomes a limited partner or other similar party and, through that vehicle, another party (often
the general partner or an affiliate) contracts to manage assets of the limited partners including
those of the retirement board or system.
In the limited partnership, trust and mutual fund context the application of the statutory terms is
required but the manner in which that is accomplished is different. In the absence of the
necessary terms being in the partnership or trust agreement the normal method of establishing
unique terms for one investor is through a legally binding contractual agreement referred to as a
"side letter". In the event that the partnership agreement does not comply with the statute, the
23B mandatory terms relating to fiduciary status, indemnification and disclosure must be set
forth in such an agreement between the retirement board and the contractor.
MEMORANDUM-Page Threе
TO: All Retirement Boards
FROM:
RE:
DATE:
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
It is particularly important to note that the indemnification exclusion relates to the contractor or
general partner in the limited partnership situation because it is the general partner that is providing services to the retirement board and not the limited partnership itself. Thus, although
the law prohibits the retirement board from indemnifying the "contractor", in this case the
general partner, it does not prohibit the retirement board in its capacity as a limited partner from indemnifying the limited partnership.
Recently the Commission addressed this issue with a Board and its attorneys and the following
language in the side letter was deemed to comply with the statute:
"Section 3(a) of the Investment Manager and Subscription Agreement of (the
"Subscription Agreement") is deleted in its entirety and the Manager hereby waives all right to
indemnity by that it would otherwise be entitled to under the terms of the LLC
Agreement, Confidential Placement Memorandum, and/or Subscription Agreement."
A second issue that arises in the context of these investment vehicles and indemnification is how
to address liabilities that result from the misfeasance or malfeasance of a limited partner when
that limited partner is a retirement board. In making these investments retirement boards provide
various assurances to the other limited partners as well as the general partners relative to the
status of the retirement board, its legal ability to make the investment and other issues.
Responsibility for liability to the partnership or general partner arising from the retirement board
making inaccurate or misleading assertions as to these matters or a failure of the retirement board
to meet it obligations under the agreement is not the type of "indemnification" that the statute
prohibits.
Again we recently addressed this issue and the following language was deemed satisfactory:
"(a) Section 3(b) of the Subscription Agreement is deleted in its entirety and replaced
with the following:
Notwithstanding anything to the contrary in the LLC Documents, the client
hereby agrees to indemnify, to the fullest extent permitted by law, the LLC, within the meaning
of Section 15 of the Securities Act of 1933, as amended (the "Securities Act"), against any and
all losses, claims, damages expenses and liabilities, including, but not limited to, any reasonable
investigation, or reasonable legal or other reasonable expenses incurred in connection with (i(
any false representation or warranty made by the Client, or breach or failure by the Client to
comply with any covenant or agreement made by the Client, in the LLC documents or in any
other document furnished by the client to any of the foregoing in connection with this transaction
or (ii) any action for securities law violations instituted by the Client which is finally resolved by
judgment against the Client. The Client also agrees to indemnify the LLC, to the fullest extent
permitted by law for any and all costs, fees, and expenses resulting from the Client's assertion of
MEMORANDU M - Page Four
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and
Fiduciary Duty
October 18, 2012
lack of proper authorization to enter into this Agreement or perform the obligations hereof
because such Client is acting as agent, representative or nominee for a subscriber."
Disclosure
As cited above Section 23B also mandates that contractors provide annual disclosures to the
retirement board and PERAC. Under separate cover guidance will be provided in that regard. In
this memo we are addressing the meaning of that requirement in the context of contract
agreements, particularly the arrangements outlined above.
The disclosure requirement required by statute states "(d) requiring the contractor to annually
disclose to the commission and the retirement board compensation, in whatever form, paid or
expected to be paid, directly or indirectly, by the contractor or a related person to others in
relation to the contractors services to the retirement board or any other client;"(similar language
appears in (c)).
The primary concern in this regard is the meaning of the term "...any other client". PERAC
believes that the statute did not intend that every possible arrangement relating to all public,
private, and individual clients of a contractor be disclosed. It is the position of the Commission
that the statutory requirement to disclose the noted compensation "...in relation to the
contractors services to ... any other client" can be met by disclosing such compensation in
connection with the investment being made by the other clients in the same product or for the
same service in which the retirement board is investing. For example, if the retirement board is
investing in Venture Capital Limited Partnership V, compensation paid in relation to the
retirement boards' investment and the investment of others in that partnership must be disclosed.
The identity of the other client need not be disclosed.
In addition the statute uses the term "related person". The Commission interprets that phrase in a
manner that is generally consistent with the definitions included in the SEC ADV Glossary of
Terms. Applying that here results in a "related person" being any affiliate or any person that is
under common control with the contractor. Section 23B defines a "person" as "a natural person,
business, partnership, corporation, union, committee, club or other organization, entity or group
of individuals.". "Control" means the power, directly or indirectly, to direct the management or
policies of a person whether through ownership of securities, by contract or otherwise.
MEMORANDUM - Page Five
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 32B Contract Terms, Indemnification, Disclosure, and Fiduciary Duty
October 18, 2012
Fiduciary Duty
Finally the Commission has addressed the issue of the Fiduciary Representation in the context of
these arrangements by finding that the following is deemed satisfactory in a side letter:
"The Manager hereby represents and warrants to, and agrees with , that the
Manager, and any investment advisor employed in connection with this Fund, is a fiduciary with
respect to the Fund, which includes the assets invested by _, and will discharge its duties
to the Fund, including the assets invested by _, with the care, skill, prudence anp
diligence under the circumstances then prevailing that a prudent person acting in a like capacity
and familiar with such matters would use in the conduct of an enterprise of a like character and
with like aims and investment policies."
Retirement boards should carefully review partnership agreements, trust agreements and other
similar investment vehicles to discern if the terms of such agreements run afoul of Section 23B.
In such instances the retirement board may wish to explore the possibility of negotiating a side
letter with the general partners or other similar entities that bring the contract between the
retirement board and the contractor into compliance with the law.
PERAC PERAC Memo # 32/2018
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chairman
Auditor
JOSEPH E. CONNARTON, Executive Director
SUZANNE M. BUMP | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES M. MACHADO | ROBERT B. McCARTHY | JENNIFER F. SULLIVAN
MEMORANDUM
TO:
FROM:
Torept 3.Gno Joseph E. Connarton, Executive Director
RE: Procurement
DATE: November 5, 2018
In the upcoming months retirement boards will be seeking to procure various services in order to
comply with the statutory limitations on contract length. As that process unfolds retirement
board members must comply with their fiduciary duty. This memo outlines several reminders
based on what the Commission has experienced since the adoption of Section 23B of Chapter 32.
the
The Inspector General ("IG") issues a regular Procurement Bulletin which is helpful to those
to engage in a competitive process. The Bulletin issued in April, 2017 provided
following advice in the article entitled:
about
Promote Robust Competition Among All Qualified Vendors by Addressing Any
Inadvertent or Intentional Bid Tailoring
When conducting a public procurement, the government acts as an agent for the
taxpayers, and, therefore, procurement officials must comply with both the letter
and the spirit of public procurement laws. All public procurement processes must
be conducted in a fair and open manner that maximizes competition among all
qualified vendors. Why is this a fundamental principle in public procurement?
Because the goal of the public procurement process is twofold: (1) to ensure that
taxpayers (and other stakeholders) get the best prices for the goods or services
needed; and (2) to provide an equal opportunity to all qualified vendors interested
in bidding.
Some procurement officials may not be aware of this duty while others simply
neglect it. Neglect may be rooted in a desire to move the process along quickly or
a mistaken belief that an open, competitive process will not result in the best deal.
Some procurement officials may intentionally avoid a fair and open process
because they want to ensure that a favored vendor wins the bid. In the worst
cases, this conduct constitutes procurement fraud.
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
PERAC
MEMORANDU M - Page Two
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Procurement
November 5, 2018
A common form of procurement neglect or fraud is bid tailoring. Bid tailoring
happens when specifications, qualifications, or other bid or contract requirements
favor one or more vendors and effectively exclude others. Sometimes this
tailoring is intentional; other times it is inadvertent. For example, a procurement
official mistakenly believes that a service provider requires professional licensure,
and includes this requirement in the bid specifications. In fact, the type of service
does not require the provider to be licensed, but only two of eight local vendors
happen to be licensed. Adding this particular licensing qualification might have
been a mistake based on misinformation or lack of research. As a result, the
procurement official effectively limited the local bidder pool to only two vendors.
Consider the following examples of bidder requirements:
A bidder must have a minimum of 40 years of experience in the trade
Any firm submitting a bid must have an industry market share of more than
50%
Vendors must have a facility within five miles of Town Hall
Providers must be equipped with Acme products
Vendors must own all equipment
After reviewing the examples above, you may see how such requirements might
severely restrict competition while adding little to no benefit to the supply or
service. If there is no legitimate business reason to include these requirements,
then reconsider their inclusion in your bid specifications.
Even if there is a legitimate reason for the requirements, if they are detrimental to
fair, open and competitive process, you should re-examine whether these
requirements are really necessary for a successful contract.
a
Procurement officials make mistakes like we all do, but what appears to be a
mistake can also be procurement fraud. For example, a request for proposals
("RFP") for landscaping states that vendors must have a facility within five miles
of Town Hall. The official who included the requirement claims that it is to
ensure a quick response time from the vendor. However, response time is not a
significant factor in the contract (in fact, the landscaping work will not be done at Town Hall). Further, while many potential vendors are located between six and
ten miles of Town Hall, only one vendor, who also has personal ties to the
official, is within five miles. In such a situation, what appears to be a poorly
drafted RFP could actually be procurement fraud.
MEMORANDUM - Page Three
TO: All Retirement Boards
FROM: Joseph E. Connarton, Executive Director
RE: Procurement
DATE: November 5, 2018
To help deter or detect procurement fraud based on bid tailoring, you may:
1) Question a requirement in the bid package that could limit competition. Make
sure you know (1) what the reason is for including it; (2) whether the reason is
logical; and (3) if the requirement is necessary.
2)
3)
4)
Listen to vendor complaints. Most vendors want to increase their business by
submitting bids. Vendors therefore often pinpoint the specification
requirement that deters or limits competition.
If you receive only one bid or a very small number of bids, review your bid
specifications. The same is true if you receive bids from the same vendor(s)
all the time. If you are using a fair and open competitive process, then you
should generate robust competition. If you are not, then check your
requirements for anything that might be deterring competition. If the bidder
pool is severely limited, that may be a red flag indicating some sort of bid
tailoring.
Compare your requirements to those of other jurisdictions purchasing the
same goods or services. Compare their competitive pool of vendors to yours.
5) If vendors are not bidding, then ask them why they are not.
Elaborating on the examples set forth, PERAC's Compliance Unit has seen many RFP's that
reject a submission if the service provider does not meet a minimum number of Massachusetts
public pension fund clients, fails to manage a minimum level of assets, in general or in a
particular asset class or similar requirements. Mandating such requirements prevents otherwise
eligible firms from even submitting responses. It is not an open process if the minimum criteria
discourage RFP responses. The proper approach is to assess the substance of each RFP response
and award points based on meeting the criteria (for example a firm with no Massachusetts
pension fund clients could be awarded 0 points; a firm with 1-5 clients could be awarded x points
and a firm with 5-10 clients could be awarded y points). A mandatory requirement requiring
rejection of the RFP submission due to failing to have a certain level or type of client or lack of a
certain number of years in business is particularly pernicious because it assures that only
incumbents will respond.
An additional issue has arisen, as some retirement boards and consultants have enunciated
reluctance to conduct in-person interviews as part of the assessment of service providers.
a
MEMORAND UM - Page Four
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Procurement
November 5, 2018
The failure to conduct such interviews does not expose the fiduciary to personal liability until
something goes wrong. In that situation, the fact that interviews were conducted as part of the
search process has been a key aspect of a ruling in favor of the fiduciary.
Erik Daley, CFA Managing Principal of the MULTNOMAH Group, states the following "Conducting a Vendor Search: Benefits and Best Practices":
Once proposals are reviewed and compared, the plan sponsor typically selects
three to four finalists from among the candidate pool. The finalists represent the
proposals that best address the plan's unique objectives and overall
circumstances. Finalists are typically given another opportunity to present the
highlights of their offering in-person at the plan sponsor's location. The analysis
phase concludes with the selection of the plan's vendor.
He goes on to observe that:
Although there is no "uniform checklist" for procedural prudence, Tatum, 761
F.3d at 358, it must be the case that prudence requires more than blindly to defer
to the decisions of someone else, no matter how qualified. Brotherson v. Putnam
Invs., LLC.
in
for
In a convoluted but seminal case with numerous appeals, Unisys mounteda successful defense to
a claim of a violation of fiduciary duty in selecting an insurance company GIC product
employees to choose as part of a 402(k) type plan. The Appeals Court in reviewing the findings
of the District Court stated:
Unisys delegated the responsibility of investing for the Fund to Davis White and
Leon Level. White and Level have educational and practical backgrounds in
financial matters. At the direction of White and Level, Unisys purchased three
Executive Life GIC's as investments for the Fund through bidding processes in
June 1987, December 1987 ... and January 1988. Of the many GICs purchased
for the Fund, only three were Executive Life GICs, constituting between 15 and
20 per cent of the Fund's assets. Unisys, through White and Level, considered
many firms through a process of competitive bidding, and Unisys heard in-person
presentations from the insurance companies.
In this case Unisys (1) delegated/assigned responsibility to employees with a financial
background (thus avoiding allegations that individuals who were not up to the job were selected);
(2) engaged in a competitive bidding process; and (3) "heard in-person presentations from the
insurance companies.
MEMORAND UM - Page Five
All Retirement Boards
Joseph E. Connarton, Executive Director
TO:
FROM:
RE:
DATE: November 5, 2018
Procurement
Commentators have made it clear that in-person interviews provide a shield against charges of a
violation of fiduciary duty in the selection of service providers. For example the Schiff Hardin
Law Firm citing Unisys notes:
This
Having a prudent process for selecting a service provider can be a critical step in
defending against a breach of fiduciary duty claim. The case of In re Unisys
Savings Plan Litigation [22 EBC 2945 (3d Cir. 1999)] demonstrates this point.
Unisys included a guaranteed insurance contract (GIC) as an investment choice
that participants could select in their directed accounts. At some point, the
insurance company was placed into receivership and participants who had
invested in the GIC stood to lose the guaranteed return promised in the GIC.
Participants who invested in the GIC sued Unisys, alleging that it had imprudently
selected the insurance company. The court, however, concluded that Unisys had
engaged in a prudent selection process. The court noted that Unisys had retained
the services of two highly qualified consultants to help it select the insurance
company that it had engaged in a competitive bidding process, that it had inperson presentations from the insurance companies under consideration, and
that it had reviewed the ratings of the insurance companies before making the
selection. Under the circumstances, the court held that Unisys had discharged its
duties to the plan prudently, and therefore was not liable for the losses to the plan.
issue comes up only after losses have been incurred and recovery is sought from
fiduciary. A hypothetical might assist in understanding the importance of interviews:
the
Investment consultant X, following a review of RFP responses, recommended to retirement
board Y, that $100 million be allocated to a fund managed by Bernie Madoff. The investment
consultant said that no interview is needed and Mr. Madoff is somewhat of a recluse and does
not participate in such interviews. Retirement board Y voted to allocate $100 million to the
Bernie Madoff Fund. Several months later it is discovered that the valuations of the Fund were
fraudulent and the $100 million is lost. Securities litigation firms, having seen their fees for that
kind of lawsuit diminish, have branched out and are now representing retirement system
members suing trustees for breaches of fiduciary duty. Such a lawsuit has been filed against you
due to the Madoff loss. The plaintiff's attorney asks you "Did you ever meet Mr. Madoff?" You
respond "No". He says "Do you mean to tell the members of this jury that as a fiduciary you
gave Bernie Madoff $100 million to invest without reviewing other firms?" "Yes." "Do you
mean to tell the members of this jury that you gave Bernie Madoff $100 million that he has lost
without even interviewing him?" "Yes." "Your honor, I rest my case!"
MEMORAND U M - Page Six
All Retirement Boards
Joseph E. Connarton, Executive Director
Procurement
TO:
FROM:
RE:
DATE: November 5, 2018
In addition to issues pertaining to searches for investment service providers, some have
expressed reservations about conducting interviews as part of the search for legal services.
In the advisory entitled "How to Choose a Lawyer in Five Easy Steps" the first step is:
"Conduct Candidate Interviews"
One of the best ways to assess a lawyer's legal ability is by interviewing the lawyer. Most
attorneys will provide an initial consultation (usually an hour or less) at no charge. A few
important questions to ask during this meeting are:
What experience does the lawyer have in your type of legal matter?
How long has he been in practice?
What is his track record of success?
What percentage of his caseload is dedicated to handling your type of legal problem?
Does he have any special skills or certifications?
What are his fees and how are they structured?
Does he carry malpractice insurance? If so, how much?
Who else would be working on your case and what are their rates?
Does he outsource any key legal tasks for functions?
What additional costs may be involved in addition to lawyer fees (postage, filing fees,
copy fees, etc.)?
How often will you be billed?
Can he provide references from other clients?
Does he have a written fee agreement or representation agreement?
How will he inform you of developments in your case?
The Commission understands that this period of increased procurement activity is a challenging
one for board members. Please contact PERAC Compliance Officer, Tom O'Donnell, if you
need assistance or have questions regarding the procurement process.
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chairman
Auditor
JOSEPH E. CONNARTON, Executive Director
SUZANNE M. BUMP | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES M. MACHADO | ROBERT B. McCARTHY | JENNIFER F. SULLIVAN
MEMORANDUM
TO:
FROM:
Torept 3.Gno Joseph E. Connarton, Executive Director
RE: Procurement
DATE: November 5, 2018
In the upcoming months retirement boards will be seeking to procure various services in order to
comply with the statutory limitations on contract length. As that process unfolds retirement
board members must comply with their fiduciary duty. This memo outlines several reminders
based on what the Commission has experienced since the adoption of Section 23B of Chapter 32.
the
The Inspector General ("IG") issues a regular Procurement Bulletin which is helpful to those
to engage in a competitive process. The Bulletin issued in April, 2017 provided
following advice in the article entitled:
about
Promote Robust Competition Among All Qualified Vendors by Addressing Any
Inadvertent or Intentional Bid Tailoring
When conducting a public procurement, the government acts as an agent for the
taxpayers, and, therefore, procurement officials must comply with both the letter
and the spirit of public procurement laws. All public procurement processes must
be conducted in a fair and open manner that maximizes competition among all
qualified vendors. Why is this a fundamental principle in public procurement?
Because the goal of the public procurement process is twofold: (1) to ensure that
taxpayers (and other stakeholders) get the best prices for the goods or services
needed; and (2) to provide an equal opportunity to all qualified vendors interested
in bidding.
Some procurement officials may not be aware of this duty while others simply
neglect it. Neglect may be rooted in a desire to move the process along quickly or
a mistaken belief that an open, competitive process will not result in the best deal.
Some procurement officials may intentionally avoid a fair and open process
because they want to ensure that a favored vendor wins the bid. In the worst
cases, this conduct constitutes procurement fraud.
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
PERAC
MEMORANDU M - Page Two
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Procurement
November 5, 2018
A common form of procurement neglect or fraud is bid tailoring. Bid tailoring
happens when specifications, qualifications, or other bid or contract requirements
favor one or more vendors and effectively exclude others. Sometimes this
tailoring is intentional; other times it is inadvertent. For example, a procurement
official mistakenly believes that a service provider requires professional licensure,
and includes this requirement in the bid specifications. In fact, the type of service
does not require the provider to be licensed, but only two of eight local vendors
happen to be licensed. Adding this particular licensing qualification might have
been a mistake based on misinformation or lack of research. As a result, the
procurement official effectively limited the local bidder pool to only two vendors.
Consider the following examples of bidder requirements:
A bidder must have a minimum of 40 years of experience in the trade
Any firm submitting a bid must have an industry market share of more than
50%
Vendors must have a facility within five miles of Town Hall
Providers must be equipped with Acme products
Vendors must own all equipment
After reviewing the examples above, you may see how such requirements might
severely restrict competition while adding little to no benefit to the supply or
service. If there is no legitimate business reason to include these requirements,
then reconsider their inclusion in your bid specifications.
Even if there is a legitimate reason for the requirements, if they are detrimental to
fair, open and competitive process, you should re-examine whether these
requirements are really necessary for a successful contract.
a
Procurement officials make mistakes like we all do, but what appears to be a
mistake can also be procurement fraud. For example, a request for proposals
("RFP") for landscaping states that vendors must have a facility within five miles
of Town Hall. The official who included the requirement claims that it is to
ensure a quick response time from the vendor. However, response time is not a
significant factor in the contract (in fact, the landscaping work will not be done at Town Hall). Further, while many potential vendors are located between six and
ten miles of Town Hall, only one vendor, who also has personal ties to the
official, is within five miles. In such a situation, what appears to be a poorly
drafted RFP could actually be procurement fraud.
MEMORANDUM - Page Three
TO: All Retirement Boards
FROM: Joseph E. Connarton, Executive Director
RE: Procurement
DATE: November 5, 2018
To help deter or detect procurement fraud based on bid tailoring, you may:
1) Question a requirement in the bid package that could limit competition. Make
sure you know (1) what the reason is for including it; (2) whether the reason is
logical; and (3) if the requirement is necessary.
2)
3)
4)
Listen to vendor complaints. Most vendors want to increase their business by
submitting bids. Vendors therefore often pinpoint the specification
requirement that deters or limits competition.
If you receive only one bid or a very small number of bids, review your bid
specifications. The same is true if you receive bids from the same vendor(s)
all the time. If you are using a fair and open competitive process, then you
should generate robust competition. If you are not, then check your
requirements for anything that might be deterring competition. If the bidder
pool is severely limited, that may be a red flag indicating some sort of bid
tailoring.
Compare your requirements to those of other jurisdictions purchasing the
same goods or services. Compare their competitive pool of vendors to yours.
5) If vendors are not bidding, then ask them why they are not.
Elaborating on the examples set forth, PERAC's Compliance Unit has seen many RFP's that
reject a submission if the service provider does not meet a minimum number of Massachusetts
public pension fund clients, fails to manage a minimum level of assets, in general or in a
particular asset class or similar requirements. Mandating such requirements prevents otherwise
eligible firms from even submitting responses. It is not an open process if the minimum criteria
discourage RFP responses. The proper approach is to assess the substance of each RFP response
and award points based on meeting the criteria (for example a firm with no Massachusetts
pension fund clients could be awarded 0 points; a firm with 1-5 clients could be awarded x points
and a firm with 5-10 clients could be awarded y points). A mandatory requirement requiring
rejection of the RFP submission due to failing to have a certain level or type of client or lack of a
certain number of years in business is particularly pernicious because it assures that only
incumbents will respond.
An additional issue has arisen, as some retirement boards and consultants have enunciated
reluctance to conduct in-person interviews as part of the assessment of service providers.
a
MEMORAND UM - Page Four
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Procurement
November 5, 2018
The failure to conduct such interviews does not expose the fiduciary to personal liability until
something goes wrong. In that situation, the fact that interviews were conducted as part of the
search process has been a key aspect of a ruling in favor of the fiduciary.
Erik Daley, CFA Managing Principal of the MULTNOMAH Group, states the following "Conducting a Vendor Search: Benefits and Best Practices":
Once proposals are reviewed and compared, the plan sponsor typically selects
three to four finalists from among the candidate pool. The finalists represent the
proposals that best address the plan's unique objectives and overall
circumstances. Finalists are typically given another opportunity to present the
highlights of their offering in-person at the plan sponsor's location. The analysis
phase concludes with the selection of the plan's vendor.
He goes on to observe that:
Although there is no "uniform checklist" for procedural prudence, Tatum, 761
F.3d at 358, it must be the case that prudence requires more than blindly to defer
to the decisions of someone else, no matter how qualified. Brotherson v. Putnam
Invs., LLC.
in
for
In a convoluted but seminal case with numerous appeals, Unisys mounteda successful defense to
a claim of a violation of fiduciary duty in selecting an insurance company GIC product
employees to choose as part of a 402(k) type plan. The Appeals Court in reviewing the findings
of the District Court stated:
Unisys delegated the responsibility of investing for the Fund to Davis White and
Leon Level. White and Level have educational and practical backgrounds in
financial matters. At the direction of White and Level, Unisys purchased three
Executive Life GIC's as investments for the Fund through bidding processes in
June 1987, December 1987 ... and January 1988. Of the many GICs purchased
for the Fund, only three were Executive Life GICs, constituting between 15 and
20 per cent of the Fund's assets. Unisys, through White and Level, considered
many firms through a process of competitive bidding, and Unisys heard in-person
presentations from the insurance companies.
In this case Unisys (1) delegated/assigned responsibility to employees with a financial
background (thus avoiding allegations that individuals who were not up to the job were selected);
(2) engaged in a competitive bidding process; and (3) "heard in-person presentations from the
insurance companies.
MEMORAND UM - Page Five
All Retirement Boards
Joseph E. Connarton, Executive Director
TO:
FROM:
RE:
DATE: November 5, 2018
Procurement
Commentators have made it clear that in-person interviews provide a shield against charges of a
violation of fiduciary duty in the selection of service providers. For example the Schiff Hardin
Law Firm citing Unisys notes:
This
Having a prudent process for selecting a service provider can be a critical step in
defending against a breach of fiduciary duty claim. The case of In re Unisys
Savings Plan Litigation [22 EBC 2945 (3d Cir. 1999)] demonstrates this point.
Unisys included a guaranteed insurance contract (GIC) as an investment choice
that participants could select in their directed accounts. At some point, the
insurance company was placed into receivership and participants who had
invested in the GIC stood to lose the guaranteed return promised in the GIC.
Participants who invested in the GIC sued Unisys, alleging that it had imprudently
selected the insurance company. The court, however, concluded that Unisys had
engaged in a prudent selection process. The court noted that Unisys had retained
the services of two highly qualified consultants to help it select the insurance
company that it had engaged in a competitive bidding process, that it had inperson presentations from the insurance companies under consideration, and
that it had reviewed the ratings of the insurance companies before making the
selection. Under the circumstances, the court held that Unisys had discharged its
duties to the plan prudently, and therefore was not liable for the losses to the plan.
issue comes up only after losses have been incurred and recovery is sought from
fiduciary. A hypothetical might assist in understanding the importance of interviews:
the
Investment consultant X, following a review of RFP responses, recommended to retirement
board Y, that $100 million be allocated to a fund managed by Bernie Madoff. The investment
consultant said that no interview is needed and Mr. Madoff is somewhat of a recluse and does
not participate in such interviews. Retirement board Y voted to allocate $100 million to the
Bernie Madoff Fund. Several months later it is discovered that the valuations of the Fund were
fraudulent and the $100 million is lost. Securities litigation firms, having seen their fees for that
kind of lawsuit diminish, have branched out and are now representing retirement system
members suing trustees for breaches of fiduciary duty. Such a lawsuit has been filed against you
due to the Madoff loss. The plaintiff's attorney asks you "Did you ever meet Mr. Madoff?" You
respond "No". He says "Do you mean to tell the members of this jury that as a fiduciary you
gave Bernie Madoff $100 million to invest without reviewing other firms?" "Yes." "Do you
mean to tell the members of this jury that you gave Bernie Madoff $100 million that he has lost
without even interviewing him?" "Yes." "Your honor, I rest my case!"
MEMORAND U M - Page Six
All Retirement Boards
Joseph E. Connarton, Executive Director
Procurement
TO:
FROM:
RE:
DATE: November 5, 2018
In addition to issues pertaining to searches for investment service providers, some have
expressed reservations about conducting interviews as part of the search for legal services.
In the advisory entitled "How to Choose a Lawyer in Five Easy Steps" the first step is:
"Conduct Candidate Interviews"
One of the best ways to assess a lawyer's legal ability is by interviewing the lawyer. Most
attorneys will provide an initial consultation (usually an hour or less) at no charge. A few
important questions to ask during this meeting are:
What experience does the lawyer have in your type of legal matter?
How long has he been in practice?
What is his track record of success?
What percentage of his caseload is dedicated to handling your type of legal problem?
Does he have any special skills or certifications?
What are his fees and how are they structured?
Does he carry malpractice insurance? If so, how much?
Who else would be working on your case and what are their rates?
Does he outsource any key legal tasks for functions?
What additional costs may be involved in addition to lawyer fees (postage, filing fees,
copy fees, etc.)?
How often will you be billed?
Can he provide references from other clients?
Does he have a written fee agreement or representation agreement?
How will he inform you of developments in your case?
The Commission understands that this period of increased procurement activity is a challenging
one for board members. Please contact PERAC Compliance Officer, Tom O'Donnell, if you
need assistance or have questions regarding the procurement process.
PERAC PERAC МЕМО #16/2025
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chair WILLIAM T. KEEFE, Executive Director
Auditor DIANA DIZOGLIO | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES J. GUIDO | RICHARD MACKINNON, JR. | JENNIFER F. SULLIVAN, ESQ.
MEMORANDUM
TO: All Retirement Boards
FROM: John P. Galvin, Compliance Manager
RE: Tobacco Company List
DATE: June 20, 2025
On October 22, 1997 PERAC Memo #37/1997 informed you of the adoption of Chapter 119 of
the Acts of 1997. That statute prohibits retirement systems from making any new investments in
stocks, securities, or other obligations of any company which derives more than 15% of its
revenue from the sale of tobacco products. On December 18, 1997 PERAC sent Memo #48
regarding the implementation of Chapter 119 and the first Tobacco Company List.
Enclosed please find a Tobacco Company List dated July 2025. This list replaces any other
Tobacco Company List previously sent to your board and is effective upon receipt by the
retirement boards. Most of these companies appeared on previous lists and such investments
were prohibited from the time the companies first appeared on the list. Please forward a copy to
your investment advisors or inform them that this list is available on the PERAC website. In
communicating with your investment advisors, please inform them that the Tobacco Company
List is only for their Massachusetts public fund clients and that any other use of the list is strictly
prohibited.
As part of its audit process, PERAC will assess the portfolio of each board to determine
compliance. That review will determine if the board, after January 13, 1998, has purchased
stock, securities, or other obligations of any company which derives more than 15% of its
revenue from the sale of tobacco products. In the event a portfolio is not in compliance, the
board must bring the portfolio into compliance by divesting in a prudent manner. Prior to taking
any action, the board shall consult with PERAC.|
In applying the statute to pooled funds, PERAC will assess the 15% rule against the entire pool
as the board is purchasing shares in the pool not the individual holdings of the pool. Thus a
pooled fund, if in violation of this standard, will be included on the list.
If you have any questions, please contact this office.
/ram
Enclosure 10 CABOT ROAD, SUITE 300 | MEDFORD, MA 02155
PH 617 666 4446 | FAX 617 628 4002 | WWW.MASS.GOV/PERAC
BLIC EMPLOYEE RET PERASE
MISTRATIONCO
A
ТОВАССO COMPANY LIST
JULY 2025
COMPANY COUNTRY
22nd Century Group, Inc. United States
Altria Group, Inc. United States
AMCON Distributing Company United States
В.А.Т. Саpital Corporation United States
Charlie's Holdings, Inc. United States
Fyolo Technology Corp United States
Performance Food Group Company United States
Philip Morris International Inc. United States
Pyxus International, Inc. United States
Reynolds American Inc. United States
Starfleet Innotec Inc United States
Turning Point Brands, Inc. United States
Universal Corporation
Vapor Group Inc
Vapor Hub International Inc.
Vector Group Ltd.
VPR Brands LP
United States
United States
United States
United States
United States
British American Tobacco Bangladesh Co. Ltd.
Badeco Adria d.d. Sarajevo
Bangladesh
Bosnia & Herzegovina
Bulgartabac Holding AD
Gotse Delchev Tabac AD
Nicotiana BT Holding AD
Sila Holding Plc
Yuri Gagarin AD
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Anhui Genuine New Materials Co Ltd China
Chengdu Hongqi Chain Co Ltd
Huabao Flavours & Fragrances Co Ltd
Mudanjiang Hengfeng Paper Co., Ltd.
RLX Technology Inc
China
China
China
China
Shenzhen Jinjia Group Co., Ltd. China
Smoore International Holdings Ltd China
WEIli Holdings Ltd China
COMPANY
Cyprus Trading Corporation Plc
Philip Morris CR as
Scandinavian Tobacco Group A/S
STG Global Finance B.V.
COUNTRY
Cyprus
Czech Republic
Denmark
Denmark
Eastern Company SAE Egypt
Kumulus Vape SA France
Karelia Tobacco Company Inc Greece
China Boton Group Company Limited
China Tobacco International HK Co Ltd
Ecogreen International Group Limited
Huabao International Holdings Ltd.
Litu Holdings Limited
Hong Kong
Hong Kong
Hong Kong
Hong Kong
Hong Kong
Godfrey Phillips India Limited
ITC Limited
India
India
NTC Industries Ltd. India
Sinnar Bidi Udyog Ltd.
VST Industries Limited
India
India
Indonesian Tobacco Tbk PT Indonesia
PT Bentoel International Investama Tbk Indonesia
PT Gudang Garam Tbk
PT Hanjaya Mandala Sampoerna Tbk
PT Wicaksana Overseas International Tbk
Wismilak Inti Makmur Tbk PТ
Indonesia
Indonesia
Indonesia
Indonesia
Globrands Group Ltd. Israel
Societe Ivoirienne des Tabacs SA Ivory Coast
Carreras Ltd. Jamaica
Japan Tobacco Inc. Japan
Al-Eqbal Investment Company PLC Jordan
Jordanian Duty Free Shops PSC Jordan
Union Investment Corporation P.L.C.
Union Tobacco & Cigarette Industries Co PSC
Jordan
Jordan
COMPANY COUNTRY
British American Tobacco Kenya PLC Kenya
BGF Retail Co Ltd Korea
KT&G Corporation Korea
Kuk-Il Paper Mfg Co., Ltd. Korea
Tutunski Kombinat AD Prilep Macedonia
7-Eleven Malaysia Holdings Berhad
Bright Packaging Industry Bhd
Malaysia
Malaysia
British American Tobacco (Malaysia) Berhad Malaysia
B.A.T. Netherlands Finance B.V.
Khyber Tobacco Company Ltd.
Pakistan Tobacco Company Ltd.
Philip Morris (Pakistan) Limited
Tri Pack Films Ltd.
Jerusalem Cigarette Co Ltd.
Eurocash Spolka Akcyjna
Netherlands
Pakistan
Pakistan
Pakistan
Pakistan
Palestinian Territory
Poland
Duvanska Industrija Coka ad Coka
Philip Morris Operations a.d. Nis
Serbia
Serbia
New Toyo International Holdings Ltd. Singapore
Logista Integral S.A.
Miquel y Costas & Miquel, S.A.
Spain
Spain
Ceylon Tobacco Company Plc Sri Lanka
Swedish Match AB Sweden
Taiwan FamilyMart Co., Ltd.
Tanzania Cigarette Company Ltd.
Taiwan
Tanzania
The West Indian Tobacco Company Ltd. Trinidad and Tobago
Bizim Toptan Satis Magazalari AS
British American Tobacco Uganda
Turkey
Uganda
COMPANY COUNTRY
B.A.T. International Finance P.L.C.
British American Tobacco Plc
Imperial Brands Finance Plc
Imperial Brands Plc
United Kingdom
United Kingdom
United Kingdom
United Kingdom
McColl's Retail Group Plc United Kingdom
Cat Loi JSC Vietnam
Cong ty Co phan Ngan Son Vietnam
British American Tobacco (Zambia) Plc
British American Tobacco Zimbabwe (Holdings) Ltd.
Zambia
Zimbabwe
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chair WILLIAM T. KEEFE, Executive Director
Auditor DIANA DIZOGLIO | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES J. GUIDO | RICHARD MACKINNON, JR. | JENNIFER F. SULLIVAN, ESQ.
MEMORANDUM
TO: All Retirement Boards
FROM: John P. Galvin, Compliance Manager
RE: Tobacco Company List
DATE: June 20, 2025
On October 22, 1997 PERAC Memo #37/1997 informed you of the adoption of Chapter 119 of
the Acts of 1997. That statute prohibits retirement systems from making any new investments in
stocks, securities, or other obligations of any company which derives more than 15% of its
revenue from the sale of tobacco products. On December 18, 1997 PERAC sent Memo #48
regarding the implementation of Chapter 119 and the first Tobacco Company List.
Enclosed please find a Tobacco Company List dated July 2025. This list replaces any other
Tobacco Company List previously sent to your board and is effective upon receipt by the
retirement boards. Most of these companies appeared on previous lists and such investments
were prohibited from the time the companies first appeared on the list. Please forward a copy to
your investment advisors or inform them that this list is available on the PERAC website. In
communicating with your investment advisors, please inform them that the Tobacco Company
List is only for their Massachusetts public fund clients and that any other use of the list is strictly
prohibited.
As part of its audit process, PERAC will assess the portfolio of each board to determine
compliance. That review will determine if the board, after January 13, 1998, has purchased
stock, securities, or other obligations of any company which derives more than 15% of its
revenue from the sale of tobacco products. In the event a portfolio is not in compliance, the
board must bring the portfolio into compliance by divesting in a prudent manner. Prior to taking
any action, the board shall consult with PERAC.|
In applying the statute to pooled funds, PERAC will assess the 15% rule against the entire pool
as the board is purchasing shares in the pool not the individual holdings of the pool. Thus a
pooled fund, if in violation of this standard, will be included on the list.
If you have any questions, please contact this office.
/ram
Enclosure 10 CABOT ROAD, SUITE 300 | MEDFORD, MA 02155
PH 617 666 4446 | FAX 617 628 4002 | WWW.MASS.GOV/PERAC
BLIC EMPLOYEE RET PERASE
MISTRATIONCO
A
ТОВАССO COMPANY LIST
JULY 2025
COMPANY COUNTRY
22nd Century Group, Inc. United States
Altria Group, Inc. United States
AMCON Distributing Company United States
В.А.Т. Саpital Corporation United States
Charlie's Holdings, Inc. United States
Fyolo Technology Corp United States
Performance Food Group Company United States
Philip Morris International Inc. United States
Pyxus International, Inc. United States
Reynolds American Inc. United States
Starfleet Innotec Inc United States
Turning Point Brands, Inc. United States
Universal Corporation
Vapor Group Inc
Vapor Hub International Inc.
Vector Group Ltd.
VPR Brands LP
United States
United States
United States
United States
United States
British American Tobacco Bangladesh Co. Ltd.
Badeco Adria d.d. Sarajevo
Bangladesh
Bosnia & Herzegovina
Bulgartabac Holding AD
Gotse Delchev Tabac AD
Nicotiana BT Holding AD
Sila Holding Plc
Yuri Gagarin AD
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Anhui Genuine New Materials Co Ltd China
Chengdu Hongqi Chain Co Ltd
Huabao Flavours & Fragrances Co Ltd
Mudanjiang Hengfeng Paper Co., Ltd.
RLX Technology Inc
China
China
China
China
Shenzhen Jinjia Group Co., Ltd. China
Smoore International Holdings Ltd China
WEIli Holdings Ltd China
COMPANY
Cyprus Trading Corporation Plc
Philip Morris CR as
Scandinavian Tobacco Group A/S
STG Global Finance B.V.
COUNTRY
Cyprus
Czech Republic
Denmark
Denmark
Eastern Company SAE Egypt
Kumulus Vape SA France
Karelia Tobacco Company Inc Greece
China Boton Group Company Limited
China Tobacco International HK Co Ltd
Ecogreen International Group Limited
Huabao International Holdings Ltd.
Litu Holdings Limited
Hong Kong
Hong Kong
Hong Kong
Hong Kong
Hong Kong
Godfrey Phillips India Limited
ITC Limited
India
India
NTC Industries Ltd. India
Sinnar Bidi Udyog Ltd.
VST Industries Limited
India
India
Indonesian Tobacco Tbk PT Indonesia
PT Bentoel International Investama Tbk Indonesia
PT Gudang Garam Tbk
PT Hanjaya Mandala Sampoerna Tbk
PT Wicaksana Overseas International Tbk
Wismilak Inti Makmur Tbk PТ
Indonesia
Indonesia
Indonesia
Indonesia
Globrands Group Ltd. Israel
Societe Ivoirienne des Tabacs SA Ivory Coast
Carreras Ltd. Jamaica
Japan Tobacco Inc. Japan
Al-Eqbal Investment Company PLC Jordan
Jordanian Duty Free Shops PSC Jordan
Union Investment Corporation P.L.C.
Union Tobacco & Cigarette Industries Co PSC
Jordan
Jordan
COMPANY COUNTRY
British American Tobacco Kenya PLC Kenya
BGF Retail Co Ltd Korea
KT&G Corporation Korea
Kuk-Il Paper Mfg Co., Ltd. Korea
Tutunski Kombinat AD Prilep Macedonia
7-Eleven Malaysia Holdings Berhad
Bright Packaging Industry Bhd
Malaysia
Malaysia
British American Tobacco (Malaysia) Berhad Malaysia
B.A.T. Netherlands Finance B.V.
Khyber Tobacco Company Ltd.
Pakistan Tobacco Company Ltd.
Philip Morris (Pakistan) Limited
Tri Pack Films Ltd.
Jerusalem Cigarette Co Ltd.
Eurocash Spolka Akcyjna
Netherlands
Pakistan
Pakistan
Pakistan
Pakistan
Palestinian Territory
Poland
Duvanska Industrija Coka ad Coka
Philip Morris Operations a.d. Nis
Serbia
Serbia
New Toyo International Holdings Ltd. Singapore
Logista Integral S.A.
Miquel y Costas & Miquel, S.A.
Spain
Spain
Ceylon Tobacco Company Plc Sri Lanka
Swedish Match AB Sweden
Taiwan FamilyMart Co., Ltd.
Tanzania Cigarette Company Ltd.
Taiwan
Tanzania
The West Indian Tobacco Company Ltd. Trinidad and Tobago
Bizim Toptan Satis Magazalari AS
British American Tobacco Uganda
Turkey
Uganda
COMPANY COUNTRY
B.A.T. International Finance P.L.C.
British American Tobacco Plc
Imperial Brands Finance Plc
Imperial Brands Plc
United Kingdom
United Kingdom
United Kingdom
United Kingdom
McColl's Retail Group Plc United Kingdom
Cat Loi JSC Vietnam
Cong ty Co phan Ngan Son Vietnam
British American Tobacco (Zambia) Plc
British American Tobacco Zimbabwe (Holdings) Ltd.
Zambia
Zimbabwe
PERAC PERAC МЕМО #8/2025
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chair WILLIAM T. KEEFE, Executive Director
Auditor DIANA DIZOGLIO | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES J. GUIDO | RICHARD MACKINNON, JR. | JENNIFER F. SULLIVAN, ESQ.
МЕMORANDUM
TO: All Retirement Boards
FROM: Bill Keefe, Executive Director
RE: Investment Manager Statements via PROSPER
DATE: January 27, 2025
Not too long ago, we introduced the Cash Book panel in PROSPER allowing retirement boards to
electronically submit cash book reporting and documentation in a more secure and efficient
manner to PERAC. This year, there will be a dedicated panel to upload the Board's investment
manager statements in PROSPER. Until this point, this information was submitted via various
methods. This new feature will further streamline the cash book reporting process and expand the
library of reporting documents in a secure central online location. As you are aware, the investment
manager statements, along with the custodian and consultant statements, are required additional
components of the monthly cash books. The requirement to submit investment manager statements
via the dedicated panel in PROSPER will start with the January 2025 cash books. We are rolling
it out in advance of the January 2025 cash book due date and encourage boards to test out this new
function with your remaining 2024 cash book submissions.
Please note that retirement boards only need to provide statements for their non-PRIM
investments. We receive monthly statements directly from PRIM for all Massachusetts Retirement
Boards.
We have attached a user manual to provide step by step instructions to assist you with the new
application. Board staff who currently have the Finance role in PROSPER will automatically have
access to the Investment Manager Statement panel. If your board needs to add a new staff member
to access the Finance tab, please fill out the Individual Account Request Form for PROSPER
(available on our website), select the Finance role, and submit the form with all required signatures
to PERAC, Attention: Rose Morrison. You can scan the completed form and e-mail it to
Rose.A.Morrison@mass.gov.
If you have any questions, please contact Sarita Yee at Sarita.Yee@mass.gov or PERAC's
Investment Unit at PER-DL-CashBooks@mass.gov.
sy
Attachment
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERA
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chair WILLIAM T. KEEFE, Executive Director
Auditor DIANA DIZOGLIO | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES J. GUIDO | RICHARD MACKINNON, JR. | JENNIFER F. SULLIVAN, ESQ.
МЕMORANDUM
TO: All Retirement Boards
FROM: Bill Keefe, Executive Director
RE: Investment Manager Statements via PROSPER
DATE: January 27, 2025
Not too long ago, we introduced the Cash Book panel in PROSPER allowing retirement boards to
electronically submit cash book reporting and documentation in a more secure and efficient
manner to PERAC. This year, there will be a dedicated panel to upload the Board's investment
manager statements in PROSPER. Until this point, this information was submitted via various
methods. This new feature will further streamline the cash book reporting process and expand the
library of reporting documents in a secure central online location. As you are aware, the investment
manager statements, along with the custodian and consultant statements, are required additional
components of the monthly cash books. The requirement to submit investment manager statements
via the dedicated panel in PROSPER will start with the January 2025 cash books. We are rolling
it out in advance of the January 2025 cash book due date and encourage boards to test out this new
function with your remaining 2024 cash book submissions.
Please note that retirement boards only need to provide statements for their non-PRIM
investments. We receive monthly statements directly from PRIM for all Massachusetts Retirement
Boards.
We have attached a user manual to provide step by step instructions to assist you with the new
application. Board staff who currently have the Finance role in PROSPER will automatically have
access to the Investment Manager Statement panel. If your board needs to add a new staff member
to access the Finance tab, please fill out the Individual Account Request Form for PROSPER
(available on our website), select the Finance role, and submit the form with all required signatures
to PERAC, Attention: Rose Morrison. You can scan the completed form and e-mail it to
Rose.A.Morrison@mass.gov.
If you have any questions, please contact Sarita Yee at Sarita.Yee@mass.gov or PERAC's
Investment Unit at PER-DL-CashBooks@mass.gov.
sy
Attachment
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERA
The Competitive
Bid Process
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
Robert E.Tierney, Chairman | A. Joseph DeNucci, Vice Chairman
C. Christopher Alberti | Stephen P. Crosby| Kenneth J. Donnelly | James M. Machado | Donald R. Marquis
Joseph E. Connarton, Executive Director
5 Middlesex Avenue, Third Floor, Somerville, MA 02145
ph 617 666 4446 | fax 617 628 4002 | tty 617 591 8917 | web www.mass.gov/perac
Published by PERAC, 2002. Printed on recycled paper.
The Competitive Bid Process
Joseph I. Martin, PERAC Deputy Executive Director of Policy Development
Deputy Executive Director’s Letter
There is no more challenging responsibility for Retirement Board members than
that of prudently selecting investment consultants, managers and custodians.
Under the provisions of Chapter 32 Boards rely on the advice of consultants,
delegate direct investment of assets to money managers and depend on custodians to account for financial activity. PERAC has often stressed the need for
Board members to comply with their fiduciary duty in managing the retirement
system.The potential problems that could arise from mismanaging investments
underscore the need to act as a prudent expert would in selecting, monitoring
and retaining these vendors.
This booklet contains material relating to the competitive bid process, including
an outline of the components of such a process and a sample Request for
Proposals. It is our hope that PERAC, through this material as well as its
Regulations, memos and opinions, will be able to assist Boards in fulfilling the
trust owed to system members and their beneficiaries.
Sincerely,
Joseph I. Martin
PERAC Deputy Executive Director of Policy Development
ii | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Table of Contents
Section Page
The Competitive Process and Fiduciary Duty ..................................................................................................1
Outline of the Competitive Process....................................................................................................................2
Investment Consultant Request for Proposals............................................................................................... 5
Appendix A: Investment Consulting Services Questionnaire ......................................................................19
Appendix B: Fee Schedule ....................................................................................................................................31
Appendix C: QRB Investment Managers ..........................................................................................................31
Attachment A:Vendor Certification...................................................................................................................32
Attachment B: Disclosure Statement ................................................................................................................34
THE COMPETITIVE BID PROCESS | iii
iv | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
The Competitive Process and Fiduciary Duty
Section 1 of Chapter 32 of the General Laws defines a fiduciary as “any person
who exercises any discretionary authority or discretionary control respecting
management of the funds of any retirement system or exercises any authority or
control respecting management or disposition of its assets.”
The fiduciary standards are set forth in section 23 of Chapter 32 of the
General Laws which state,“A fiduciary as defined in section one shall discharge
his duties for the exclusive purpose of providing benefits to members and their
beneficiaries with the care, skill, prudence and diligence under the circumstances
then prevailing that a prudent person acting in a like capacity and familiar with
such matters would use in the conduct of an enterprise of a like character and
with like aims and by diversifying the investments of the system so as to minimize the risk of large losses unless under the circumstances it is clearly prudent
not to do so.”
Fiduciary Duty has three components—an Exclusive Purpose Rule, a Prudent
Expert Rule, and a Diversification Rule. In the context of competitive procurement our focus is on the Prudent Expert Rule. In short the question is—How
would a prudent expert proceed in selecting a vendor?
Chapter 32
THE COMPETITIVE BID PROCESS | 1
Outline of the Competitive Process
COMPETITIVE PROCESS
➤ Open
➤ Objective
➤ Fair
➤ RFP
➤ Processing
➤ Record Keeping
OPEN
➤ Public Notice - Reasonable time
➤ Posted
➤ Published
➤ Secretary of State notice
➤ May send to prospective bidders
OBJECTIVE
➤ Evaluation based only on requirements and criteria in RFP
➤ Pre-established criteria
➤ Objective and relevant criteria
➤ Business/Technical
➤ GFOA, PERAC, PRIM examples
PROCESSING RESPONSES
➤ No alteration/corrections after date for submission
➤ Date stamped on receipt
➤ Witness to opening RFPs
PROCUREMENT FILE
➤ Record of procurement
➤ Selection process
➤ Selection criteria
➤ RFP
➤ Copy of minutes
➤ Copy of responses
➤ Disposal schedule/6 yrs. after contract ends
2 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
ROLE OF CONSULTANT
➤ Board is decision maker
➤ Develop RFP
➤ Data base screen
➤ Incorporate into data base and analyze respondents
➤ Selection of consultant
➤ Ability to meet fiduciary duty of board
CONTRACT
➤ Written contract
➤ Executed prior to assuming duties
➤ Investment objectives
➤ Brokerage practices
➤ Fees
➤ Termination
BOARD NOTICE OF COMPETITIVE PROCESS
➤ Prior to retention of manager/consultant
➤ Board must notify PERAC competitive process followed
➤ Chapter 32 provisions met
➤ PERAC regulations met
➤ In all cases exemption or not
➤ No form-statement from board
VENDOR CERTIFICATION FORM
➤ All vendors submitting bids
➤ Selected vendor must submit to PERAC
➤ Good faith submission
➤ Without collusion or fraud
➤ In all cases exemption or not
THE COMPETITIVE BID PROCESS | 3
Introduction:
In order for a potential vendor to make a knowledgeable response to the RFP it is necessary that
information about the retirement system be made available.This includes present asset allocation,
asset size and funded status. In this example, information about the number of managers is also included.The Board should consider this element of the RFP carefully and include more information rather
than less. For example, in the case of the RFP for a consultant, Boards may wish to include a copy of
the existing Investment Objectives.
Schedule of Events:
The Board must inform the potential respondents of the various deadlines associated with the RFP
and must make every effort to meet the schedule.The date and time for submission of the RFP
response must be clear and final.Those failing to submit on time must be disqualified.
Scope of Services:
Although the Board will ask for specifics in several areas this section establishes the expectations of
the Board in general terms.The particulars that form the basis of the selection decision address how
the vendor will accomplish these tasks. In the case of a consultant RFP, the scope includes Investment
Policy/Objectives Development,Asset Allocation and Investment Management. In the latter category,
services are to be provided relating to portfolio structure, manager selection, and manager monitoring
and performance evaluation. In addition, the consultant is expected to provide the Board with reports
related to these areas and when called upon to attend Board meetings. Depending on the Board’s
present situation other services such as custodian search, investment research and education may also
be outlined in the Scope of Services. Boards should also include in this section the requirement that
the consultant and other vendors assist the Board in complying with PERAC Regulations.
Key Points & Concepts
4 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Investment Consultant Request for Proposals
Quabbin Contributory Retirement System (QRS), Quabbin, Massachusetts,
administers an investment portfolio of approximately $130 million in assets.As of
January 1, 2002 the assets were invested as follows: 54% in domestic equities,
40% in domestic fixed income and 6% in cash.The portfolio is managed by 12
outside investment managers. QRS has a ratio of assets to liabilities of 65%.
QRS is seeking investment consulting services to assist the Quabbin Retirement
Board (QRB) in making prudent investment management decisions related to the
QRS.An investment consultant is not presently advising QRS.
Section I:
Introduction
Pension & Investments Ad 7/29/02
Deadline for Submitting Written Questions 8/13/02
Deadline for Submitting RFP Response 8/20/02 (5:00 p.m.)
Review Completed 9/7/02
Interview at QRB (tentative) 9/19/02
Finalists Selected 9/24/02
Site visits for Finalists (tentative) 10/15/02
Finalists’ Presentations 10/30/02
Finalist Selected 11/27/02
Contract Begins 1/1/03
Section II:
Schedule of
Events
Under the direction of the QRB, the services to be provided by the investment Section III:
consulting firm shall include, but are not limited to, the following: Services to
A. General be Provided
1. Prepare reports reviewing and updating QRS investment policy, criteria and
objectives that include strategies for bonds, stock, real estate, alternative and
cash investments.
2. Prepare recommendations for amendments or modifications to the QRS portfolio structure with justification for the same.
3. Maintain a broad database of investment managers including their philosophies,
styles, fee schedules, portfolio characteristics, firm characteristics, performance,
and client base.The information should be available for a wide range of investment managers including equity, bond, international managers, as well as, real
estate fund managers and alternative investment managers.
THE COMPETITIVE BID PROCESS | 5
6 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
4.Assist in the development of policies, procedures and guidelines for the various
investment programs.
5.Attendance at the meetings of the QRB and other meetings as required.
6. Research and make recommendations for use of real estate investment and
alternative investment strategies.
7.Appear before legislative and regulatory bodies as requested by QRB.
8.Assist the QRB in complying with directives of the Public Employee
Retirement Administration Commission (PERAC).
B.Asset Allocation
Provide continuous review of investment policy, portfolio mix, and investment
strategy relative to changes in the capital market and structure of similar retirement systems.Advise the QRB as to the relationship between these aspects of
investment management and the funding status of the QRS.
C. Manager Search and Selection
Provide analysis of and assist in hiring external managers.
D. Performance Measurement and Reporting
1. Prepare quarterly evaluation reports on the performance of QRS portfolio
managers including a comparison with the performance of other managers and
public plans.
2. Provide QRB with quarterly and annual performance analysis.
3. Provide QRB with quarterly and annual performance reports of theoretical
portfolios, i.e. market indices, benchmarks and composite fund portfolios.
4. Assist QRB in assessing manager performance in accordance with 840 CMR
16.07 including participation in annual manager meetings, review of manager
reports and the annual assessment of each manager.
E. Research and Analysis
Prepare comprehensive analysis and advice on specific pension issues as requested by the QRB.
Section III:
Services to
be Provided
(cont.)
THE COMPETITIVE BID PROCESS | 7
Minimum Qualifications:
Every RFP should include a set of minimum standards that must be met by all respondents.These
primarily focus on business specifications. In this case the standards focus on client asset base, experience of the primary consultant, the firms’ years of business and the number of public pension fund
clients. In addition the regulatory requirement that respondents be registered under the Investment
Advisers Act of 1940 contained in 840 CMR 26.01 (2) is addressed.
Key Points & Concepts
8 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
IV. Minimum Qualifications Section IV:
Minimum A.The respondent must meet all minimum qualifications to be given further
consideration. Failure to satisfy each of the minimum qualifications will result in Qualifications
the immediate rejection of the proposal. Please indicate if your firm meets the
following minimum qualifications:
1.The firm must provide investment consulting services to clients with assets
totaling at least $2 billion.
2.The primary consultant assigned to the QRS account must have a minimum of
five (5) years experience providing domestic and international investment consulting services to public and/or private pension plans.
3.As of January 1, 2002 the firm must have been in business at least two (2)
years.
4.As of January 1, 2002 the firm must have at least two (2) public pension fund
clients.
5. In accordance with 840 CMR 26.01 (2) the firm must be registered as an
investment adviser pursuant to the Investment Advisers Act of 1940 (15 U.S.C.
80b -1 et seq.)
THE COMPETITIVE BID PROCESS | 9
Response Procedures:
The Board must inform the potential respondents of the items that must be part of the response.
These must include the PERAC Disclosure Forms and the Vendor Certification.This forms a checklist
for the vendor consisting of the Questionnaire, Fee Proposal, Disclosures, and Vendor Certification.
Key Points & Concepts
10 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
The following is a list of the required information to be provided by the
respondent.A respondent that does not provide the information requested
below will be rejected. Please provide the information in the same order in
which it is requested.
A. Proposal Questionnaire
Respondents must complete and return the Proposal Questionnaire contained in
Appendix A.The information requested must be provided in the prescribed format. Responses, which, in the opinion of QRB, materially deviate from the prescribed format, shall be rejected.All responses to the questionnaire will be subject to verification for accuracy. Proposals containing false or misleading information shall be rejected.
B. Fee Proposal
Respondents must submit their fee in the format prescribed in Appendix B.
The proposed fee shall include all costs and expenses for providing the services
to QRS as described in this RFP, and shall be guaranteed for the term of the
contract.
C. Disclosures
Respondents must submit the Disclosures prescribed in Section VI of Appendix
A. In addition, respondents must complete the Disclosure Forms in Attachment
A.The response must detail the amount of compensation in whatever form that
is associated with the relationship that is being disclosed. Failure to submit the
Disclosures shall result in the rejection of the proposal.
D. Certification of Good Faith
Respondents must submit a completed certification form prescribed in
Attachment B. Failure to submit the certification form shall result in the rejection
of the proposal.
Section V:
Information
to be
Provided by
Respondent
THE COMPETITIVE BID PROCESS | 11
Written Questions
The process must allow for inquiries to be made by potential respondents.This sometimes takes place
through a vendor conference as well as the submission of written questions. In this section of the RFP,
the rules for submission of questions and the response to those questions are stated. It is important
to note that a date certain for the submission is necessary and answers must be sent to all those who
have shown an interest in the RFP, not just the vendor that submitted the question.
Submission Process
The RFP must state what is expected of the respondent in relation to the submission of the RFP.
What must be submitted is addressed in Section V. In this section, the number of copies, method of
delivery, and other matters are addressed. It is important that responses be directly submitted in hand
or by mail and not through fax, e-mail, or disk. In addition, the requirement that a filing that contains
errors must be withdrawn and resubmitted in its entirety is stated.
Key Points & Concepts
12 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Questions respondents may have regarding the information presented in this
Request for Proposal must be received in writing to the attention of the QRB
no later than August 13, 2002. All questions received by that date will be
answered by QRB in writing. Copies of all questions and QRB responses will
be sent to all parties who indicate the intent to respond to the Request for
Proposal.
Section VI:
Submission of
Written
Questions
A. Submit six (6) copies of your proposal in a sealed package. Clearly identify the
outside of the sealed proposal package with the respondent’s name and return
address and the statement “Response to Request for Proposal, Investment
Consultant, 2002”. FAILURE TO CLEARLY IDENTIFY THE OUTSIDE OF THE
PROPOSAL PACKAGE MAY RESULT IN THE REJECTION OF THE PROPOSAL.
QRB is not responsible for receipt of any proposal that is improperly labeled.
B. Submission of proposals or any portion thereof via facsimile transmission, electronic, or magnetic media shall not be allowed. QRB shall not accept or consider
any proposal material submitted in this manner.
C. If, prior to the final filing date for submission of proposals, a respondent
discovers an error or omission in a proposal already submitted to QRB the only
method of correcting, modifying, or completing the proposal is to withdraw the
proposal in its entirety prior to the final filing date and time by written notification to QRB. A complete, corrected proposal package may be resubmitted, but
not after the final filing date and time. Modification offered in any other manner,
oral, written, or facsimile transmission, will not be considered.
D.The proposals become the property of QRB upon submission.All costs for
developing proposals and attending interviews are entirely the responsibility
of the respondent and shall not be chargeable to QRB. QRB accepts no
responsibility for lost and/or late delivery of proposals.
E. Only one proposal from an individual, firm, partnership, corporation, or
combination thereof, will be considered. Reasonable ground for believing a
respondent has submitted multiple proposals under more than one name will
be cause for rejection of all proposals in which the respondent is interested.
Section VII:
Submission of
Proposals
THE COMPETITIVE BID PROCESS | 13
Evaluation:
Fairness dictates that respondents be provided with some idea of the manner to be used in evaluating
the responses. In addition, the Board must state that it has the right to reject responses in certain
circumstances, particularly on the basis of information provided in various disclosures. Generally,
objectivity requires some type of numerical scoring system.Also, it must be made clear that interview
and reference checks as well as Questionnaire responses will be evaluated.
Key Points & Concepts
14 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
The purpose of the proposal evaluation process is twofold: (1) to assess the
responses for compliance with minimum qualifications, content, and format
requirements; and (2) to identify the respondent that has the highest probability
of satisfactorily performing the services as described herein.The evaluation
process will be conducted in a comprehensive and impartial manner.
QRB may reject any or all proposals and may or may not waive any immaterial
deviation or defect in a proposal. QRB will award points based on an analysis of
the responses to the Investment Consulting Services Questionnaire, the reference checks and, for semi-finalists and finalists, the oral presentation. QRB
reserves the right to reject any proposal based on the disclosures required in
Section VI of Appendix A and in the Disclosure Form (Attachment A). In addition
failure to file the completed Certification (Attachment B) shall disqualify the
respondent from consideration.
Proposals that contain false or misleading statements, or which provide references that do not support an attribute or condition claimed by the respondent
shall be rejected.
A.Written Proposal Evaluation
Proposals that meet the minimum qualifications will undergo an evaluation
process conducted by the QRB.
B. Semi-Finalist Interviews
Up to six (6) of the highest scoring Respondents, after the written proposal and
fee evaluation, will be considered semi-finalists and will have an oral interview
with QRB.The semi-finalists will be notified of the date and time of the interview
to be held at the QRB offices.
C. Finalists Selections
After completion of all evaluations, up to three (3) finalists will be determined.
D. Reference Checks and On-Site Inspections
Reference checks will be conducted for each semi-finalist. On-site inspections of
offices may be conducted for any or all finalists at the option of QRB.
E. Finalist Interviews
The finalists will have an interview with the QRB.
Section VIII:
Standards for
Evaluating
Proposals
THE COMPETITIVE BID PROCESS | 15
16 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Based upon the overall scoring including the finalists’ presentations before the Section IX:
QRB the contract will be awarded on or before November 27, 2002. Award of the
Contract
The contract shall be effective January 1, 2003. Section X:
Commencement
Date
THE COMPETITIVE BID PROCESS | 17
Appendix A-Investment Consulting Services Questionnaire:
There are different styles of RFP. Some use the Questionnaire format that separates the questions
that relate to the ability of the respondent to perform the Scope of Services from the other procedural provisions of the RFP. In any event, substantive, technical inquiries emphasizing the firms’ ability
to provide the services form the central component of any RFP.
Points are generally granted based on an assessment of each response.Although it is often difficult to
quantify a vendor’s ability, the need for objective comparison between respondents dictates the use of
a point system.
General Information:
The focus of this section is the organization itself, its ownership structure, recent significant developments, and anticipated changes in that structure.The experience of personnel, particularly those who
would be responsible for the account, client base, and regulatory/litigation history are covered in this
section. It is also important to assess the number of clients that each individual consultant in a firm is
expected to service, in order to gauge the level of service the Board would receive. Litigation/regulatory action against the firm or its owners and officers is a crucial question as it reflects on the past
compliance of the firm with statutes and regulations that establish the environment in which the firm
will serve the Board.All RFPs seeking a service should include similar inquiries.This is also the section
in which inquiry is made regarding the respondent’s insurance coverage.
Key Points & Concepts
18 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Appendix A: Quabbin Retirement System
Request for Proposal, Investment Consulting
Services Questionnaire, 2002
A. Provide a brief history of your firm and its operation. Include the year formed,
ownership, structure, and biographies of the principals, affiliations, profit sharing
programs, and ownership changes in the last five (5) years. Describe your firm’s
growth objectives and your plans for managing that projected growth.
B. Explain how the firm controls the quality of service provided to the clients, the
number of consultants in the firm, and the average number of clients assigned per
consultant.What is the maximum number of clients per consultants you maintain?
C.What is your firm’s mission statement? What do you see as your organization’s
strongest area of expertise?
D. Provide the names, portfolio sizes and lengths of engagements for the client
base using your services for full service consulting.
E. How many personnel in your firm are CFAs? How many have at least one
year of institutional experience in public funds administration? Active equity
management? Fixed income management? Cash management? Equities trading?
Bond trading? Real estate management? Alternative investment?
F. Assuming your firm is selected, provide biographical information on the individual proposed to serve as the primary consultant, his/her principal assistant and
other key members assigned to the account. Specify the anticipated role and scope
of involvement of each individual. For the primary consultant and principal assistant, provide the names of all clients and nature of their relationships. Describe
their experience in dealing with legislative and regulatory bodies.
G. Provide a listing of clients lost or gained during the past five (5) years. List size
of the fund and reason for ending the relationship(s).
H. Describe your firms’ commitment to research and systems enhancements.What,
if any, expansions do you anticipate in your technical and systems capabilities?
I. Has there been any litigation or regulatory action against your firm or its
principal/owners/officers in the last five (5) years? If yes, please explain.
Section I:
General
Information
THE COMPETITIVE BID PROCESS | 19
Performance Measurement and Portfolio Analytics:
This series of questions focuses on services to be provided by the consultant.Areas such as the data
sources used, method of data collection, reporting format and the different reports that can be generated, and performance comparison methodology are all elements of the consultants operation that
are reviewed in this section.
Key Points & Concepts
20 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
J. Does your firm, its principals and affiliates subscribe to the AIMR Code of Section I:
Ethics? General
K. Describe the levels of coverage for errors and omissions insurance and any
Information
fiduciary or professional liability insurance your firm carries. List the insurance (cont.)
carriers.
A. Describe the content and format of all performance reports.
B.Are all performance reports compliant with AIMR Performance Presentation
Standards?
C.What is the anticipated availability dates for each report in terms of the
number of calendar days after quarter end?
D. How much flexibility is there in your reporting format? Can reports be
customized at our request? Within what time can requested changes in reporting
be made; i.e., at the beginning of the relationship only or anytime changes are
needed?
E. Please provide samples of your performance reports.
F. Briefly describe your firm’s database(s), include size, composition, % public
funds, % private funds, etc. Is it proprietary or purchased from an independent
source? If proprietary, how is the data compiled?
G. Describe your firm’s capabilities to evaluate securities lending programs.
H. Describe your firm’s capabilities to perform trading cost evaluations.
Section II:
Performance
Measurement
and Portfolio
Analytics
THE COMPETITIVE BID PROCESS | 21
Asset Allocation Model:
In this section the consultants’ ability in the area of asset allocation is reviewed.The technical methodology used, participation by the Board, and time frames involved form the basis of the questions.
Key Points & Concepts
22 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
A. Describe how your firm is prepared to consult with and make presentations
to the Board on asset allocation changes and other asset allocation issues related
to total portfolio.
B.Address the ability of your process to work within existing, long-term policy
guidelines. How are investment objectives and range constraints factored into the
optimization process?
C.What is your commitment to internal research into the construction and
assumptions used in your asset allocation model(s)?
D.To what extent do you rely on a static model and/or inputs and construction
process of an outside vendor’s model?
E.To what extent would you involve QRB fiduciaries and staff in discussing the
economic climate and asset return assumptions that form the basis of your asset
allocation model?
F.What strategy or evaluation process does your firm employ to measure the
risk tolerance of your client fiduciaries?
G. How do you address those fiduciaries’ biases that may adversely affect the
outcome of the asset allocation model or manager selection processes?
H.What time frame does your asset allocation model use?
I. Describe the models or process used for optimizing strategic asset allocation
in changing economic circumstances.
J. How often do you recommend a formal review of asset allocation policies?
Section III:
Asset
Allocation
Model
THE COMPETITIVE BID PROCESS | 23
Manager Search Process and Asset Allocation Implementation:
After development of an investment plan and the establishment of investment objectives, the implementation stage begins. Manager search capabilities form an important aspect of the services being
sought by the Board.The search process and methodology, benchmarks/comparisons, database of
managers, research ability and manager monitoring approach are all elements reviewed in this section.
This is also the section to seek information about the consultants experience with various screens
such as tobacco, as well as the ability of the consultant to assist in searches seeking alternative or real
estate managers.
Key Points & Concepts
24 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
A. Describe in detail your manager database and search process.
B. Explain how firms enter your search universe. How do they “get a foot in the
door” of your database?
C. Describe the frequency and magnitude of manager turnover resulting from
performance reports, portfolio reviews or asset allocation changes resulting from
the optimization strategy provided to your clients.
D.What role does passive management play in your firm’s general view of the
asset allocation process for your clients?
E. How many active managers are retained by your average client? To what styles
and market cap ranges are they assigned?
F. Has your manager evaluation process resulted in the recommendation of the
same equity and fixed income managers consistently over several searches?
Please explain and provide examples of recent studies.
G. Have you ever assisted any clients in the development and/or evaluation of: (a)
social or country screens such as evaluating a portfolio for holdings in tobacco
companies, or (b) economically targeted investments or other “social” programs?
Provide a brief outline of your experiences, if any, and your general view of the
role of such screens and programs in pension plans like QRS.
H. Describe your role in implementing manager transitions and/or rebalancing
strategic asset allocation targets.
I. Explain how due diligence reviews are performed and at what point such
reviews would be initiated. Do you initiate or do you wait for instructions from
your client to do so?
J. Describe your capabilities to evaluate specialty asset managers.Are there any
manager types which you have difficulty evaluating? If so, why and what plans are
there for alleviating the problem?
K. Describe your firm’s expertise in the area of real estate. How many professionals, if any, are dedicated to your real estate research area?
L. How many clients do you have who currently invest in real estate? Do they
use your firm as their sole consultant for real estate or do they also use a dedicated real estate consultant?
Section IV:
Manager
Search Process
and Asset
Allocation
Implementation
THE COMPETITIVE BID PROCESS | 25
26 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
M.What is your experience with initiating a real estate investment program?
Please describe in detail how you would approach assisting a client in establishing
a real estate investment program.
N. Discuss the role of alternative investments within a pension portfolio? Do you
have clients using alternative investments? If so, what form of alternatives? How
does your firm assist in the design, implementation and monitoring of such an
investment program? Do you have staff dedicated to researching this asset class?
Section IV:
Manager
Search Process
and Asset
Allocation
Implementation
(cont.)
In the event that a respondent is selected as a semi-finalist, QRB will contact
three references provided and points will be awarded based on the response.
A. Please supply a list of your five largest clients and include size of their fund.
Section V:
Reference
Information
B. Please list all public fund clients. Include the size of their fund and length of
service to them.
C. Please provide three references including at least one public fund client.
Include name, title, fund, address, and phone number.
THE COMPETITIVE BID PROCESS | 27
General Disclosures:
Various disclosures are central to insuring that the Board makes a reasoned and knowledgeable
decision.This is true of all services or products that the Board may seek but it is of particular concern
in the area of investment consultant.The Board will be relying on objective, unbiased advice from
the consultant and must be aware of potential conflicts that may impact that advice prior to selecting
the consultant. Many consultant firms receive revenue from managers, brokers and other service
providers. In some cases, such as money managers, the consultant may be recommending a manager
with whom it has a relationship to the Board.This must be disclosed.Any relationship with the
Board’s existing managers must also be disclosed.
Key Points & Concepts
28 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
A. Please list all services your firm, its principals or any affiliate provide that
generate revenues for the firm and indicate the applicable percent of your
firm’s total revenue during the past three years.These should include consulting
services for Plan Sponsors, money management activities and services to money
managers.
Did these services produce 100% of your firm’s revenue during the reporting
period? If not, provide information regarding the differences.
B. Does your firm, its principals, or any affiliate, own any part of a money
management firm, broker-dealer or other organization that sells services to
institutional investors and/or SEC registered investment advisors? If so, identify
the firm(s) and describe the relationship.
C. Has your firm, its principals or any affiliate ever (i) been the focus of a nonroutine Securities and Exchange Commission (SEC) inquiry or investigation or
a similar inquiry or investigation from any similar federal, state or self-regulatory
body or organization, (ii) been a party to any litigation concerning fiduciary
responsibility or other investment related matters, or (iii) submitted a claim
to your errors and omissions, fiduciary liability, and/or fidelity bond insurance
carrier(s)? If yes to any, please provide details.
D. Please list all money management firms from which your firm, its principals,
or any affiliates receive compensation. Please identify these revenue sources as
client directed, payment for services, and/or revenues not related to a letter of
direction or specific services. For the year ended 12/31/01, please provide specific information related to amounts your firm, its principals, or any affiliate received
from each of QRS money managers (listed in Appendix C) identifying all revenues
resulting from direct payments and gross directed brokerage.
Section VI:
General
Disclosures
THE COMPETITIVE BID PROCESS | 29
Appendix B:
Under PERAC Regulations, the fee for investment consultant services must be paid in a fixed dollar
amount and cannot be based on a percentage of assets. (840 CMR 26.01(5)
Key Points & Concepts
30 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Appendix B: Fee Schedule
A.Annual fee for full-service consulting arrangement in hard dollars.
$ _________
Appendix C: QRB Investment Managers
Dennis Investments
Martin,Valeri and Lamenzo
The Boorack Group
Cipriani Investment Management
Marcorelle, Colon & Nimiera
Phillips Partners
XYZ Capital
Seven Hills Investments
JPMCO
Dane Street
Dartmouth Bartlett
Lynch Park Capital
S&P 500 Index
Russell 100Value Enhanced Index
Large Cap Growth
Mid Cap Value
Mid Cap Growth
Small Cap Value
Small Cap Growth
Domestic Fixed Income
Domestic Fixed Income
Domestic Fixed Income
Lehman Aggregate Index
Lehman Govt/Corp Index
THE COMPETITIVE BID PROCESS | 31
Attachment A: Vendor Certification
This form is available for download at the PERAC Web site: www.mass.gov/perac.
32 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 33
Attachment B: Disclosure Statement
This form is available for download at the PERAC Web site: www.mass.gov/perac.
34 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 35
36 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 37
38 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 39
Notes
40 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
5 Middlesex Avenue
Third Floor
Somerville, MA 02145
ph 617 666 4446
fax 617 628 4002
tty 617 591 8917
web www.mass.gov/perac
Bid Process
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
Robert E.Tierney, Chairman | A. Joseph DeNucci, Vice Chairman
C. Christopher Alberti | Stephen P. Crosby| Kenneth J. Donnelly | James M. Machado | Donald R. Marquis
Joseph E. Connarton, Executive Director
5 Middlesex Avenue, Third Floor, Somerville, MA 02145
ph 617 666 4446 | fax 617 628 4002 | tty 617 591 8917 | web www.mass.gov/perac
Published by PERAC, 2002. Printed on recycled paper.
The Competitive Bid Process
Joseph I. Martin, PERAC Deputy Executive Director of Policy Development
Deputy Executive Director’s Letter
There is no more challenging responsibility for Retirement Board members than
that of prudently selecting investment consultants, managers and custodians.
Under the provisions of Chapter 32 Boards rely on the advice of consultants,
delegate direct investment of assets to money managers and depend on custodians to account for financial activity. PERAC has often stressed the need for
Board members to comply with their fiduciary duty in managing the retirement
system.The potential problems that could arise from mismanaging investments
underscore the need to act as a prudent expert would in selecting, monitoring
and retaining these vendors.
This booklet contains material relating to the competitive bid process, including
an outline of the components of such a process and a sample Request for
Proposals. It is our hope that PERAC, through this material as well as its
Regulations, memos and opinions, will be able to assist Boards in fulfilling the
trust owed to system members and their beneficiaries.
Sincerely,
Joseph I. Martin
PERAC Deputy Executive Director of Policy Development
ii | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Table of Contents
Section Page
The Competitive Process and Fiduciary Duty ..................................................................................................1
Outline of the Competitive Process....................................................................................................................2
Investment Consultant Request for Proposals............................................................................................... 5
Appendix A: Investment Consulting Services Questionnaire ......................................................................19
Appendix B: Fee Schedule ....................................................................................................................................31
Appendix C: QRB Investment Managers ..........................................................................................................31
Attachment A:Vendor Certification...................................................................................................................32
Attachment B: Disclosure Statement ................................................................................................................34
THE COMPETITIVE BID PROCESS | iii
iv | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
The Competitive Process and Fiduciary Duty
Section 1 of Chapter 32 of the General Laws defines a fiduciary as “any person
who exercises any discretionary authority or discretionary control respecting
management of the funds of any retirement system or exercises any authority or
control respecting management or disposition of its assets.”
The fiduciary standards are set forth in section 23 of Chapter 32 of the
General Laws which state,“A fiduciary as defined in section one shall discharge
his duties for the exclusive purpose of providing benefits to members and their
beneficiaries with the care, skill, prudence and diligence under the circumstances
then prevailing that a prudent person acting in a like capacity and familiar with
such matters would use in the conduct of an enterprise of a like character and
with like aims and by diversifying the investments of the system so as to minimize the risk of large losses unless under the circumstances it is clearly prudent
not to do so.”
Fiduciary Duty has three components—an Exclusive Purpose Rule, a Prudent
Expert Rule, and a Diversification Rule. In the context of competitive procurement our focus is on the Prudent Expert Rule. In short the question is—How
would a prudent expert proceed in selecting a vendor?
Chapter 32
THE COMPETITIVE BID PROCESS | 1
Outline of the Competitive Process
COMPETITIVE PROCESS
➤ Open
➤ Objective
➤ Fair
➤ RFP
➤ Processing
➤ Record Keeping
OPEN
➤ Public Notice - Reasonable time
➤ Posted
➤ Published
➤ Secretary of State notice
➤ May send to prospective bidders
OBJECTIVE
➤ Evaluation based only on requirements and criteria in RFP
➤ Pre-established criteria
➤ Objective and relevant criteria
➤ Business/Technical
➤ GFOA, PERAC, PRIM examples
PROCESSING RESPONSES
➤ No alteration/corrections after date for submission
➤ Date stamped on receipt
➤ Witness to opening RFPs
PROCUREMENT FILE
➤ Record of procurement
➤ Selection process
➤ Selection criteria
➤ RFP
➤ Copy of minutes
➤ Copy of responses
➤ Disposal schedule/6 yrs. after contract ends
2 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
ROLE OF CONSULTANT
➤ Board is decision maker
➤ Develop RFP
➤ Data base screen
➤ Incorporate into data base and analyze respondents
➤ Selection of consultant
➤ Ability to meet fiduciary duty of board
CONTRACT
➤ Written contract
➤ Executed prior to assuming duties
➤ Investment objectives
➤ Brokerage practices
➤ Fees
➤ Termination
BOARD NOTICE OF COMPETITIVE PROCESS
➤ Prior to retention of manager/consultant
➤ Board must notify PERAC competitive process followed
➤ Chapter 32 provisions met
➤ PERAC regulations met
➤ In all cases exemption or not
➤ No form-statement from board
VENDOR CERTIFICATION FORM
➤ All vendors submitting bids
➤ Selected vendor must submit to PERAC
➤ Good faith submission
➤ Without collusion or fraud
➤ In all cases exemption or not
THE COMPETITIVE BID PROCESS | 3
Introduction:
In order for a potential vendor to make a knowledgeable response to the RFP it is necessary that
information about the retirement system be made available.This includes present asset allocation,
asset size and funded status. In this example, information about the number of managers is also included.The Board should consider this element of the RFP carefully and include more information rather
than less. For example, in the case of the RFP for a consultant, Boards may wish to include a copy of
the existing Investment Objectives.
Schedule of Events:
The Board must inform the potential respondents of the various deadlines associated with the RFP
and must make every effort to meet the schedule.The date and time for submission of the RFP
response must be clear and final.Those failing to submit on time must be disqualified.
Scope of Services:
Although the Board will ask for specifics in several areas this section establishes the expectations of
the Board in general terms.The particulars that form the basis of the selection decision address how
the vendor will accomplish these tasks. In the case of a consultant RFP, the scope includes Investment
Policy/Objectives Development,Asset Allocation and Investment Management. In the latter category,
services are to be provided relating to portfolio structure, manager selection, and manager monitoring
and performance evaluation. In addition, the consultant is expected to provide the Board with reports
related to these areas and when called upon to attend Board meetings. Depending on the Board’s
present situation other services such as custodian search, investment research and education may also
be outlined in the Scope of Services. Boards should also include in this section the requirement that
the consultant and other vendors assist the Board in complying with PERAC Regulations.
Key Points & Concepts
4 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Investment Consultant Request for Proposals
Quabbin Contributory Retirement System (QRS), Quabbin, Massachusetts,
administers an investment portfolio of approximately $130 million in assets.As of
January 1, 2002 the assets were invested as follows: 54% in domestic equities,
40% in domestic fixed income and 6% in cash.The portfolio is managed by 12
outside investment managers. QRS has a ratio of assets to liabilities of 65%.
QRS is seeking investment consulting services to assist the Quabbin Retirement
Board (QRB) in making prudent investment management decisions related to the
QRS.An investment consultant is not presently advising QRS.
Section I:
Introduction
Pension & Investments Ad 7/29/02
Deadline for Submitting Written Questions 8/13/02
Deadline for Submitting RFP Response 8/20/02 (5:00 p.m.)
Review Completed 9/7/02
Interview at QRB (tentative) 9/19/02
Finalists Selected 9/24/02
Site visits for Finalists (tentative) 10/15/02
Finalists’ Presentations 10/30/02
Finalist Selected 11/27/02
Contract Begins 1/1/03
Section II:
Schedule of
Events
Under the direction of the QRB, the services to be provided by the investment Section III:
consulting firm shall include, but are not limited to, the following: Services to
A. General be Provided
1. Prepare reports reviewing and updating QRS investment policy, criteria and
objectives that include strategies for bonds, stock, real estate, alternative and
cash investments.
2. Prepare recommendations for amendments or modifications to the QRS portfolio structure with justification for the same.
3. Maintain a broad database of investment managers including their philosophies,
styles, fee schedules, portfolio characteristics, firm characteristics, performance,
and client base.The information should be available for a wide range of investment managers including equity, bond, international managers, as well as, real
estate fund managers and alternative investment managers.
THE COMPETITIVE BID PROCESS | 5
6 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
4.Assist in the development of policies, procedures and guidelines for the various
investment programs.
5.Attendance at the meetings of the QRB and other meetings as required.
6. Research and make recommendations for use of real estate investment and
alternative investment strategies.
7.Appear before legislative and regulatory bodies as requested by QRB.
8.Assist the QRB in complying with directives of the Public Employee
Retirement Administration Commission (PERAC).
B.Asset Allocation
Provide continuous review of investment policy, portfolio mix, and investment
strategy relative to changes in the capital market and structure of similar retirement systems.Advise the QRB as to the relationship between these aspects of
investment management and the funding status of the QRS.
C. Manager Search and Selection
Provide analysis of and assist in hiring external managers.
D. Performance Measurement and Reporting
1. Prepare quarterly evaluation reports on the performance of QRS portfolio
managers including a comparison with the performance of other managers and
public plans.
2. Provide QRB with quarterly and annual performance analysis.
3. Provide QRB with quarterly and annual performance reports of theoretical
portfolios, i.e. market indices, benchmarks and composite fund portfolios.
4. Assist QRB in assessing manager performance in accordance with 840 CMR
16.07 including participation in annual manager meetings, review of manager
reports and the annual assessment of each manager.
E. Research and Analysis
Prepare comprehensive analysis and advice on specific pension issues as requested by the QRB.
Section III:
Services to
be Provided
(cont.)
THE COMPETITIVE BID PROCESS | 7
Minimum Qualifications:
Every RFP should include a set of minimum standards that must be met by all respondents.These
primarily focus on business specifications. In this case the standards focus on client asset base, experience of the primary consultant, the firms’ years of business and the number of public pension fund
clients. In addition the regulatory requirement that respondents be registered under the Investment
Advisers Act of 1940 contained in 840 CMR 26.01 (2) is addressed.
Key Points & Concepts
8 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
IV. Minimum Qualifications Section IV:
Minimum A.The respondent must meet all minimum qualifications to be given further
consideration. Failure to satisfy each of the minimum qualifications will result in Qualifications
the immediate rejection of the proposal. Please indicate if your firm meets the
following minimum qualifications:
1.The firm must provide investment consulting services to clients with assets
totaling at least $2 billion.
2.The primary consultant assigned to the QRS account must have a minimum of
five (5) years experience providing domestic and international investment consulting services to public and/or private pension plans.
3.As of January 1, 2002 the firm must have been in business at least two (2)
years.
4.As of January 1, 2002 the firm must have at least two (2) public pension fund
clients.
5. In accordance with 840 CMR 26.01 (2) the firm must be registered as an
investment adviser pursuant to the Investment Advisers Act of 1940 (15 U.S.C.
80b -1 et seq.)
THE COMPETITIVE BID PROCESS | 9
Response Procedures:
The Board must inform the potential respondents of the items that must be part of the response.
These must include the PERAC Disclosure Forms and the Vendor Certification.This forms a checklist
for the vendor consisting of the Questionnaire, Fee Proposal, Disclosures, and Vendor Certification.
Key Points & Concepts
10 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
The following is a list of the required information to be provided by the
respondent.A respondent that does not provide the information requested
below will be rejected. Please provide the information in the same order in
which it is requested.
A. Proposal Questionnaire
Respondents must complete and return the Proposal Questionnaire contained in
Appendix A.The information requested must be provided in the prescribed format. Responses, which, in the opinion of QRB, materially deviate from the prescribed format, shall be rejected.All responses to the questionnaire will be subject to verification for accuracy. Proposals containing false or misleading information shall be rejected.
B. Fee Proposal
Respondents must submit their fee in the format prescribed in Appendix B.
The proposed fee shall include all costs and expenses for providing the services
to QRS as described in this RFP, and shall be guaranteed for the term of the
contract.
C. Disclosures
Respondents must submit the Disclosures prescribed in Section VI of Appendix
A. In addition, respondents must complete the Disclosure Forms in Attachment
A.The response must detail the amount of compensation in whatever form that
is associated with the relationship that is being disclosed. Failure to submit the
Disclosures shall result in the rejection of the proposal.
D. Certification of Good Faith
Respondents must submit a completed certification form prescribed in
Attachment B. Failure to submit the certification form shall result in the rejection
of the proposal.
Section V:
Information
to be
Provided by
Respondent
THE COMPETITIVE BID PROCESS | 11
Written Questions
The process must allow for inquiries to be made by potential respondents.This sometimes takes place
through a vendor conference as well as the submission of written questions. In this section of the RFP,
the rules for submission of questions and the response to those questions are stated. It is important
to note that a date certain for the submission is necessary and answers must be sent to all those who
have shown an interest in the RFP, not just the vendor that submitted the question.
Submission Process
The RFP must state what is expected of the respondent in relation to the submission of the RFP.
What must be submitted is addressed in Section V. In this section, the number of copies, method of
delivery, and other matters are addressed. It is important that responses be directly submitted in hand
or by mail and not through fax, e-mail, or disk. In addition, the requirement that a filing that contains
errors must be withdrawn and resubmitted in its entirety is stated.
Key Points & Concepts
12 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Questions respondents may have regarding the information presented in this
Request for Proposal must be received in writing to the attention of the QRB
no later than August 13, 2002. All questions received by that date will be
answered by QRB in writing. Copies of all questions and QRB responses will
be sent to all parties who indicate the intent to respond to the Request for
Proposal.
Section VI:
Submission of
Written
Questions
A. Submit six (6) copies of your proposal in a sealed package. Clearly identify the
outside of the sealed proposal package with the respondent’s name and return
address and the statement “Response to Request for Proposal, Investment
Consultant, 2002”. FAILURE TO CLEARLY IDENTIFY THE OUTSIDE OF THE
PROPOSAL PACKAGE MAY RESULT IN THE REJECTION OF THE PROPOSAL.
QRB is not responsible for receipt of any proposal that is improperly labeled.
B. Submission of proposals or any portion thereof via facsimile transmission, electronic, or magnetic media shall not be allowed. QRB shall not accept or consider
any proposal material submitted in this manner.
C. If, prior to the final filing date for submission of proposals, a respondent
discovers an error or omission in a proposal already submitted to QRB the only
method of correcting, modifying, or completing the proposal is to withdraw the
proposal in its entirety prior to the final filing date and time by written notification to QRB. A complete, corrected proposal package may be resubmitted, but
not after the final filing date and time. Modification offered in any other manner,
oral, written, or facsimile transmission, will not be considered.
D.The proposals become the property of QRB upon submission.All costs for
developing proposals and attending interviews are entirely the responsibility
of the respondent and shall not be chargeable to QRB. QRB accepts no
responsibility for lost and/or late delivery of proposals.
E. Only one proposal from an individual, firm, partnership, corporation, or
combination thereof, will be considered. Reasonable ground for believing a
respondent has submitted multiple proposals under more than one name will
be cause for rejection of all proposals in which the respondent is interested.
Section VII:
Submission of
Proposals
THE COMPETITIVE BID PROCESS | 13
Evaluation:
Fairness dictates that respondents be provided with some idea of the manner to be used in evaluating
the responses. In addition, the Board must state that it has the right to reject responses in certain
circumstances, particularly on the basis of information provided in various disclosures. Generally,
objectivity requires some type of numerical scoring system.Also, it must be made clear that interview
and reference checks as well as Questionnaire responses will be evaluated.
Key Points & Concepts
14 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
The purpose of the proposal evaluation process is twofold: (1) to assess the
responses for compliance with minimum qualifications, content, and format
requirements; and (2) to identify the respondent that has the highest probability
of satisfactorily performing the services as described herein.The evaluation
process will be conducted in a comprehensive and impartial manner.
QRB may reject any or all proposals and may or may not waive any immaterial
deviation or defect in a proposal. QRB will award points based on an analysis of
the responses to the Investment Consulting Services Questionnaire, the reference checks and, for semi-finalists and finalists, the oral presentation. QRB
reserves the right to reject any proposal based on the disclosures required in
Section VI of Appendix A and in the Disclosure Form (Attachment A). In addition
failure to file the completed Certification (Attachment B) shall disqualify the
respondent from consideration.
Proposals that contain false or misleading statements, or which provide references that do not support an attribute or condition claimed by the respondent
shall be rejected.
A.Written Proposal Evaluation
Proposals that meet the minimum qualifications will undergo an evaluation
process conducted by the QRB.
B. Semi-Finalist Interviews
Up to six (6) of the highest scoring Respondents, after the written proposal and
fee evaluation, will be considered semi-finalists and will have an oral interview
with QRB.The semi-finalists will be notified of the date and time of the interview
to be held at the QRB offices.
C. Finalists Selections
After completion of all evaluations, up to three (3) finalists will be determined.
D. Reference Checks and On-Site Inspections
Reference checks will be conducted for each semi-finalist. On-site inspections of
offices may be conducted for any or all finalists at the option of QRB.
E. Finalist Interviews
The finalists will have an interview with the QRB.
Section VIII:
Standards for
Evaluating
Proposals
THE COMPETITIVE BID PROCESS | 15
16 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Based upon the overall scoring including the finalists’ presentations before the Section IX:
QRB the contract will be awarded on or before November 27, 2002. Award of the
Contract
The contract shall be effective January 1, 2003. Section X:
Commencement
Date
THE COMPETITIVE BID PROCESS | 17
Appendix A-Investment Consulting Services Questionnaire:
There are different styles of RFP. Some use the Questionnaire format that separates the questions
that relate to the ability of the respondent to perform the Scope of Services from the other procedural provisions of the RFP. In any event, substantive, technical inquiries emphasizing the firms’ ability
to provide the services form the central component of any RFP.
Points are generally granted based on an assessment of each response.Although it is often difficult to
quantify a vendor’s ability, the need for objective comparison between respondents dictates the use of
a point system.
General Information:
The focus of this section is the organization itself, its ownership structure, recent significant developments, and anticipated changes in that structure.The experience of personnel, particularly those who
would be responsible for the account, client base, and regulatory/litigation history are covered in this
section. It is also important to assess the number of clients that each individual consultant in a firm is
expected to service, in order to gauge the level of service the Board would receive. Litigation/regulatory action against the firm or its owners and officers is a crucial question as it reflects on the past
compliance of the firm with statutes and regulations that establish the environment in which the firm
will serve the Board.All RFPs seeking a service should include similar inquiries.This is also the section
in which inquiry is made regarding the respondent’s insurance coverage.
Key Points & Concepts
18 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Appendix A: Quabbin Retirement System
Request for Proposal, Investment Consulting
Services Questionnaire, 2002
A. Provide a brief history of your firm and its operation. Include the year formed,
ownership, structure, and biographies of the principals, affiliations, profit sharing
programs, and ownership changes in the last five (5) years. Describe your firm’s
growth objectives and your plans for managing that projected growth.
B. Explain how the firm controls the quality of service provided to the clients, the
number of consultants in the firm, and the average number of clients assigned per
consultant.What is the maximum number of clients per consultants you maintain?
C.What is your firm’s mission statement? What do you see as your organization’s
strongest area of expertise?
D. Provide the names, portfolio sizes and lengths of engagements for the client
base using your services for full service consulting.
E. How many personnel in your firm are CFAs? How many have at least one
year of institutional experience in public funds administration? Active equity
management? Fixed income management? Cash management? Equities trading?
Bond trading? Real estate management? Alternative investment?
F. Assuming your firm is selected, provide biographical information on the individual proposed to serve as the primary consultant, his/her principal assistant and
other key members assigned to the account. Specify the anticipated role and scope
of involvement of each individual. For the primary consultant and principal assistant, provide the names of all clients and nature of their relationships. Describe
their experience in dealing with legislative and regulatory bodies.
G. Provide a listing of clients lost or gained during the past five (5) years. List size
of the fund and reason for ending the relationship(s).
H. Describe your firms’ commitment to research and systems enhancements.What,
if any, expansions do you anticipate in your technical and systems capabilities?
I. Has there been any litigation or regulatory action against your firm or its
principal/owners/officers in the last five (5) years? If yes, please explain.
Section I:
General
Information
THE COMPETITIVE BID PROCESS | 19
Performance Measurement and Portfolio Analytics:
This series of questions focuses on services to be provided by the consultant.Areas such as the data
sources used, method of data collection, reporting format and the different reports that can be generated, and performance comparison methodology are all elements of the consultants operation that
are reviewed in this section.
Key Points & Concepts
20 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
J. Does your firm, its principals and affiliates subscribe to the AIMR Code of Section I:
Ethics? General
K. Describe the levels of coverage for errors and omissions insurance and any
Information
fiduciary or professional liability insurance your firm carries. List the insurance (cont.)
carriers.
A. Describe the content and format of all performance reports.
B.Are all performance reports compliant with AIMR Performance Presentation
Standards?
C.What is the anticipated availability dates for each report in terms of the
number of calendar days after quarter end?
D. How much flexibility is there in your reporting format? Can reports be
customized at our request? Within what time can requested changes in reporting
be made; i.e., at the beginning of the relationship only or anytime changes are
needed?
E. Please provide samples of your performance reports.
F. Briefly describe your firm’s database(s), include size, composition, % public
funds, % private funds, etc. Is it proprietary or purchased from an independent
source? If proprietary, how is the data compiled?
G. Describe your firm’s capabilities to evaluate securities lending programs.
H. Describe your firm’s capabilities to perform trading cost evaluations.
Section II:
Performance
Measurement
and Portfolio
Analytics
THE COMPETITIVE BID PROCESS | 21
Asset Allocation Model:
In this section the consultants’ ability in the area of asset allocation is reviewed.The technical methodology used, participation by the Board, and time frames involved form the basis of the questions.
Key Points & Concepts
22 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
A. Describe how your firm is prepared to consult with and make presentations
to the Board on asset allocation changes and other asset allocation issues related
to total portfolio.
B.Address the ability of your process to work within existing, long-term policy
guidelines. How are investment objectives and range constraints factored into the
optimization process?
C.What is your commitment to internal research into the construction and
assumptions used in your asset allocation model(s)?
D.To what extent do you rely on a static model and/or inputs and construction
process of an outside vendor’s model?
E.To what extent would you involve QRB fiduciaries and staff in discussing the
economic climate and asset return assumptions that form the basis of your asset
allocation model?
F.What strategy or evaluation process does your firm employ to measure the
risk tolerance of your client fiduciaries?
G. How do you address those fiduciaries’ biases that may adversely affect the
outcome of the asset allocation model or manager selection processes?
H.What time frame does your asset allocation model use?
I. Describe the models or process used for optimizing strategic asset allocation
in changing economic circumstances.
J. How often do you recommend a formal review of asset allocation policies?
Section III:
Asset
Allocation
Model
THE COMPETITIVE BID PROCESS | 23
Manager Search Process and Asset Allocation Implementation:
After development of an investment plan and the establishment of investment objectives, the implementation stage begins. Manager search capabilities form an important aspect of the services being
sought by the Board.The search process and methodology, benchmarks/comparisons, database of
managers, research ability and manager monitoring approach are all elements reviewed in this section.
This is also the section to seek information about the consultants experience with various screens
such as tobacco, as well as the ability of the consultant to assist in searches seeking alternative or real
estate managers.
Key Points & Concepts
24 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
A. Describe in detail your manager database and search process.
B. Explain how firms enter your search universe. How do they “get a foot in the
door” of your database?
C. Describe the frequency and magnitude of manager turnover resulting from
performance reports, portfolio reviews or asset allocation changes resulting from
the optimization strategy provided to your clients.
D.What role does passive management play in your firm’s general view of the
asset allocation process for your clients?
E. How many active managers are retained by your average client? To what styles
and market cap ranges are they assigned?
F. Has your manager evaluation process resulted in the recommendation of the
same equity and fixed income managers consistently over several searches?
Please explain and provide examples of recent studies.
G. Have you ever assisted any clients in the development and/or evaluation of: (a)
social or country screens such as evaluating a portfolio for holdings in tobacco
companies, or (b) economically targeted investments or other “social” programs?
Provide a brief outline of your experiences, if any, and your general view of the
role of such screens and programs in pension plans like QRS.
H. Describe your role in implementing manager transitions and/or rebalancing
strategic asset allocation targets.
I. Explain how due diligence reviews are performed and at what point such
reviews would be initiated. Do you initiate or do you wait for instructions from
your client to do so?
J. Describe your capabilities to evaluate specialty asset managers.Are there any
manager types which you have difficulty evaluating? If so, why and what plans are
there for alleviating the problem?
K. Describe your firm’s expertise in the area of real estate. How many professionals, if any, are dedicated to your real estate research area?
L. How many clients do you have who currently invest in real estate? Do they
use your firm as their sole consultant for real estate or do they also use a dedicated real estate consultant?
Section IV:
Manager
Search Process
and Asset
Allocation
Implementation
THE COMPETITIVE BID PROCESS | 25
26 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
M.What is your experience with initiating a real estate investment program?
Please describe in detail how you would approach assisting a client in establishing
a real estate investment program.
N. Discuss the role of alternative investments within a pension portfolio? Do you
have clients using alternative investments? If so, what form of alternatives? How
does your firm assist in the design, implementation and monitoring of such an
investment program? Do you have staff dedicated to researching this asset class?
Section IV:
Manager
Search Process
and Asset
Allocation
Implementation
(cont.)
In the event that a respondent is selected as a semi-finalist, QRB will contact
three references provided and points will be awarded based on the response.
A. Please supply a list of your five largest clients and include size of their fund.
Section V:
Reference
Information
B. Please list all public fund clients. Include the size of their fund and length of
service to them.
C. Please provide three references including at least one public fund client.
Include name, title, fund, address, and phone number.
THE COMPETITIVE BID PROCESS | 27
General Disclosures:
Various disclosures are central to insuring that the Board makes a reasoned and knowledgeable
decision.This is true of all services or products that the Board may seek but it is of particular concern
in the area of investment consultant.The Board will be relying on objective, unbiased advice from
the consultant and must be aware of potential conflicts that may impact that advice prior to selecting
the consultant. Many consultant firms receive revenue from managers, brokers and other service
providers. In some cases, such as money managers, the consultant may be recommending a manager
with whom it has a relationship to the Board.This must be disclosed.Any relationship with the
Board’s existing managers must also be disclosed.
Key Points & Concepts
28 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
A. Please list all services your firm, its principals or any affiliate provide that
generate revenues for the firm and indicate the applicable percent of your
firm’s total revenue during the past three years.These should include consulting
services for Plan Sponsors, money management activities and services to money
managers.
Did these services produce 100% of your firm’s revenue during the reporting
period? If not, provide information regarding the differences.
B. Does your firm, its principals, or any affiliate, own any part of a money
management firm, broker-dealer or other organization that sells services to
institutional investors and/or SEC registered investment advisors? If so, identify
the firm(s) and describe the relationship.
C. Has your firm, its principals or any affiliate ever (i) been the focus of a nonroutine Securities and Exchange Commission (SEC) inquiry or investigation or
a similar inquiry or investigation from any similar federal, state or self-regulatory
body or organization, (ii) been a party to any litigation concerning fiduciary
responsibility or other investment related matters, or (iii) submitted a claim
to your errors and omissions, fiduciary liability, and/or fidelity bond insurance
carrier(s)? If yes to any, please provide details.
D. Please list all money management firms from which your firm, its principals,
or any affiliates receive compensation. Please identify these revenue sources as
client directed, payment for services, and/or revenues not related to a letter of
direction or specific services. For the year ended 12/31/01, please provide specific information related to amounts your firm, its principals, or any affiliate received
from each of QRS money managers (listed in Appendix C) identifying all revenues
resulting from direct payments and gross directed brokerage.
Section VI:
General
Disclosures
THE COMPETITIVE BID PROCESS | 29
Appendix B:
Under PERAC Regulations, the fee for investment consultant services must be paid in a fixed dollar
amount and cannot be based on a percentage of assets. (840 CMR 26.01(5)
Key Points & Concepts
30 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Appendix B: Fee Schedule
A.Annual fee for full-service consulting arrangement in hard dollars.
$ _________
Appendix C: QRB Investment Managers
Dennis Investments
Martin,Valeri and Lamenzo
The Boorack Group
Cipriani Investment Management
Marcorelle, Colon & Nimiera
Phillips Partners
XYZ Capital
Seven Hills Investments
JPMCO
Dane Street
Dartmouth Bartlett
Lynch Park Capital
S&P 500 Index
Russell 100Value Enhanced Index
Large Cap Growth
Mid Cap Value
Mid Cap Growth
Small Cap Value
Small Cap Growth
Domestic Fixed Income
Domestic Fixed Income
Domestic Fixed Income
Lehman Aggregate Index
Lehman Govt/Corp Index
THE COMPETITIVE BID PROCESS | 31
Attachment A: Vendor Certification
This form is available for download at the PERAC Web site: www.mass.gov/perac.
32 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 33
Attachment B: Disclosure Statement
This form is available for download at the PERAC Web site: www.mass.gov/perac.
34 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 35
36 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 37
38 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
THE COMPETITIVE BID PROCESS | 39
Notes
40 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
5 Middlesex Avenue
Third Floor
Somerville, MA 02145
ph 617 666 4446
fax 617 628 4002
tty 617 591 8917
web www.mass.gov/perac
Maintaining Investor Trust:
Independent Oversight in the System of Quality Control
J. Robert Brown, Jr.1
“You can’t really know where you are going until you know where you have been.”2
Thank you, John [Parsons], for the kind introduction.
It is a pleasure to have an opportunity to speak to a group of professionals dedicated to
protecting the well-being of our teachers, firefighters, policemen, and other local and state
workers. It’s also a pleasure to be in Massachusetts, albeit virtually. The Commonwealth of
Massachusetts is one of significant achievement, including the first subway in the U.S., the first
college in North America, and, perhaps most important for me, the fig newton cookie. I look
forward to a time when I can be back in Massachusetts in person.
Before I go on, I want to note that the views I share today are my own and do not
necessarily reflect the views of the Public Company Accounting Oversight Board (“PCAOB”),
my fellow Board members, or the staff of the PCAOB.
I want to talk today about the vital importance of quality control.
We rely on quality control in all aspects of our daily lives. We get on a plane with little or
no apprehension because of the quality control system operating behind the scenes that helps
ensure safety. Dynamic and robust systems protect the quality of our cars, our food, our
clothing. When the COVID-19 vaccine arrives, and I hope it’s soon, quality control will
hopefully make certain that each dose is safe and effective.
Properly done, quality control allows us to simply trust that the expected results will
occur. Our markets, economy, and society rely on trust to function efficiently and effectively.
The same principles apply to financial reporting. Trust in the accuracy of financial
statements is essential to investors of public companies. Some of that trust is due to the annual
audit by independent accounting firms.3
1 Board Member, Public Company Accounting Oversight Board, see PCAOB, J. Robert Brown, Jr.
(available at https://pcaobus.org/About/Board/Pages/J-Robert-Brown.aspx). This statement is based upon remarks
made at the Massachusetts Public Employee Retirement Administration Commission’s Emerging Issues Webinar
(Sept. 17, 2020). I want to thank Clara Fryer, an intern in my office during the fall of 2020, for her valuable work in
this statement.
2 Maya Angelou, Academy of Achievement Interview, High Point, NC (Jan. 22, 1997).
3 James R. Doty, Chairman, PCAOB, The PCAOB’s Initiatives to Bolster Investor Trust in the Audit,
AICPA Conference on SEC and PCAOB Developments, Washington, DC (Dec. 4, 2017) (available at
https://pcaobus.org/News/Speech/Pages/initiatives-bolster-investor-trust-in-audit-12-4-17.aspx) (“At the end of the
day, the purpose of the audit and the audit report has always been to communicate a basis for trust to investors.”).
2
Trust in audits, like medicine, food or transportation, depends upon a robust system of
quality control. The requirements for the audit firms’ system of quality control are set out in
PCAOB’s standards.4
These standards, however, are out-of-date. They were written decades
ago, with little, if any, input from investors. They do not reflect changes in the business and audit
environment or the financial failures and crises that have occurred since the PCAOB opened its
doors in 2003.
Our current standards were, in other words, written in, and for, another time.5
Efforts to revise these quality control (“QC”) standards are underway. The International
Auditing and Assurance Standards Board (“IAASB”) is meeting this week to consider adopting
changes to its QC standards;6
while the PCAOB has sought comments in a Concept Release
about possible revisions to its QC standards, including whether any future U.S. effort should be
based on the IAASB’s standards.7
We have learned from comments by investors and others that aspects of the QC approach
proposed by the IAASB raise concerns. In particular, investors indicated that such an approach
may not adequately address the importance of independent oversight for audit quality and I want
to talk about this issue.
Independent oversight takes into account the possible conflict between the commercial
interests of an audit firm and audit quality. This is only one aspect of any system of quality
control, nonetheless an important one.
Investors through the comment process provided strong views on this issue and, as a
result, they deserve careful consideration. The failure to do so would risk repeating history.
During the period of self-regulation by the audit profession, investor input was largely absent
4 In April 2003, the Board adopted certain preexisting standards as its “interim” standards. See PCAOB,
Release No. 2003-006: Establishment of Interim Professional Auditing Standards (Apr. 18, 2003) (available at
https://pcaobus.org/Rulemaking/Interim_Standards/Release2003-006.pdf). See also Order Regarding Section
103(a)(3)(B) of the Sarbanes-Oxley Act of 2002, Securities Exchange Act Release No. 47745 (Apr. 25, 2003)
(available at https://pcaobus.org/Rulemaking/Pages/InterimStandards.aspx). The elements of quality control are
identified in QC Section 20 - System of Quality Control for a CPA Firm's Accounting and Auditing Practice. See
QC Section 20, System of Quality Control for a CPA Firm’s Accounting and Auditing Practice (available at
https://pcaobus.org/Standards/QC/Pages/QC20.aspx).
5 See Megan Zietsman, Chief Auditor, PCAOB, Annual Auditing Conference at Baruch (Feb. 26, 2020)
(available at https://www.cpajournal.com/2020/02/26/regulators-and-standards-setters-2/ ) (“Clearly, the PCAOB
standards are old. They haven’t been substantially overhauled since they were adopted as interim standards back
when the PCAOB was established. For example, they don’t even take into account how technology is transforming
not only how audits are being done, but how firms are using technology as part of quality control and broadly as part
of running their businesses.”).
6 See IAASB Board Meeting, Virtual by Videoconference (Sept. 14-23, 2020) (available at
https://www.iaasb.org/meetings/iaasb-board-meeting-virtual-videoconferencing-1).
7 PCAOB, Release No. 2019-003: Potential Approach to Revisions to PCAOB Quality Control Standards
(Dec. 17, 2019) (available at https://pcaobus.org/Rulemaking/Pages/docket-046-quality-control.aspx).
3
from the standard-writing process. This failure resulted in a lack of investor trust, causing harm
to the capital markets, to investors and to companies. Congress altered that dynamic with the
creation of the PCAOB. The PCAOB was given an explicit mission of acting in the interests of
investors and the public.8
As we consider what to do with respect to QC standards, we are in mid-flight in the
process. The debate is ongoing. Whether we issue any proposal to revise our QC standards
remains to be seen. To the extent that we do, the need for, and the role of, independent oversight
over a firm’s QC system is something that will be determined only after a fulsome debate that is
only just beginning. As we continue to consider the matter, I am interested in hearing comments
and views from all stakeholders on the issue and encourage everyone here to participate in the
discussion.
So today, I’d like to talk about quality control and what we have learned so far from
investors and others, particularly about their views on the importance of independent oversight in
a QC standard.
First, I’d like to discuss the importance of revising the standards governing an audit
firm’s system of quality control.
Second, I’d like to discuss the comment letters we received on our Concept Release,
particularly the views on independent oversight.
Finally, I’d like to talk about possible future steps by the PCAOB and the role everyone
listening to this talk can play.
I. The Outdated Standards Governing Quality Control
The largest firms audit hundreds of public companies each year.9
Investors, and the
public, benefit from these audits.10 To make sure that audits deliver the expected quality, firms
8 See 15 U.S.C. § 7211(a) (mission of PCAOB “to protect the interests of investors and further the public
interest in the preparation of informative, accurate, and independent audit reports”). See also Bill Gradison & Ron
Boster, The PCAOB’s First Seven Years: A Retrospection, 4 CURRENT ISSUES IN AUDITING A9, A12 (2010)
(describing the mission as “precise and unambiguous” and noting that “the Board’s statutory mandate is to protect
investors, not issuers or their management, nor their external auditors.”).
9 PCAOB, PCAOB Issues Six Largest U.S. Firm Inspection Reports in New User-Friendly Format, Guide to
Reading Reports, (June 1, 2020) (available at https://pcaobus.org/News/Releases/Pages/PCAOB-issues-six-largestUS-firm-inspection-reports-new-user-friendly-format-guide-to-reading-reports.aspx).
10 PCAOB Release No. 2017-001: The Auditor’s Report on an Audit of Financial Statements when the
Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards (June 1, 2017) (available
at https://pcaobus.org/Rulemaking/Docket034/2017-001-auditors-report-final-rule.pdf ) (“Investors are the
beneficiaries of the audit and the auditor’s report is the primary means by which the auditor communicates with
them.”).
4
are required to have in place a system of controls that seek to ensure the engagements are
properly conducted.11
The standards governing quality control are in serious need of revision. They were
written in the era of self-regulation when the audit profession held the drafting pen12 and
investors and the public had little input into the process.13 The PCAOB, when it opened its doors
in 2003, adopted these same standards on an “interim” basis.14 While some auditing standards
have since been amended or updated, those governing the system of quality control largely have
not.
The IAASB and the PCAOB are, fortunately, taking steps to consider whether and how to
revise their respective quality control standards. The IAASB’s approach includes as a goal the
continuous improvement in audits through the implementation of a feedback loop.15 Under this
11 AS 1110: Relationship of Auditing Standards to Quality Control Standards (available at
https://pcaobus.org/Standards/Auditing/Pages/AS1110.aspx) (“A firm of independent auditors has a responsibility to
adopt a system of quality control in conducting an audit practice.”).
12 As late as 2002, the Auditing Standards Board, which drafted the standards, consisted entirely of practicing
auditors, excepting only an academic and state regulatory. See Public Oversight Board, Final Annual Report 2001,
at 32 (available at http://3197d6d14b5f19f2f440-
5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/2000/2002_0501_POBAnnualReport.
pdf) (“Members for the ASB’s 2001-2002 year include one representative from each of the eight largest accounting
firms, five from local or regional firms, one from academia, and one from government.”). See also United States
General Accounting Office, GAO/AIMD-96-98, The Accounting Profession, Major Issues: Progress and Concerns
(September 1996) (available at https://www.govinfo.gov/content/pkg/GAOREPORTS-AIMD-96-
98/pdf/GAOREPORTS-AIMD-96-98.pdf) (“In practice, audit standard setting has been primarily the domain of the
accounting profession. In that respect, auditing standards have been influenced by auditors’ liability concerns.”).
13 Accounting Reform and Investor Protection, Hearings Before the S. Comm. on Banking, Hous., and Urban
Aff., 107th Cong. (Feb. 26, 2002) (Statement of Shaun F. O’Malley, Chairman, 2000 Public Oversight Board Panel
on Audit Effectiveness, Former Chairman, Price Waterhouse, Past President, Financial Accounting Foundation,
Accounting Reform and Investor Protection) (“The panel found that the current system of governance lacks
sufficient public representation”). See also Id. (testimony of Lynn Turner, Chief Accountant, SEC) (during era of
self-regulation, standards “written to protect the accounting firms in case they get in trouble on an audit;”), quoting
Testimony of John C. (Sandy) Burton, Chief Accountant, SEC (1978) (“As long as you leave that standard setting
process in the hands of the firms and the firm's legal counsel, you are going to get standards written to protect them
in court, as opposed to standards written to ensure that they do audits that will protect the public.”).
14 See PCAOB, Release No. 2003-006: Establishment of Interim Professional Auditing Standards (Apr. 18,
2003) (available at https://pcaobus.org/Rulemaking/Interim_Standards/Release2003-006.pdf). See also Order
Regarding Section 103(a)(3)(B) of the Sarbanes-Oxley Act of 2002, Securities Exchange Act Release No. 47745
(Apr. 25, 2003) (available at https://pcaobus.org/Rulemaking/Pages/InterimStandards.aspx). This was of course a
necessary expediency. The PCAOB adopted the standards only on an interim basis. The expectation was that they
would eventually be replaced by provisions that better reflected the interests of investors and the public.
15 This is no accident. The Concept Release specifically quoted extensively from the IAASB proposal and
referenced it as a possible “starting point” for revisions of PCAOB standard. See Concept Release, supra note 7
(“We are considering whether and how PCAOB QC standards should be revised to address developments in audit
practices and provide more definitive direction regarding firms’ QC systems. We are considering an approach based
on Proposed ISQM 1 as the starting point for potential revisions to PCAOB QC standards.”).
5
approach, firms would be required to put in place a system to identify risks that could
compromise audit quality.
Once identified, the QC system would need to be adjusted to prevent the risk from
recurring or, better still, from occurring in the first place. By repeating the process, a QC system
would constantly evolve and the quality of audits would continually improve.16 The PCAOB’s
Concept Release asks whether the PCAOB should use a similar approach with respect to any
future PCAOB QC standard.
Whatever the promise of this approach, investors through the comment process raised a
number of significant concerns.17 Investors indicated that the approaches under consideration
would be improved by greater accountability, including increased transparency18 and metrics
16 This is in fact an old idea. See The Commission on Auditors’ Responsibilities: Report, Conclusions, and
Recommendations, at 128 (1978) (available at http://3197d6d14b5f19f2f440-
5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1970/1978_0101_CohenAuditors.pdf)
(“This suggests the profession must continuously monitor performance, deal quickly with substandard performance,
and attempt to anticipate future problems.”).
17 PCAOB, Comment Letters for Docket 046 (available at
https://pcaobus.org/Rulemaking/Pages/Docket046Comments.aspx).
18 Letter from CFA Institute to PCAOB, PCAOB Rulemaking Docket No. 046: Concept Release, Potential
Approach to Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket
No. 046)-- (May 11, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/036_CFA.pdf) (“The details of
the quality control system of each audit firm should be fully communicated to the users of financial statements
including investors – as the standard being proposed is meant to accommodate public company audits, companies
that are public because of their listing, in the United States. Firms should be required to provide disclosures of audit
quality and quality control, including audit quality indicators (AQIs) and how the firm responds to identified
deficiencies. ”); Letter from AFL-CIO to PCAOB, PCAOB Release No. 2019-003, Potential Approach to Revisions
to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16,
2020) (available at https://pcaobus.org/Rulemaking/Docket046/024_AFL-CIO.pdf) (“As we commented in our
September 29, 2015 letter to the PCAOB, we also support the disclosure of quantitative data on audit quality
indicators as a matter of transparency to investors.”); Letter from Colorado Public Employees’ Retirement
Association to PCAOB, Rulemaking Docket No. 046 - Request for Comments on the Potential Approach to
Revisions to PCAOB Quality Control Standards Concept Release (Mar. 18, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/033_CoPERA.pdf) (“Along with publication of AQIs, we also believe
that auditors should provide a detailed account of their audit quality control systems. Updating and strengthening the
quality control standards will help to improve audit quality, but the addition of AQIs and quality control
transparency would be the critical driver of improved investor confidence.”); Letter from CII to PCAOB, PCAOB
Rulemaking Docket No. 046 Concept Release, Potential Approach to Revisions to PCAOB Quality Control
Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 19, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/035_CII.pdf) (“We believe a future PCAOB QC standard should require
public disclosure by firms about their QC systems.”).
6
designed to measure quality,19 an omission of which one commenter labeled “inconceivable.”20
Investors also asked for mandatory outreach by audit firms to investors as part of the feedback
loop,21 heightened accountability through a certification requirement,22 and a broader objective
against which to measure the success or failure of the system.23
19 See Letter from CFA Institute, supra note 18 (“However, for a market to be perfectively competitive not
only does an efficient market need numerous buyers and sellers but they also need them to be well informed. In the
current audit market, buyers of audit services – ultimately investors – do not have the information necessary to judge
audit quality.”); see also Letter from AFL-CIO, supra note 18 (“we urge the PCAOB to require the use of audit
quality indicators as part of audit firm quality control standards. Measuring audit quality indicators will promote
enhanced audit quality.”); Letter from Colorado PERA, supra note 18 (“The PCAOB can further the connection
between these two critical groups through the adoption of Audit Quality Indicators (AQIs) as part of the quality
control standards. The adoption of Audit Quality Indicators has been discussed at the PCAOB for years, and we
believe the review of the quality control standards is an excellent opportunity to finalize the process of developing
AQIs.”); Letter from CII, supra note 18 (“We believe firms should be required to establish quantifiable performance
measures for the achievement of quality objectives.”).
20 Letter from Consumer Federation of America to PCAOB, PCAOB Release No. 2019-003, Concept
Release, Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003;
Rulemaking Docket No. 046) (Mar. 16, 2020) (“Consumer Federation”) (available at
https://pcaobus.org/Rulemaking/Docket046/014_CFA.pdf) (“It is frankly inconceivable to us that the Board would
update its quality control standards without including a requirement on AQIs.”).
21 Letter from ICGN to PCAOB, ICGN Response to the PCAOB Concept Release for Potential Approach to
Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046)
(Mar. 16, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/016_ICGN.pdf) (“We note that there is an
ongoing gap in consideration of the investor in these processes. We believe that QC standards should include
express efforts to engage with investors and reflect those investor needs. This would be welcome at a firm level as
well as at individual engagement levels, where investors offer a valuable sounding board for potential concerns
around accounting quality that could help direct auditors’ work.”); Letter from Colorado PERA, supra note 18 (“We
view the reassessment of quality control standards as another opportunity to further improve the connection and
communication between investors and auditors.”).
22 Letter from Colorado PERA, supra note 18 (“Based on our discussions with management teams during the
implementation of Sarbanes-Oxley, having to sign off on their company’s financial statements was an important
driver in improving financial reporting quality. We believe having senior management at the audit firms sign off on
their quality control systems will create the same level of personal accountability.”). Certification or attestation can
improve the quality of the decision making process. See, e.g., Nationally Recognized Statistical Rating
Organizations, Securities Exchange Act Release No. 72936 (Aug. 27, 2014) (“the Commission believes that having
an individual attest to the information disclosed in the form will promote analytical independence. In particular, the
individual executing the attestation will want to ensure that it contains no untrue or inaccurate statements.
Consequently, the individual will have an incentive to take steps to verify that the credit rating was not influenced
by any other business activities, was based solely on the merits of the instruments being rated, and was
an independent evaluation of the risks and merits of the instrument.”).
23 Investors and academic commenters noted that the objective of an audit firm’s system of quality control
should explicitly refer to the protection of investors and customers of broker dealers. See, e.g., Letter from Douglas
R. Carmichael, Ph.D., CPA and Thomas J. Ray, CPA Eli and Claire Mason Professor Distinguished Lecturer Baruch
College, CUNY Baruch College, CUNY, to PCAOB (Mar. 13, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/008_Carmichael-Ray.pdf) (“We recommend that the goals of a system
of quality control include explicitly the goal of performing audits in a manner that protects the interests of investors,
and customers of broker dealers, as applicable, and furthers the public interest in the preparation of audit reports that
are informative, accurate, and independent.”).
7
II. The PCAOB Concept Release
These are all issues that should be given serious consideration. In my remarks today,
though, I want to focus on another concern raised by investors, the importance of independent
oversight for any system of quality control. Investors expressed strong support for the inclusion
of independent oversight in any potential revision of our QC standards.
The issue of independent oversight arises, as the letters indicated, from the potential
conflict between the commercial nature of firms and audit quality.24 Partners at firms are
compensated based on the profits generated by the firms.25 Audit quality, in turn, is a cost that
can conflict with commercial interests, at least in the short term.26 A potential risk exists,
therefore, that commercial interests may sometimes improperly override audit quality.
How might this occur? Given the competing nature of these interests, investors identified
some possibilities. Firms might under-invest in audit quality, leaving the area without adequate
resources. Firms may be less willing to dismiss a lucrative client notwithstanding concerns over
quality. Those responsible for audit quality may be less willing to make difficult or unpopular
decisions out of concerns over the impact on their professional standing within the firm.
Independent oversight is used throughout the capital markets to address similar conflicts
of interest. Listed companies address the potential conflict between the interests of management
and shareholders through the use of independent directors.27 The major stock exchanges in the
24 See The Dutch Authority for the Financial Market, Vulnerabilities in the Structure of the Audit Sector
(Nov. 2018) (“Vulnerabilities in The Structure of The Audit Sector”) (available at
https://www.afm.nl/~/profmedia/files/doelgroepen/accountantsorganisaties/2018/engels-rapport-kwaliteitstructuur.pdf?la=en) (“Although both attitudes of course exist, this study revealed that the technical-commercial
attitude had the upper hand among auditors at the organisations reviewed. One important reason for this is that
people with this attitude are more likely to be promoted to partner status. The study concludes that this culture, in
which employees with a commercial attitude to their work strive to progress to become partners, is contrary to the
‘accounting profession’s public interest mandate’.”).
25 Jan Bouwens, Olaf Bik, & Yuxia Zou, Determinants of Audit Partner Compensation, (Aug. 2019)
(available at https://pcaobus.org/EconomicAndRiskAnalysis/Conference/Documents/Submission%2023%20-
%20Determinants%20of%20Audit%20Partner%20Compensation%20v20190909.pdf) (“Partnerships use profitsharing systems to incentivize individual partners as each time when firm profit increases, so will each partner’s
profit share).
26 See Vulnerabilities in The Structure of The Audit Sector, supra note 24 (“Such investment will take a long
time to be repaid, and the return is by no means certain in advance. In other words, it takes a relatively long time
before investment in matters such as quality control and compliance systems, innovation and training in ethics,
business conduct and professional behaviour will result in higher earnings. The propensity to make such investments
on the basis of the principle of an economic return may thus be lower than desirable from the point of view of the
public interest. This effect possibly intensifies as the partners approach retirement, since they will not see a return at
all.”).
27 See NYSE: Corporate Governance Guide (Dec. 2014) (available at
https://www.nyse.com/publicdocs/nyse/listing/NYSE_Corporate_Governance_Guide.pdf).
8
U.S. use independent oversight to safeguard regulatory responsibilities from undue influence
from commercial interests.28 Independent oversight, as part of the investment company
regulatory framework, has been characterized as “fundamental.”29 Accordingly, mechanisms of
independent oversight are well-known by investors.
We specifically asked about the issue in the Concept Release. We sought comments on
whether any future PCAOB standard should “incorporate mechanisms of independent oversight
over firms’ QC system”.30 The question struck a nerve.
A. Comments We Received
Investors, investor associations, consumer groups, and the U.S. Government
Accountability Office (GAO) all supported requirements of independent oversight as an element
of a audit firm’s system of quality control.31 They agreed that such oversight should be
28 Self-Regulatory Organizations; New York Stock Exchange LLC; Order Approving Proposed Rule Change
Amending the Eighth Amended and Restated Operating Agreement of the Exchange to Establish a Regulatory
Oversight Committee as a Committee of the Board of Directors of the Exchange and Amending Other Rules of the
Exchange, Exchange Act Release No. 75991 (Sept. 28, 2015) (available at
https://www.sec.gov/rules/sro/nyse/2015/34-75991.pdf) (“The Exchange believes that its proposal to establish a
ROC to undertake the independent oversight of the Exchange's regulatory responsibilities would
ensure independent oversight of the regulatory process and would have the additional benefit of aligning the
Exchange's corporate governance practices with its industry peers.”). See also Findings, Opinion, and Order of the
Commission Exchange Act Release No. 53128 (Jan. 13, 2006) (available at
https://www.sec.gov/litigation/opinions/34-53128.pdf) (“In addition, the Nasdaq Exchange has created
an independent regulatory department, Nasdaq Regulation, for the purpose of functionally separating its regulatory
functions from its business lines. Nasdaq Regulation will carry out many of the Nasdaq Exchange's regulatory
functions, including administering its membership and disciplinary rules.”).
29 Treatment of Asset-Backed Issuers Under the Investment Company Act, Investment Company Act Release
No. 29779 (Sept. 7, 2011) (available at https://www.sec.gov/rules/concept/2011/ic-29779.pdf) (“The concept
of independent oversight or independent review is fundamental to the regulatory framework of the Investment
Company Act. Registered investment companies typically rely for their structure and operations on third parties that
have their own financial interests separate and distinct from those of the investment companies and their
shareholders, presenting potential conflicts of interest that require independent oversight. The
independent oversight in the case of registered management investment companies is provided by the company's
board of directors, and in particular the independent board members, as required by the Act.”). There are other
examples that employ structural mechanisms to operationalize independent oversight. Investment banks have in
place quality controls that separate their brokerage business from the analyst function to ensure the integrity and
independence of the research function. Similarly, credit-rating agencies must separate the ratings function from
sales and marketing activities as part of their system of quality control. The structural mechanisms, however, often
accompany robust independent oversight.
30 See Concept Release, supra note 7 (“We are considering whether a future PCAOB QC standard should
address mechanisms for independent oversight over firms’ QC systems (for example, boards with independent
directors or equivalent).”).
31 Of the 25 or so commenters who expressed views on public disclosures as a component of a firm’s system
of quality control, 100% of investors supported public disclosures. No comment letter from a registered accounting
firms supported the requirement. But see Letter from Institute of Management Accountants (IMA) to PCAOB,
PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB
9
required32 and made part of the “structure” of such a system.33 Independent oversight would
“greatly enhance the quality of controls standards”34 and improve accountability.35 In particular,
the Consumer Federation of America told us that independent oversight “has the potential to help
counteract economic incentives to under-invest in audit quality or to view retaining customers,
rather than protecting investors, as the firm’s top focus.”36
The letters included specific suggestions for the largest firms. Investor concerns about a
firm being too commercially driven could be mitigated37 through a system that incorporated
Release No. 2019-003; Rulemaking Docket No. 046) (Feb. 26, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/005_IMA_FRC.pdf) (“The time probably has come for there to be a
requirement for an annual quality control report to be issued by at least the largest accounting firms – perhaps,
initially, for those firms that audit more than 100 registrants. However, this is an area where scalability should be
considered; the public interest in such a report would be much less for smaller firms and need not be required at this
time. We do continue to believe that firms should be given wide discretion in the form and content of such
reports.”).
32 See Letter from CII, supra note 18 (“Given the importance of independent oversight to audit quality, we
believe audit firms should be required to have independent oversight of their systems.” ); see also Letter from CFA
Institute to PCAOB, supra note 18 (“[A]ll the largest audit firms should be required to have independent directors
on their boards.”).
33 Letter from California Public Employees' Retirement System (CalPERS), Concept Release, Potential
Approach to Revisions to PCAOB Quality Control Standard (PCAOB Release No. 2019-003; Rulemaking Docket
No. 046) (Mar. 18, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/034_CalPERS.pdf) (“Having
high level independent oversight in a company’s governance structure provides an objective point to mitigate
concerns with conflicts of interest as well as assessing the effectiveness of the auditor. We support more
independent governance structures and would like it to become a central part of audit firm governance.”).
34 See Letter from Colorado PERA, supra note 18 (“We believe independent oversight would greatly
enhance the quality control standards.”).
35 See Letter from CFA Institute, supra note 18 (“We believe, however, that this goal is most likely to be
achieved if firm leaders are held accountable for results achieved. And this in turn can only be achieved through
independent oversight of the quality control system and where there is transparency of the details of the quality
control system of each audit firm. . .”).
36 See Letter from Consumer Federation, supra note 20 (“Given the incentives firms have to under-invest in
quality control, we believe that goal is most likely to be achieved where there is independent oversight of the quality
control”). See also id. (“Independent oversight also has the potential to help counteract economic incentives to
under-invest in audit quality or to view retaining customers, rather than protecting investors, as the firm’s top
focus.”).
37 See Letter from CalPERS, supra note 33 (“Independent directors can mitigate concerns over a firm being
too commercially driven.”). See also Letter from CFA Institute, supra note 18 (“Given the importance of
independent oversight to audit quality, we believe audit firms should be required to have independent oversight of
their systems of governance and quality control”) and consequently that all of the largest audit firms should be
required to have independent directors on their boards.”); see also Letter from CII, supra note 18 (“We believe that
all of the largest audit firms should be required to have independent directors on their boards. We believe the
benefits of requiring independent directors on firm boards would exceed the costs of imposing such a change at the
largest audit firms. In addition, we believe the duties of those providing independent oversight should include,
among other responsibilities, “resource allocation decisions . . . the annual review of the QC system, the
10
independent oversight, such as a mechanism to report directly to independent directors on the
firm’s board.38 A reporting line directly to these directors could result in a board better informed
about audit quality issues.39
The Council of Institutional Investors (“CII”) endorsed a U.S. Treasury Report
recommendation that audit firms’ boards should have “independent members with full voting
power.” CII further explained that the benefits of independent oversight exceed the “costs of
imposing such a change at the largest audit firms.” 40
At the same time, commenters recognized that independent oversight could be made
scalable. As the letter from the Consumer Federation of America stated:
Much as an independent board committee is required to oversee the public company
audit, an independent board committee of the audit firm should have responsibility for
overseeing the firm’s quality control system. For smaller firms that do not have
independent boards or advisory committees, responsibility for maintaining a robust QC
system should reside with top firm leadership.41
B. Possible Concerns
The views of audit firms and their associations were more mixed. Most commenters from
audit firms or their associations recognized the value and importance of independence.42 Indeed
effectiveness of remediation of QC concerns, and the integration of audit quality into the system of incentives and
rewards for firm personnel.”).
38 See Letter from AFL-CIO, supra note 18 (“Accordingly, we support improving the oversight of quality
control systems through the appointment of independent directors to audit firm boards for this purpose.”).
39 John Armour, Jeffrey Gordon & Geeyoung Min, Taking Compliance Seriously, 37 YALE J. ON REG. 1
(Winter 2020) (“A direct channel of reporting from compliance personnel to the board is thought to be a means of
fostering not only autonomy within the compliance program but also open upward transmission of information.”).
40 See Letter from CII, supra note 18 (“We believe that all of the largest audit firms should be required to
have independent directors on their boards. We believe the benefits of requiring independent directors on firm
boards would exceed the costs of imposing such a change at the largest audit firms. In addition, we believe the
duties of those providing independent oversight should include, among other responsibilities, “resource allocation
decisions . . . the annual review of the QC system, the effectiveness of remediation of QC concerns, and the
integration of audit quality into the system of incentives and rewards for firm personnel.”)
41 Letter from Consumer Federation, supra note 20.
42 A number of letters, including many from audit firms, recognized the value of independence. See Letter
from KPMG to PCAOB, PCAOB Rulemaking Docket No. 46: Concept Release: Potential Approach to Revisions to
PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/020_KPMG.pdf) (“Independent oversight of the firm’s QC
system can provide benefits to the system of quality control. In our experience, independent directors provide
valuable insight and support the achievement of the firm’s quality objectives.”); See Letter from PwC to PCAOB,
PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB
Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/030_PwC.pdf) (“Perspectives from independent third parties can add an
11
many firms have incorporated some form of independence and external participation into their
governance structures through in a variety of ways. No firm commenter, with one possible
exception,43 however, supported making this a requirement for a firm’s system of quality control
in a future PCAOB standard.
important dimension of input to a firm’s internal assessments and can benefit audit quality by enhancing a firm’s
governance and decision-making processes. This approach is consistent with widely-accepted governance best
practices.”); Letter from EY to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB
Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/021_EY.pdf ) (“Independent perspective can enhance
stakeholder confidence in audit firms by providing valuable insights about matters that can affect a firm’s audit
quality, such as its business, operations, culture, talent, strategy, governance and risk management.”); Letter from
Grant Thornton to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality
Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020) (available at
https://www.grantthornton.com/-/media/content-page-files/audit/pdfs/comment-letters-2020/comment-PCAOBquality-control-revisions-1.ashx) (“We are supportive of the notion that independent directors or advisory
committees can provide helpful business insights to audit firms.”); see also Letter from Committee on Corporate
Reporting, Financial Executives International, to PCAOB, PCAOB Concept Release on Potential Approach to
Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046)
(Mar. 16, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/019_FEI_CCR.pdf) (“We acknowledge
the role that audit firm governance plays in contributing to audit quality and that this is an area where the profession
continues to evolve.). One firm did suggest that an independence requirement could harm audit quality. See Letter
from MAZARS to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality
Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/029_MAZARS_US.pdf) (“No, we do not believe the revised PCAOB
QC standard should include the incorporation of independent oversight over firms’ QC systems. The prescribing of
such mechanisms may not be adaptable to all firms of varying sizes; limiting scalability. In addition, mandating
independent oversight may result in unintentional consequences that would compromise audit quality, as firms may
be forced to expend financial resources that would be more effectively used on audit quality initiatives.”).
43 See Letter from Grant Thornton, supra note 42 (“Regardless of the path the Board chooses, we do not
believe specific criteria should be used to determine which firms would be required to have independent oversight.
If the Board believes that audit quality will be enhanced by such oversight, we do not believe certain firms should be
exempt from such requirements. Rather, we encourage the Board to establish requirements that can be appropriately
instituted by all registered firms, considering the operational challenges we noted above.”).
12
Their hesitancy seemed to be mostly about application.44 Firms expressed concern over
scalability,45 particularly the impact of any such requirement on smaller firms.46 They also noted
44 Some objected to the requirement as inconsistent with a risk based approach to quality control. See Letter
from CAQ to PCAOB, PCAOB Rulemaking Docket No. 46: Concept Release: Potential Approach to Revisions to
PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/010_CAQ.pdf ) (“We do not believe such a provision
should be required, as we are concerned this would limit the scalability of a future PCAOB QC standard.
Independent oversight may be an appropriate response for some firms based on their risk assessment; however, such
a requirement may not be necessary or effective for all firms. Further, independent oversight may take various forms
including independent advisors who are not board members.”); Letter from Crowe LLP to PCAOB, PCAOB
Rulemaking Docket No. 46: Concept Release: Potential Approach to Revisions to PCAOB Quality Control
Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (available at
https://pcaobus.org/Rulemaking/Docket046/025_Crowe.pdf) (“Independent oversight over a firm’s QC systems is a
relatively new concept for most firms, and while it is clearly an option a firm might take, firms do not have public
investors who have the same level of need for independent oversight as that of a public company. We believe that
with a risk-based approach, a firm may determine that independent oversight or independent advisors is an
appropriate response to their risk assessment process, however, it should be part of a firm’s overall response to its
risk assessment not a prescriptive requirement. Requiring independent oversight may also limit the scalability of a
future PCAOB QC standard.”); Letter from Moss Adams to PCAOB, PCAOB Rulemaking Docket No. 46 (Mar. 16,
2020) (available at https://pcaobus.org/Rulemaking/Docket046/023_Moss_Adams.pdf) (“We do not believe such a
provision should be required as we are concerned this would limit the scalability of a future PCAOB QC standard.
Independent oversight may be an appropriate response for some firms based on their risk assessment; however, such
a requirement may not be necessary or effective for all firms. Further, independent oversight may take various forms
including independent advisors who are not board members.”).
45 See Letter from PwC, supra note 42 (“Regarding scalability, we note that certain incremental requirements
could disproportionately affect smaller firms. For example, requirements for firms to have mechanisms for
independent oversight over their QC systems could prove challenging for smaller firms – whether due to an inability
to remunerate suitable candidates competitively with other firms or finding individuals willing to be subject to a
firm’s independence requirements.”); Letter from KPMG, supra note 42 (“While there is value to including an
element of independent oversight to support the QC system, we also acknowledge that it is challenging to identify
qualified, diverse and independent individuals that can fulfill this role. These challenges may impact the scalability
of a future PCAOB QC standard to all firms; and, therefore, we do not recommend that a future Quality Control
standard require a mechanism for independent oversight.”); Letter from RSM US LLP to PCAOB, PCAOB Concept
Release on Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003;
Rulemaking Docket No. 046) (Mar. 13, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/009_RSMUS-LLP.pdf) (“Also, a requirement to incorporate mechanisms for independent oversight would not make the
standard easily scalable for smaller firms. We believe the discernment regarding whether to have independent
directors or other advisory oversight bodies should take place in the board room of the individual firms.”); see also
Letter from NYSSCPA to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB
Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 17, 2020) available
at https://pcaobus.org/Rulemaking/Docket046/032_NYSSCPA.pdf) (“Consistent with our view set forth under our
General Comments above, we believe scalability should be a primary consideration in determining the nature and
extent of any oversight to be applied to a firm’s QC function . . . and that an “independent” QC oversight should not
be mandated except perhaps for the largest of firms.”).
46 Letter from Baker Tilly to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to
PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/011_Bakertilly.pdf) (“This approach should not be a
requirement. Firms have developed different forms of governance that are suitable for them. To prescribe some sort
of required structure would be contrary to a risk-based approach and probably unsuitable for the smaller firms.”).
13
the need for flexibility.47 A consistent theme was that a single model for independent oversight
had not emerged and therefore should not be required.48 Instead, there should be room to allow
for evolution49 and to consider alternative models.50
To the extent that the structure would include oversight by independent directors, a
number of issues would need to be addressed.51 Questions were raised about the ability of small
firms to find qualified candidates,52 with suggestions that any independent oversight “should not
47 See Letter from PwC, supra note 42 (“It is important for firms to have flexibility to consider whether
independent oversight is necessary and, if so, what is most appropriate based on the structure of their firm and where
they operate.”); Letter from EY, supra note 42 (“Today, there are a variety of ways that firms gather perspectives
from an independent body as a means to strengthen audit quality. We believe firms should continue to have this
flexibility.”).
48 Letter from BDO to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB
Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/018_BDO.pdf ) (“we do not believe that there is
observable evidence that the use of independent directors is effective in improving audit quality with accounting
firms, as we believe that firms that have voluntarily adopted the use of independent directors have not used them in
an oversight capacity as proposed by the PCAOB.”). See also Letter from RSM, supra note 45 (“Currently,
professionals from outside a firm primarily are hired in an advisory (i.e., not an oversight) capacity. We do not
believe it would be helpful or practicable to require firms to incorporate mechanisms for independent oversight as
we believe that, even with a requirement to have such independent oversight, the roles of independent directors
would vary as to levels of authority, responsibility and influence within each firm.”).
49 See Letter from IMA, supra note 31 (“We acknowledge that various practices have emerged in recent years
including independent directors on firms’ boards of directors and separate audit advisory boards comprised of
independent individuals. It is too early to know which form of oversight, if any, will be most effective in improving
firm-wide audit quality. Likewise, it would be premature to specify duties for such oversight. We believe that best
practices for such oversight will develop in the marketplace. This is like the evolution of audit committees within the
corporate governance system. For decades, such committees were considered a good practice, but few companies
established them, and the existing committees had widely varied practices. Only in relatively recent years has it
become accepted that such committees are an essential element of corporate governance, should be required, and
should follow at least a minimum list of required procedures.”).
50 A variety of other options were also suggested. See Letter from Grant Thornton, supra note 42 (“We
believe that a similar objective can be met by either designating an individual on a firm’s board as an ‘audit quality
expert’ (similar to audit committee requirements for a ‘financial expert’) or by having independent external advisors
outside of the board construct, to focus on and advise firms regarding audit quality or their systems of quality
control.”).
51 Letter from NYSSCPA, supra note 45 (“Also, we believe that the size, composition and qualifications of
members of a body designated with responsibility for overseeing a firm’s internal QC function might best be similar
to those of audit committees – with independent members and at least one representative who represents a wider
scope of stakeholders, for example, someone who is not a CPA or an auditor.”).
52 See Letter from PwC, supra note 42 (“Requirements for firms to have mechanisms for independent
oversight over their QC system could make it challenging, especially for smaller firms, to attract suitable candidates
– whether due to an inability to remunerate them competitively with other firms or difficulty finding individuals
willing to be subject to relevant aspects of a firm’s independence requirements.”). See also Letter from KPMG,
supra note 42 (“While there is value to including an element of independent oversight to support the QC system, we
also acknowledge that it is challenging to identify qualified, diverse and independent individuals that can fulfill this
role. These challenges may impact the scalability of a future PCAOB QC standard to all firms; and, therefore, we do
not recommend that a future Quality Control standard require a mechanism for independent oversight.”).
14
be mandated except perhaps for the largest firms.”53 Some commenters favored increased
disclosure about “the composition and activities of the firm’s governance structure… ”54 All of
these concerns are important and deserve serious consideration.
In addition to concerns over scalability and flexibility, at least two other reasons have
been suggested for omitting independent oversight from any future QC standard. Let me briefly
discuss these reasons and what I understand so far.
First, the inclusion of an independent oversight requirement in a future PCAOB standard
may result in differences in approach between the IAASB and the PCAOB, and therefore, should
not be implemented.
The PCAOB’s Concept Release described the IAASB’s approach as a possible “starting
point”55 but indicated a goal of minimizing the differences between the two approaches.56 The
IAASB is considering adopting standards this week that may not include any requirements for
independent oversight.
The goal of minimalizing differences as a justification for leaving out independent
oversight has a number of flaws. The reasoning does not adequately take into account the
differences between the PCAOB and the IAASB in connection with standard setting. While the
IAASB’s proposed standard does provide useful input for the Board’s consideration, differences
in the two organizations may make one universal standard on quality control difficult to achieve
and not necessarily desirable.
For one thing, the IAASB’s standards are intended to be implemented across the globe
and, therefore they must, by their nature, be general enough to suit a wide array of stakeholders,
including the varied legal and cultural needs in other countries. Many jurisdictions that
implement IAASB standards can, and sometimes do, add additional requirements in order to
reflect specific local needs.57 The PCAOB, in contrast, is in a position to include those “local
needs” suggested by investors in the comment process directly in any revised QC standard.
53 See Letter from NYSSCPA, supra note 45.
54 See Letter from FEI, supra note 42 (“It is likely too soon, however, to know which type of independent
oversight mechanism, if any, is most effective in promoting quality audits. Thus, at this time, we would not support
either a required certain composition of a firm oversight body, or requirements for the duties of those providing
oversight. On the other hand, we would support disclosure of the composition and activities of the firm's governance
structure, such as in the audit quality reports the largest firms now issue annually, in order to allow the market to
drive best practice in this area.”). See also Letter from IMA, supra note 31 (“We would support disclosure of the
composition and the general responsibilities of such independent audit oversight activities in the quality control
reports mentioned in Question 39 below.”).
55 See supra note 15.
56 See Concept Release, supra note 7 (“Due to the foundational nature of QC systems, we believe that it
would not be practical to require firms to comply with fundamentally different QC standards.”).
57 Japan has adopted requirements designed to “clarify audit procedures to address the risks of material
misstatements due to fraud. . . .” See Opinion on the Standard Setting to Address Risks of Fraud in an Audit,
15
Further, the mission of the PCAOB specifically emphasizes the interests of investors,
something that reflects both the particular concerns present with respect to the U.S. capital
markets and the deficiencies that arose during the period when the auditing profession engaged
in self-regulation.58 The PCAOB’s standard-setting activities therefore must give significant
weight to this mission in connection with its oversight of auditors for both issuers and brokerdealers, as well as any other current and emerging issues applicable to the U.S. capital markets.59
In fulfilling this mission, the PCAOB has, at least historically, considered the
perspectives of an advisory group that consisted entirely of investors and their representatives.60
One out of every five comment letters received on the PCAOB’s Concept Release came from the
investor community.
The views of these commenters on the relationship between the IAASB proposal and the
PCAOB’s approach to a future QC standard are instructive. They did not see the IAASB
proposal as a limit. One letter characterized the use of the IAASB’s approach as a “starting
point” as premature.61 Others supported coordination, but did not view it as restricting potential
incremental additions, such as independent oversight. All of this suggests that the goal of
international alignment should not be elevated above the specific concerns and interests of
investors and the public.
Business Accounting Council (Mar. 26, 2013) (available at https://www.fsa.go.jp/en/news/2013/20130411-
1/01.pdf).
58 Our mission specifically references investors. See Section 101 of the Sarbanes-Oxley Act (15 USC § 7211)
(“There is established the Public Company Accounting Oversight Board, to oversee the audit of public companies
that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the
public interest in the preparation of informative, accurate, and independent audit reports for companies the securities
of which are sold to, and held by and for, public investors.”). The IAASB mission references the public which
includes but does not specifically emphasize investors. See IAASB, About IAASB (available at
https://www.iaasb.org/about-iaasb) (“The International Auditing and Assurance Standards Board (IAASB) is an
independent standard-setting body that serves the public interest by setting high-quality international standards for
auditing, quality control, review, other assurance, and related services, and by facilitating the convergence of
international and national standards.”).
59 While this is good policy, it is also legally required. The PCAOB standards cannot take effect unless and
until approved by the SEC pursuant to Rule 19b-4 under the Securities Exchange Act of 1934. 17 CFR § 240.19b-4.
The failure to adequately consider a statutorily mandated requirement would be a basis for non-approval or a
possible legal challenge to the final standard.
60 See PCAOB, Investor Advisory Group Members (available at
https://pcaobus.org/About/Advisory/Pages/Investor_Advisory_Group_Members.aspx). The IAG has not held a
public meeting since November 2018. See PCAOB, Investor Advisory Group Meeting (available at
https://pcaobus.org/News/Events/Pages/PCAOB-IAG-Meeting.aspx). Both organizations have advisory groups that
include representatives of multiple stakeholders. The membership varies, significantly, particularly with respect to
the number of investors and investor groups. Compare PCAOB, Standing Advisory Group Members (available at
https://pcaobus.org/Standards/SAG/Pages/Current.aspx) with IAASB, Consultative Advisory Group, (available at
https://www.iaasb.org/consultative-advisory-group).
61 See Letter from Consumer Federation, supra note 20 (describing use of IAASB proposal as “starting point”
as “premature at best”).
16
And let’s be clear. Not all “differences” in standards are the same. Given the global
nature of the audit profession, inconsistencies may sometimes present unique challenges with
respect to implementation. Adding additional, more detailed requirements, however, do not raise
the same concerns. Independent oversight and other matters sought by investors commenting on
our Concept Release do not appear to result in inconsistencies with, but for the most part are
additions to, the QC approach of the IAASB.62
Second, some say that independent oversight as an element of the standard may be
unnecessary because of the role of the PCAOB.63 This is a complement when you think about it.
Some may be suggesting that a regulatory body can effectively replace an internal system of
independent oversight. Complement though it is, I am concerned that this view misconceives the
function of the PCAOB.
PCAOB inspections of audit firms can include a review of the system of quality control
for conformity with established standards.64 Accordingly, these inspections do sometimes
identify instances where the system does not meet these standards. The PCAOB cannot do this if
a requirement is not in our standards, nor will we be able to enforce what that is not there.
Without a requirement for independent oversight in an audit firm’s system of quality
control, the PCAOB has limited ability to ensure that commercial interests are not unduly
62 The IAASB approach also permits differences in approach. The IAASB QC proposed standard does not,
for example, require all firms to issue transparency reports. In response to legal and regulatory requirements in
certain jurisdictions, many audit firms are required to issue transparency reports generally containing information on
audit firm’s governance, including the firm’s internal quality control system, independence practices, compensation
and remuneration, among other things. Some firms have also chosen to issue transparency reports voluntarily, when
not mandated by regulations. See European statutory audit regulations (Article 13 of Regulation (EU) 537/2014),
Australian law (Sections 332 to 332G of the Corporations Act 2001 and Regulation 2M.4A and Part 3 of Schedule
7A in the Corporations Regulations 2001), Korean law (Regulation on External Audit and Accounting, Article
22(2)). The IAASB observed that there are still many jurisdictions where transparency reporting is not required or
common practice, largely because there is a lack of demand from stakeholders in those regions for such information.
While “certain respondents, mostly investors, did call for the IAASB to more specifically address transparency
reports in the IAASB’s standards…,” the IAASB is considering adopting a standard that does not require a firm
transparency report. See supra note 6.
63 See Letter from Deloitte & Touche LLP to PCAOB, PCAOB Concept Release on Potential Approach to
Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046)
(Mar. 16, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/031_DT.pdf ) (“Though not an aspect
within a firm’s system of quality control, mechanisms for independent oversight over firms’ systems of quality
control exist today via the PCAOB’s inspection program (which includes a review of the firm’s quality control
system) as well as inspections or similar programs in other jurisdictions or by other regulators or standard setters
(e.g., the AICPA’s peer review program).”).
64 PCAOB Inspection Procedures: What Does the PCAOB Inspect and How Are Inspections Conducted?
(available at
https://pcaobus.org/Inspections/Pages/PCAOB-inspection-procedures-what-does-PCAOB-inspect-how-inspectionsconducted.aspx) (“A PCAOB inspection is designed to assess the firm’s compliance with PCAOB standards and
rules, and other applicable regulatory and professional requirements in the firm’s system of quality control and in
the portions of audits selected for inspection. Inspections do not involve a review of all aspects of a firm’s quality
control system.”).
17
influencing or negatively impacting audit quality.65 Granted, the problem may become so severe
that it can be identified through deficient engagements. But this will be rare. And the view
fundamentally conflicts with the goal that the system of quality control should be designed to
ensure that the problems or concerns do not occur in the first instance.
On the other hand, should a requirement of independent oversight be added to any
resulting standard, the PCAOB can play an active role in ensuring adequate implementation and
enforcement. PCAOB inspections can make sure the element is present and appropriately
integrated into the firms’ system of quality control. The PCAOB can also facilitate public
accountability through disclosure. As I have said in the past, I believe that we have the authority
to include in the public portion of the inspection report a description of a firm’s QC system,
something that would presumably include the implementation of independent oversight.66
These issues clearly need to be considered, debated and addressed in determining
whether independent oversight should or should not be included in a future QC standard. Some
of these concerns were at most touched upon lightly in the comment process and would benefit
from additional insight. Moreover, there may be ways to address commercial influences. We
would benefit from further insight on this topic. I look forward to hearing those views.
III. Conclusion
So where does this leave us?
Quality control is essential for trust.67 Like consumers of food, medicine, and
transportation, those relying on audits expect regulators to require, and audit firms to implement,
a rigorous system of quality control. On that, there is, I think, agreement.
The importance of independent oversight is really one piece of that broader debate.
There may be multiple ways to construct a QC system that adequately promotes audit
quality without independent oversight. Investors have, however, advanced the view that
65 Of course, to the extent there are ways to protect audit quality from commercial interests other than
independent oversight and they are included in any revised standard, they will be subject to inspection and
enforcement.
66 J. Robert Brown, Jr., Seeing Through the Regulatory Looking Glass: PCAOB Inspection Reports, CFA
Institute’s Corporate Disclosure Policy Council and Capital Markets Policy Council, July 23, 2020 (available at
https://pcaobus.org/News/Speech/Pages/Brown-Seeing-Through-Regulatory-Looking-Glass-PCAOB-InspectionReports.aspx).
67 Competition & Markets Authority, Statutory audit and services market study (Apr. 18, 2019) (available at
https://assets.publishing.service.gov.uk/media/5d03667d40f0b609ad3158c3/audit_final_report_02.pdf) (“Lack of
trust in the provision of audits will undermine credibility and confidence in the quality of audits and the accuracy of
financial statements published by large companies. These will prevent investors, customers and suppliers from being
able to identify the companies that have more effective and those that have less effective audits (other than in the
extreme case of corporate failure).”).
18
independent oversight can improve quality,68 result in greater accountability69 and increase the
confidence placed by investors and the public in the quality of audits.70 These are important
points that warrant serious consideration.
Nonetheless, the debate is far from resolved. I very much look forward to hearing and
carefully considering any additional thoughts on this issue. I am particularly interested in views
that either support or challenge the positions taken by parties submitting comments on the
Concept Release. All of this will help develop a more fulsome record that will be useful in
determining whether independent oversight should or should not be a requirement in any
standard addressing QC systems.
I encourage everyone here to participate in the debate. Give us your thoughts on
independent oversight and anything else you think may help improve our standards on quality
control. Your participation is important. The letters we received on the Concept Release were
extremely helpful. While sometimes the interests of investors and the public can be discerned,
nothing is better than hearing from you directly.
Write to us, email us, or meet with us. I’m happy to arrange a conversation, whether with
me, our staff or other Board members.71
Should the PCAOB issue a proposed standard in the area, be prepared to give us your
feedback. I expect the issue will generate a spirited debate during any notice and comment
period over whether an independent oversight requirement should be included in the standard
and, if so, how it should be implemented.
If past history is any indication, the differences in commenter views will be significant.
The auditing profession has traditionally favored a principles-based approach that uses general
language applicable to all firms, irrespective of their differences in size, resources and number of
clients. Investors tend to favor an approach that involves a mix of principles and specific
requirements.72
68 See supra note 34. See also Securities Research: Additional Actions Could Improve Regulatory Oversight
of Analyst Conflicts of Interest, GAO-12-209 (Jan. 2012) (available at thttps://www.gao.gov/assets/590/587613.pdf
) (“Two studies found that the relationship between analyst recommendations and valuation estimates strengthened
after the regulatory reforms, indicating that the reforms improved analyst independence.”).
69 See supra note 35.
70 Letter from CalPERS, supra note 33 (“having independence within the governance structure strengthens
investor trust in the system.”)
71 My email address is brownj@pcaobus.org.
72 See Modernization of Regulation S-K, Items 101, 103, and 105, Exchange Act Release No. 86614 n. 17
(Aug. 8, 2019) (supporting disclosure standards that were “some combination of both principles-based and
prescriptive rules.”). Standards that are too general can raise accountability concerns. See supra note 13 (testimony
of Lynn Turner, Chief Accountant, SEC) (stating that standards were “so general that, as a practical matter, it is
difficult to hold anyone accountable for not following them.”).
19
And remember, your views are essential to the PCAOB. Our mission is to act in the
interests of investors and the public. To do this, we need you to tell us what those interests are.
Independent Oversight in the System of Quality Control
J. Robert Brown, Jr.1
“You can’t really know where you are going until you know where you have been.”2
Thank you, John [Parsons], for the kind introduction.
It is a pleasure to have an opportunity to speak to a group of professionals dedicated to
protecting the well-being of our teachers, firefighters, policemen, and other local and state
workers. It’s also a pleasure to be in Massachusetts, albeit virtually. The Commonwealth of
Massachusetts is one of significant achievement, including the first subway in the U.S., the first
college in North America, and, perhaps most important for me, the fig newton cookie. I look
forward to a time when I can be back in Massachusetts in person.
Before I go on, I want to note that the views I share today are my own and do not
necessarily reflect the views of the Public Company Accounting Oversight Board (“PCAOB”),
my fellow Board members, or the staff of the PCAOB.
I want to talk today about the vital importance of quality control.
We rely on quality control in all aspects of our daily lives. We get on a plane with little or
no apprehension because of the quality control system operating behind the scenes that helps
ensure safety. Dynamic and robust systems protect the quality of our cars, our food, our
clothing. When the COVID-19 vaccine arrives, and I hope it’s soon, quality control will
hopefully make certain that each dose is safe and effective.
Properly done, quality control allows us to simply trust that the expected results will
occur. Our markets, economy, and society rely on trust to function efficiently and effectively.
The same principles apply to financial reporting. Trust in the accuracy of financial
statements is essential to investors of public companies. Some of that trust is due to the annual
audit by independent accounting firms.3
1 Board Member, Public Company Accounting Oversight Board, see PCAOB, J. Robert Brown, Jr.
(available at https://pcaobus.org/About/Board/Pages/J-Robert-Brown.aspx). This statement is based upon remarks
made at the Massachusetts Public Employee Retirement Administration Commission’s Emerging Issues Webinar
(Sept. 17, 2020). I want to thank Clara Fryer, an intern in my office during the fall of 2020, for her valuable work in
this statement.
2 Maya Angelou, Academy of Achievement Interview, High Point, NC (Jan. 22, 1997).
3 James R. Doty, Chairman, PCAOB, The PCAOB’s Initiatives to Bolster Investor Trust in the Audit,
AICPA Conference on SEC and PCAOB Developments, Washington, DC (Dec. 4, 2017) (available at
https://pcaobus.org/News/Speech/Pages/initiatives-bolster-investor-trust-in-audit-12-4-17.aspx) (“At the end of the
day, the purpose of the audit and the audit report has always been to communicate a basis for trust to investors.”).
2
Trust in audits, like medicine, food or transportation, depends upon a robust system of
quality control. The requirements for the audit firms’ system of quality control are set out in
PCAOB’s standards.4
These standards, however, are out-of-date. They were written decades
ago, with little, if any, input from investors. They do not reflect changes in the business and audit
environment or the financial failures and crises that have occurred since the PCAOB opened its
doors in 2003.
Our current standards were, in other words, written in, and for, another time.5
Efforts to revise these quality control (“QC”) standards are underway. The International
Auditing and Assurance Standards Board (“IAASB”) is meeting this week to consider adopting
changes to its QC standards;6
while the PCAOB has sought comments in a Concept Release
about possible revisions to its QC standards, including whether any future U.S. effort should be
based on the IAASB’s standards.7
We have learned from comments by investors and others that aspects of the QC approach
proposed by the IAASB raise concerns. In particular, investors indicated that such an approach
may not adequately address the importance of independent oversight for audit quality and I want
to talk about this issue.
Independent oversight takes into account the possible conflict between the commercial
interests of an audit firm and audit quality. This is only one aspect of any system of quality
control, nonetheless an important one.
Investors through the comment process provided strong views on this issue and, as a
result, they deserve careful consideration. The failure to do so would risk repeating history.
During the period of self-regulation by the audit profession, investor input was largely absent
4 In April 2003, the Board adopted certain preexisting standards as its “interim” standards. See PCAOB,
Release No. 2003-006: Establishment of Interim Professional Auditing Standards (Apr. 18, 2003) (available at
https://pcaobus.org/Rulemaking/Interim_Standards/Release2003-006.pdf). See also Order Regarding Section
103(a)(3)(B) of the Sarbanes-Oxley Act of 2002, Securities Exchange Act Release No. 47745 (Apr. 25, 2003)
(available at https://pcaobus.org/Rulemaking/Pages/InterimStandards.aspx). The elements of quality control are
identified in QC Section 20 - System of Quality Control for a CPA Firm's Accounting and Auditing Practice. See
QC Section 20, System of Quality Control for a CPA Firm’s Accounting and Auditing Practice (available at
https://pcaobus.org/Standards/QC/Pages/QC20.aspx).
5 See Megan Zietsman, Chief Auditor, PCAOB, Annual Auditing Conference at Baruch (Feb. 26, 2020)
(available at https://www.cpajournal.com/2020/02/26/regulators-and-standards-setters-2/ ) (“Clearly, the PCAOB
standards are old. They haven’t been substantially overhauled since they were adopted as interim standards back
when the PCAOB was established. For example, they don’t even take into account how technology is transforming
not only how audits are being done, but how firms are using technology as part of quality control and broadly as part
of running their businesses.”).
6 See IAASB Board Meeting, Virtual by Videoconference (Sept. 14-23, 2020) (available at
https://www.iaasb.org/meetings/iaasb-board-meeting-virtual-videoconferencing-1).
7 PCAOB, Release No. 2019-003: Potential Approach to Revisions to PCAOB Quality Control Standards
(Dec. 17, 2019) (available at https://pcaobus.org/Rulemaking/Pages/docket-046-quality-control.aspx).
3
from the standard-writing process. This failure resulted in a lack of investor trust, causing harm
to the capital markets, to investors and to companies. Congress altered that dynamic with the
creation of the PCAOB. The PCAOB was given an explicit mission of acting in the interests of
investors and the public.8
As we consider what to do with respect to QC standards, we are in mid-flight in the
process. The debate is ongoing. Whether we issue any proposal to revise our QC standards
remains to be seen. To the extent that we do, the need for, and the role of, independent oversight
over a firm’s QC system is something that will be determined only after a fulsome debate that is
only just beginning. As we continue to consider the matter, I am interested in hearing comments
and views from all stakeholders on the issue and encourage everyone here to participate in the
discussion.
So today, I’d like to talk about quality control and what we have learned so far from
investors and others, particularly about their views on the importance of independent oversight in
a QC standard.
First, I’d like to discuss the importance of revising the standards governing an audit
firm’s system of quality control.
Second, I’d like to discuss the comment letters we received on our Concept Release,
particularly the views on independent oversight.
Finally, I’d like to talk about possible future steps by the PCAOB and the role everyone
listening to this talk can play.
I. The Outdated Standards Governing Quality Control
The largest firms audit hundreds of public companies each year.9
Investors, and the
public, benefit from these audits.10 To make sure that audits deliver the expected quality, firms
8 See 15 U.S.C. § 7211(a) (mission of PCAOB “to protect the interests of investors and further the public
interest in the preparation of informative, accurate, and independent audit reports”). See also Bill Gradison & Ron
Boster, The PCAOB’s First Seven Years: A Retrospection, 4 CURRENT ISSUES IN AUDITING A9, A12 (2010)
(describing the mission as “precise and unambiguous” and noting that “the Board’s statutory mandate is to protect
investors, not issuers or their management, nor their external auditors.”).
9 PCAOB, PCAOB Issues Six Largest U.S. Firm Inspection Reports in New User-Friendly Format, Guide to
Reading Reports, (June 1, 2020) (available at https://pcaobus.org/News/Releases/Pages/PCAOB-issues-six-largestUS-firm-inspection-reports-new-user-friendly-format-guide-to-reading-reports.aspx).
10 PCAOB Release No. 2017-001: The Auditor’s Report on an Audit of Financial Statements when the
Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards (June 1, 2017) (available
at https://pcaobus.org/Rulemaking/Docket034/2017-001-auditors-report-final-rule.pdf ) (“Investors are the
beneficiaries of the audit and the auditor’s report is the primary means by which the auditor communicates with
them.”).
4
are required to have in place a system of controls that seek to ensure the engagements are
properly conducted.11
The standards governing quality control are in serious need of revision. They were
written in the era of self-regulation when the audit profession held the drafting pen12 and
investors and the public had little input into the process.13 The PCAOB, when it opened its doors
in 2003, adopted these same standards on an “interim” basis.14 While some auditing standards
have since been amended or updated, those governing the system of quality control largely have
not.
The IAASB and the PCAOB are, fortunately, taking steps to consider whether and how to
revise their respective quality control standards. The IAASB’s approach includes as a goal the
continuous improvement in audits through the implementation of a feedback loop.15 Under this
11 AS 1110: Relationship of Auditing Standards to Quality Control Standards (available at
https://pcaobus.org/Standards/Auditing/Pages/AS1110.aspx) (“A firm of independent auditors has a responsibility to
adopt a system of quality control in conducting an audit practice.”).
12 As late as 2002, the Auditing Standards Board, which drafted the standards, consisted entirely of practicing
auditors, excepting only an academic and state regulatory. See Public Oversight Board, Final Annual Report 2001,
at 32 (available at http://3197d6d14b5f19f2f440-
5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/2000/2002_0501_POBAnnualReport.
pdf) (“Members for the ASB’s 2001-2002 year include one representative from each of the eight largest accounting
firms, five from local or regional firms, one from academia, and one from government.”). See also United States
General Accounting Office, GAO/AIMD-96-98, The Accounting Profession, Major Issues: Progress and Concerns
(September 1996) (available at https://www.govinfo.gov/content/pkg/GAOREPORTS-AIMD-96-
98/pdf/GAOREPORTS-AIMD-96-98.pdf) (“In practice, audit standard setting has been primarily the domain of the
accounting profession. In that respect, auditing standards have been influenced by auditors’ liability concerns.”).
13 Accounting Reform and Investor Protection, Hearings Before the S. Comm. on Banking, Hous., and Urban
Aff., 107th Cong. (Feb. 26, 2002) (Statement of Shaun F. O’Malley, Chairman, 2000 Public Oversight Board Panel
on Audit Effectiveness, Former Chairman, Price Waterhouse, Past President, Financial Accounting Foundation,
Accounting Reform and Investor Protection) (“The panel found that the current system of governance lacks
sufficient public representation”). See also Id. (testimony of Lynn Turner, Chief Accountant, SEC) (during era of
self-regulation, standards “written to protect the accounting firms in case they get in trouble on an audit;”), quoting
Testimony of John C. (Sandy) Burton, Chief Accountant, SEC (1978) (“As long as you leave that standard setting
process in the hands of the firms and the firm's legal counsel, you are going to get standards written to protect them
in court, as opposed to standards written to ensure that they do audits that will protect the public.”).
14 See PCAOB, Release No. 2003-006: Establishment of Interim Professional Auditing Standards (Apr. 18,
2003) (available at https://pcaobus.org/Rulemaking/Interim_Standards/Release2003-006.pdf). See also Order
Regarding Section 103(a)(3)(B) of the Sarbanes-Oxley Act of 2002, Securities Exchange Act Release No. 47745
(Apr. 25, 2003) (available at https://pcaobus.org/Rulemaking/Pages/InterimStandards.aspx). This was of course a
necessary expediency. The PCAOB adopted the standards only on an interim basis. The expectation was that they
would eventually be replaced by provisions that better reflected the interests of investors and the public.
15 This is no accident. The Concept Release specifically quoted extensively from the IAASB proposal and
referenced it as a possible “starting point” for revisions of PCAOB standard. See Concept Release, supra note 7
(“We are considering whether and how PCAOB QC standards should be revised to address developments in audit
practices and provide more definitive direction regarding firms’ QC systems. We are considering an approach based
on Proposed ISQM 1 as the starting point for potential revisions to PCAOB QC standards.”).
5
approach, firms would be required to put in place a system to identify risks that could
compromise audit quality.
Once identified, the QC system would need to be adjusted to prevent the risk from
recurring or, better still, from occurring in the first place. By repeating the process, a QC system
would constantly evolve and the quality of audits would continually improve.16 The PCAOB’s
Concept Release asks whether the PCAOB should use a similar approach with respect to any
future PCAOB QC standard.
Whatever the promise of this approach, investors through the comment process raised a
number of significant concerns.17 Investors indicated that the approaches under consideration
would be improved by greater accountability, including increased transparency18 and metrics
16 This is in fact an old idea. See The Commission on Auditors’ Responsibilities: Report, Conclusions, and
Recommendations, at 128 (1978) (available at http://3197d6d14b5f19f2f440-
5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1970/1978_0101_CohenAuditors.pdf)
(“This suggests the profession must continuously monitor performance, deal quickly with substandard performance,
and attempt to anticipate future problems.”).
17 PCAOB, Comment Letters for Docket 046 (available at
https://pcaobus.org/Rulemaking/Pages/Docket046Comments.aspx).
18 Letter from CFA Institute to PCAOB, PCAOB Rulemaking Docket No. 046: Concept Release, Potential
Approach to Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket
No. 046)-- (May 11, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/036_CFA.pdf) (“The details of
the quality control system of each audit firm should be fully communicated to the users of financial statements
including investors – as the standard being proposed is meant to accommodate public company audits, companies
that are public because of their listing, in the United States. Firms should be required to provide disclosures of audit
quality and quality control, including audit quality indicators (AQIs) and how the firm responds to identified
deficiencies. ”); Letter from AFL-CIO to PCAOB, PCAOB Release No. 2019-003, Potential Approach to Revisions
to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16,
2020) (available at https://pcaobus.org/Rulemaking/Docket046/024_AFL-CIO.pdf) (“As we commented in our
September 29, 2015 letter to the PCAOB, we also support the disclosure of quantitative data on audit quality
indicators as a matter of transparency to investors.”); Letter from Colorado Public Employees’ Retirement
Association to PCAOB, Rulemaking Docket No. 046 - Request for Comments on the Potential Approach to
Revisions to PCAOB Quality Control Standards Concept Release (Mar. 18, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/033_CoPERA.pdf) (“Along with publication of AQIs, we also believe
that auditors should provide a detailed account of their audit quality control systems. Updating and strengthening the
quality control standards will help to improve audit quality, but the addition of AQIs and quality control
transparency would be the critical driver of improved investor confidence.”); Letter from CII to PCAOB, PCAOB
Rulemaking Docket No. 046 Concept Release, Potential Approach to Revisions to PCAOB Quality Control
Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 19, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/035_CII.pdf) (“We believe a future PCAOB QC standard should require
public disclosure by firms about their QC systems.”).
6
designed to measure quality,19 an omission of which one commenter labeled “inconceivable.”20
Investors also asked for mandatory outreach by audit firms to investors as part of the feedback
loop,21 heightened accountability through a certification requirement,22 and a broader objective
against which to measure the success or failure of the system.23
19 See Letter from CFA Institute, supra note 18 (“However, for a market to be perfectively competitive not
only does an efficient market need numerous buyers and sellers but they also need them to be well informed. In the
current audit market, buyers of audit services – ultimately investors – do not have the information necessary to judge
audit quality.”); see also Letter from AFL-CIO, supra note 18 (“we urge the PCAOB to require the use of audit
quality indicators as part of audit firm quality control standards. Measuring audit quality indicators will promote
enhanced audit quality.”); Letter from Colorado PERA, supra note 18 (“The PCAOB can further the connection
between these two critical groups through the adoption of Audit Quality Indicators (AQIs) as part of the quality
control standards. The adoption of Audit Quality Indicators has been discussed at the PCAOB for years, and we
believe the review of the quality control standards is an excellent opportunity to finalize the process of developing
AQIs.”); Letter from CII, supra note 18 (“We believe firms should be required to establish quantifiable performance
measures for the achievement of quality objectives.”).
20 Letter from Consumer Federation of America to PCAOB, PCAOB Release No. 2019-003, Concept
Release, Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003;
Rulemaking Docket No. 046) (Mar. 16, 2020) (“Consumer Federation”) (available at
https://pcaobus.org/Rulemaking/Docket046/014_CFA.pdf) (“It is frankly inconceivable to us that the Board would
update its quality control standards without including a requirement on AQIs.”).
21 Letter from ICGN to PCAOB, ICGN Response to the PCAOB Concept Release for Potential Approach to
Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046)
(Mar. 16, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/016_ICGN.pdf) (“We note that there is an
ongoing gap in consideration of the investor in these processes. We believe that QC standards should include
express efforts to engage with investors and reflect those investor needs. This would be welcome at a firm level as
well as at individual engagement levels, where investors offer a valuable sounding board for potential concerns
around accounting quality that could help direct auditors’ work.”); Letter from Colorado PERA, supra note 18 (“We
view the reassessment of quality control standards as another opportunity to further improve the connection and
communication between investors and auditors.”).
22 Letter from Colorado PERA, supra note 18 (“Based on our discussions with management teams during the
implementation of Sarbanes-Oxley, having to sign off on their company’s financial statements was an important
driver in improving financial reporting quality. We believe having senior management at the audit firms sign off on
their quality control systems will create the same level of personal accountability.”). Certification or attestation can
improve the quality of the decision making process. See, e.g., Nationally Recognized Statistical Rating
Organizations, Securities Exchange Act Release No. 72936 (Aug. 27, 2014) (“the Commission believes that having
an individual attest to the information disclosed in the form will promote analytical independence. In particular, the
individual executing the attestation will want to ensure that it contains no untrue or inaccurate statements.
Consequently, the individual will have an incentive to take steps to verify that the credit rating was not influenced
by any other business activities, was based solely on the merits of the instruments being rated, and was
an independent evaluation of the risks and merits of the instrument.”).
23 Investors and academic commenters noted that the objective of an audit firm’s system of quality control
should explicitly refer to the protection of investors and customers of broker dealers. See, e.g., Letter from Douglas
R. Carmichael, Ph.D., CPA and Thomas J. Ray, CPA Eli and Claire Mason Professor Distinguished Lecturer Baruch
College, CUNY Baruch College, CUNY, to PCAOB (Mar. 13, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/008_Carmichael-Ray.pdf) (“We recommend that the goals of a system
of quality control include explicitly the goal of performing audits in a manner that protects the interests of investors,
and customers of broker dealers, as applicable, and furthers the public interest in the preparation of audit reports that
are informative, accurate, and independent.”).
7
II. The PCAOB Concept Release
These are all issues that should be given serious consideration. In my remarks today,
though, I want to focus on another concern raised by investors, the importance of independent
oversight for any system of quality control. Investors expressed strong support for the inclusion
of independent oversight in any potential revision of our QC standards.
The issue of independent oversight arises, as the letters indicated, from the potential
conflict between the commercial nature of firms and audit quality.24 Partners at firms are
compensated based on the profits generated by the firms.25 Audit quality, in turn, is a cost that
can conflict with commercial interests, at least in the short term.26 A potential risk exists,
therefore, that commercial interests may sometimes improperly override audit quality.
How might this occur? Given the competing nature of these interests, investors identified
some possibilities. Firms might under-invest in audit quality, leaving the area without adequate
resources. Firms may be less willing to dismiss a lucrative client notwithstanding concerns over
quality. Those responsible for audit quality may be less willing to make difficult or unpopular
decisions out of concerns over the impact on their professional standing within the firm.
Independent oversight is used throughout the capital markets to address similar conflicts
of interest. Listed companies address the potential conflict between the interests of management
and shareholders through the use of independent directors.27 The major stock exchanges in the
24 See The Dutch Authority for the Financial Market, Vulnerabilities in the Structure of the Audit Sector
(Nov. 2018) (“Vulnerabilities in The Structure of The Audit Sector”) (available at
https://www.afm.nl/~/profmedia/files/doelgroepen/accountantsorganisaties/2018/engels-rapport-kwaliteitstructuur.pdf?la=en) (“Although both attitudes of course exist, this study revealed that the technical-commercial
attitude had the upper hand among auditors at the organisations reviewed. One important reason for this is that
people with this attitude are more likely to be promoted to partner status. The study concludes that this culture, in
which employees with a commercial attitude to their work strive to progress to become partners, is contrary to the
‘accounting profession’s public interest mandate’.”).
25 Jan Bouwens, Olaf Bik, & Yuxia Zou, Determinants of Audit Partner Compensation, (Aug. 2019)
(available at https://pcaobus.org/EconomicAndRiskAnalysis/Conference/Documents/Submission%2023%20-
%20Determinants%20of%20Audit%20Partner%20Compensation%20v20190909.pdf) (“Partnerships use profitsharing systems to incentivize individual partners as each time when firm profit increases, so will each partner’s
profit share).
26 See Vulnerabilities in The Structure of The Audit Sector, supra note 24 (“Such investment will take a long
time to be repaid, and the return is by no means certain in advance. In other words, it takes a relatively long time
before investment in matters such as quality control and compliance systems, innovation and training in ethics,
business conduct and professional behaviour will result in higher earnings. The propensity to make such investments
on the basis of the principle of an economic return may thus be lower than desirable from the point of view of the
public interest. This effect possibly intensifies as the partners approach retirement, since they will not see a return at
all.”).
27 See NYSE: Corporate Governance Guide (Dec. 2014) (available at
https://www.nyse.com/publicdocs/nyse/listing/NYSE_Corporate_Governance_Guide.pdf).
8
U.S. use independent oversight to safeguard regulatory responsibilities from undue influence
from commercial interests.28 Independent oversight, as part of the investment company
regulatory framework, has been characterized as “fundamental.”29 Accordingly, mechanisms of
independent oversight are well-known by investors.
We specifically asked about the issue in the Concept Release. We sought comments on
whether any future PCAOB standard should “incorporate mechanisms of independent oversight
over firms’ QC system”.30 The question struck a nerve.
A. Comments We Received
Investors, investor associations, consumer groups, and the U.S. Government
Accountability Office (GAO) all supported requirements of independent oversight as an element
of a audit firm’s system of quality control.31 They agreed that such oversight should be
28 Self-Regulatory Organizations; New York Stock Exchange LLC; Order Approving Proposed Rule Change
Amending the Eighth Amended and Restated Operating Agreement of the Exchange to Establish a Regulatory
Oversight Committee as a Committee of the Board of Directors of the Exchange and Amending Other Rules of the
Exchange, Exchange Act Release No. 75991 (Sept. 28, 2015) (available at
https://www.sec.gov/rules/sro/nyse/2015/34-75991.pdf) (“The Exchange believes that its proposal to establish a
ROC to undertake the independent oversight of the Exchange's regulatory responsibilities would
ensure independent oversight of the regulatory process and would have the additional benefit of aligning the
Exchange's corporate governance practices with its industry peers.”). See also Findings, Opinion, and Order of the
Commission Exchange Act Release No. 53128 (Jan. 13, 2006) (available at
https://www.sec.gov/litigation/opinions/34-53128.pdf) (“In addition, the Nasdaq Exchange has created
an independent regulatory department, Nasdaq Regulation, for the purpose of functionally separating its regulatory
functions from its business lines. Nasdaq Regulation will carry out many of the Nasdaq Exchange's regulatory
functions, including administering its membership and disciplinary rules.”).
29 Treatment of Asset-Backed Issuers Under the Investment Company Act, Investment Company Act Release
No. 29779 (Sept. 7, 2011) (available at https://www.sec.gov/rules/concept/2011/ic-29779.pdf) (“The concept
of independent oversight or independent review is fundamental to the regulatory framework of the Investment
Company Act. Registered investment companies typically rely for their structure and operations on third parties that
have their own financial interests separate and distinct from those of the investment companies and their
shareholders, presenting potential conflicts of interest that require independent oversight. The
independent oversight in the case of registered management investment companies is provided by the company's
board of directors, and in particular the independent board members, as required by the Act.”). There are other
examples that employ structural mechanisms to operationalize independent oversight. Investment banks have in
place quality controls that separate their brokerage business from the analyst function to ensure the integrity and
independence of the research function. Similarly, credit-rating agencies must separate the ratings function from
sales and marketing activities as part of their system of quality control. The structural mechanisms, however, often
accompany robust independent oversight.
30 See Concept Release, supra note 7 (“We are considering whether a future PCAOB QC standard should
address mechanisms for independent oversight over firms’ QC systems (for example, boards with independent
directors or equivalent).”).
31 Of the 25 or so commenters who expressed views on public disclosures as a component of a firm’s system
of quality control, 100% of investors supported public disclosures. No comment letter from a registered accounting
firms supported the requirement. But see Letter from Institute of Management Accountants (IMA) to PCAOB,
PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB
9
required32 and made part of the “structure” of such a system.33 Independent oversight would
“greatly enhance the quality of controls standards”34 and improve accountability.35 In particular,
the Consumer Federation of America told us that independent oversight “has the potential to help
counteract economic incentives to under-invest in audit quality or to view retaining customers,
rather than protecting investors, as the firm’s top focus.”36
The letters included specific suggestions for the largest firms. Investor concerns about a
firm being too commercially driven could be mitigated37 through a system that incorporated
Release No. 2019-003; Rulemaking Docket No. 046) (Feb. 26, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/005_IMA_FRC.pdf) (“The time probably has come for there to be a
requirement for an annual quality control report to be issued by at least the largest accounting firms – perhaps,
initially, for those firms that audit more than 100 registrants. However, this is an area where scalability should be
considered; the public interest in such a report would be much less for smaller firms and need not be required at this
time. We do continue to believe that firms should be given wide discretion in the form and content of such
reports.”).
32 See Letter from CII, supra note 18 (“Given the importance of independent oversight to audit quality, we
believe audit firms should be required to have independent oversight of their systems.” ); see also Letter from CFA
Institute to PCAOB, supra note 18 (“[A]ll the largest audit firms should be required to have independent directors
on their boards.”).
33 Letter from California Public Employees' Retirement System (CalPERS), Concept Release, Potential
Approach to Revisions to PCAOB Quality Control Standard (PCAOB Release No. 2019-003; Rulemaking Docket
No. 046) (Mar. 18, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/034_CalPERS.pdf) (“Having
high level independent oversight in a company’s governance structure provides an objective point to mitigate
concerns with conflicts of interest as well as assessing the effectiveness of the auditor. We support more
independent governance structures and would like it to become a central part of audit firm governance.”).
34 See Letter from Colorado PERA, supra note 18 (“We believe independent oversight would greatly
enhance the quality control standards.”).
35 See Letter from CFA Institute, supra note 18 (“We believe, however, that this goal is most likely to be
achieved if firm leaders are held accountable for results achieved. And this in turn can only be achieved through
independent oversight of the quality control system and where there is transparency of the details of the quality
control system of each audit firm. . .”).
36 See Letter from Consumer Federation, supra note 20 (“Given the incentives firms have to under-invest in
quality control, we believe that goal is most likely to be achieved where there is independent oversight of the quality
control”). See also id. (“Independent oversight also has the potential to help counteract economic incentives to
under-invest in audit quality or to view retaining customers, rather than protecting investors, as the firm’s top
focus.”).
37 See Letter from CalPERS, supra note 33 (“Independent directors can mitigate concerns over a firm being
too commercially driven.”). See also Letter from CFA Institute, supra note 18 (“Given the importance of
independent oversight to audit quality, we believe audit firms should be required to have independent oversight of
their systems of governance and quality control”) and consequently that all of the largest audit firms should be
required to have independent directors on their boards.”); see also Letter from CII, supra note 18 (“We believe that
all of the largest audit firms should be required to have independent directors on their boards. We believe the
benefits of requiring independent directors on firm boards would exceed the costs of imposing such a change at the
largest audit firms. In addition, we believe the duties of those providing independent oversight should include,
among other responsibilities, “resource allocation decisions . . . the annual review of the QC system, the
10
independent oversight, such as a mechanism to report directly to independent directors on the
firm’s board.38 A reporting line directly to these directors could result in a board better informed
about audit quality issues.39
The Council of Institutional Investors (“CII”) endorsed a U.S. Treasury Report
recommendation that audit firms’ boards should have “independent members with full voting
power.” CII further explained that the benefits of independent oversight exceed the “costs of
imposing such a change at the largest audit firms.” 40
At the same time, commenters recognized that independent oversight could be made
scalable. As the letter from the Consumer Federation of America stated:
Much as an independent board committee is required to oversee the public company
audit, an independent board committee of the audit firm should have responsibility for
overseeing the firm’s quality control system. For smaller firms that do not have
independent boards or advisory committees, responsibility for maintaining a robust QC
system should reside with top firm leadership.41
B. Possible Concerns
The views of audit firms and their associations were more mixed. Most commenters from
audit firms or their associations recognized the value and importance of independence.42 Indeed
effectiveness of remediation of QC concerns, and the integration of audit quality into the system of incentives and
rewards for firm personnel.”).
38 See Letter from AFL-CIO, supra note 18 (“Accordingly, we support improving the oversight of quality
control systems through the appointment of independent directors to audit firm boards for this purpose.”).
39 John Armour, Jeffrey Gordon & Geeyoung Min, Taking Compliance Seriously, 37 YALE J. ON REG. 1
(Winter 2020) (“A direct channel of reporting from compliance personnel to the board is thought to be a means of
fostering not only autonomy within the compliance program but also open upward transmission of information.”).
40 See Letter from CII, supra note 18 (“We believe that all of the largest audit firms should be required to
have independent directors on their boards. We believe the benefits of requiring independent directors on firm
boards would exceed the costs of imposing such a change at the largest audit firms. In addition, we believe the
duties of those providing independent oversight should include, among other responsibilities, “resource allocation
decisions . . . the annual review of the QC system, the effectiveness of remediation of QC concerns, and the
integration of audit quality into the system of incentives and rewards for firm personnel.”)
41 Letter from Consumer Federation, supra note 20.
42 A number of letters, including many from audit firms, recognized the value of independence. See Letter
from KPMG to PCAOB, PCAOB Rulemaking Docket No. 46: Concept Release: Potential Approach to Revisions to
PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/020_KPMG.pdf) (“Independent oversight of the firm’s QC
system can provide benefits to the system of quality control. In our experience, independent directors provide
valuable insight and support the achievement of the firm’s quality objectives.”); See Letter from PwC to PCAOB,
PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB
Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/030_PwC.pdf) (“Perspectives from independent third parties can add an
11
many firms have incorporated some form of independence and external participation into their
governance structures through in a variety of ways. No firm commenter, with one possible
exception,43 however, supported making this a requirement for a firm’s system of quality control
in a future PCAOB standard.
important dimension of input to a firm’s internal assessments and can benefit audit quality by enhancing a firm’s
governance and decision-making processes. This approach is consistent with widely-accepted governance best
practices.”); Letter from EY to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB
Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/021_EY.pdf ) (“Independent perspective can enhance
stakeholder confidence in audit firms by providing valuable insights about matters that can affect a firm’s audit
quality, such as its business, operations, culture, talent, strategy, governance and risk management.”); Letter from
Grant Thornton to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality
Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020) (available at
https://www.grantthornton.com/-/media/content-page-files/audit/pdfs/comment-letters-2020/comment-PCAOBquality-control-revisions-1.ashx) (“We are supportive of the notion that independent directors or advisory
committees can provide helpful business insights to audit firms.”); see also Letter from Committee on Corporate
Reporting, Financial Executives International, to PCAOB, PCAOB Concept Release on Potential Approach to
Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046)
(Mar. 16, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/019_FEI_CCR.pdf) (“We acknowledge
the role that audit firm governance plays in contributing to audit quality and that this is an area where the profession
continues to evolve.). One firm did suggest that an independence requirement could harm audit quality. See Letter
from MAZARS to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB Quality
Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020) (available at
https://pcaobus.org/Rulemaking/Docket046/029_MAZARS_US.pdf) (“No, we do not believe the revised PCAOB
QC standard should include the incorporation of independent oversight over firms’ QC systems. The prescribing of
such mechanisms may not be adaptable to all firms of varying sizes; limiting scalability. In addition, mandating
independent oversight may result in unintentional consequences that would compromise audit quality, as firms may
be forced to expend financial resources that would be more effectively used on audit quality initiatives.”).
43 See Letter from Grant Thornton, supra note 42 (“Regardless of the path the Board chooses, we do not
believe specific criteria should be used to determine which firms would be required to have independent oversight.
If the Board believes that audit quality will be enhanced by such oversight, we do not believe certain firms should be
exempt from such requirements. Rather, we encourage the Board to establish requirements that can be appropriately
instituted by all registered firms, considering the operational challenges we noted above.”).
12
Their hesitancy seemed to be mostly about application.44 Firms expressed concern over
scalability,45 particularly the impact of any such requirement on smaller firms.46 They also noted
44 Some objected to the requirement as inconsistent with a risk based approach to quality control. See Letter
from CAQ to PCAOB, PCAOB Rulemaking Docket No. 46: Concept Release: Potential Approach to Revisions to
PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/010_CAQ.pdf ) (“We do not believe such a provision
should be required, as we are concerned this would limit the scalability of a future PCAOB QC standard.
Independent oversight may be an appropriate response for some firms based on their risk assessment; however, such
a requirement may not be necessary or effective for all firms. Further, independent oversight may take various forms
including independent advisors who are not board members.”); Letter from Crowe LLP to PCAOB, PCAOB
Rulemaking Docket No. 46: Concept Release: Potential Approach to Revisions to PCAOB Quality Control
Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (available at
https://pcaobus.org/Rulemaking/Docket046/025_Crowe.pdf) (“Independent oversight over a firm’s QC systems is a
relatively new concept for most firms, and while it is clearly an option a firm might take, firms do not have public
investors who have the same level of need for independent oversight as that of a public company. We believe that
with a risk-based approach, a firm may determine that independent oversight or independent advisors is an
appropriate response to their risk assessment process, however, it should be part of a firm’s overall response to its
risk assessment not a prescriptive requirement. Requiring independent oversight may also limit the scalability of a
future PCAOB QC standard.”); Letter from Moss Adams to PCAOB, PCAOB Rulemaking Docket No. 46 (Mar. 16,
2020) (available at https://pcaobus.org/Rulemaking/Docket046/023_Moss_Adams.pdf) (“We do not believe such a
provision should be required as we are concerned this would limit the scalability of a future PCAOB QC standard.
Independent oversight may be an appropriate response for some firms based on their risk assessment; however, such
a requirement may not be necessary or effective for all firms. Further, independent oversight may take various forms
including independent advisors who are not board members.”).
45 See Letter from PwC, supra note 42 (“Regarding scalability, we note that certain incremental requirements
could disproportionately affect smaller firms. For example, requirements for firms to have mechanisms for
independent oversight over their QC systems could prove challenging for smaller firms – whether due to an inability
to remunerate suitable candidates competitively with other firms or finding individuals willing to be subject to a
firm’s independence requirements.”); Letter from KPMG, supra note 42 (“While there is value to including an
element of independent oversight to support the QC system, we also acknowledge that it is challenging to identify
qualified, diverse and independent individuals that can fulfill this role. These challenges may impact the scalability
of a future PCAOB QC standard to all firms; and, therefore, we do not recommend that a future Quality Control
standard require a mechanism for independent oversight.”); Letter from RSM US LLP to PCAOB, PCAOB Concept
Release on Potential Approach to Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003;
Rulemaking Docket No. 046) (Mar. 13, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/009_RSMUS-LLP.pdf) (“Also, a requirement to incorporate mechanisms for independent oversight would not make the
standard easily scalable for smaller firms. We believe the discernment regarding whether to have independent
directors or other advisory oversight bodies should take place in the board room of the individual firms.”); see also
Letter from NYSSCPA to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB
Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 17, 2020) available
at https://pcaobus.org/Rulemaking/Docket046/032_NYSSCPA.pdf) (“Consistent with our view set forth under our
General Comments above, we believe scalability should be a primary consideration in determining the nature and
extent of any oversight to be applied to a firm’s QC function . . . and that an “independent” QC oversight should not
be mandated except perhaps for the largest of firms.”).
46 Letter from Baker Tilly to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to
PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/011_Bakertilly.pdf) (“This approach should not be a
requirement. Firms have developed different forms of governance that are suitable for them. To prescribe some sort
of required structure would be contrary to a risk-based approach and probably unsuitable for the smaller firms.”).
13
the need for flexibility.47 A consistent theme was that a single model for independent oversight
had not emerged and therefore should not be required.48 Instead, there should be room to allow
for evolution49 and to consider alternative models.50
To the extent that the structure would include oversight by independent directors, a
number of issues would need to be addressed.51 Questions were raised about the ability of small
firms to find qualified candidates,52 with suggestions that any independent oversight “should not
47 See Letter from PwC, supra note 42 (“It is important for firms to have flexibility to consider whether
independent oversight is necessary and, if so, what is most appropriate based on the structure of their firm and where
they operate.”); Letter from EY, supra note 42 (“Today, there are a variety of ways that firms gather perspectives
from an independent body as a means to strengthen audit quality. We believe firms should continue to have this
flexibility.”).
48 Letter from BDO to PCAOB, PCAOB Concept Release on Potential Approach to Revisions to PCAOB
Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046) (Mar. 16, 2020)
(available at https://pcaobus.org/Rulemaking/Docket046/018_BDO.pdf ) (“we do not believe that there is
observable evidence that the use of independent directors is effective in improving audit quality with accounting
firms, as we believe that firms that have voluntarily adopted the use of independent directors have not used them in
an oversight capacity as proposed by the PCAOB.”). See also Letter from RSM, supra note 45 (“Currently,
professionals from outside a firm primarily are hired in an advisory (i.e., not an oversight) capacity. We do not
believe it would be helpful or practicable to require firms to incorporate mechanisms for independent oversight as
we believe that, even with a requirement to have such independent oversight, the roles of independent directors
would vary as to levels of authority, responsibility and influence within each firm.”).
49 See Letter from IMA, supra note 31 (“We acknowledge that various practices have emerged in recent years
including independent directors on firms’ boards of directors and separate audit advisory boards comprised of
independent individuals. It is too early to know which form of oversight, if any, will be most effective in improving
firm-wide audit quality. Likewise, it would be premature to specify duties for such oversight. We believe that best
practices for such oversight will develop in the marketplace. This is like the evolution of audit committees within the
corporate governance system. For decades, such committees were considered a good practice, but few companies
established them, and the existing committees had widely varied practices. Only in relatively recent years has it
become accepted that such committees are an essential element of corporate governance, should be required, and
should follow at least a minimum list of required procedures.”).
50 A variety of other options were also suggested. See Letter from Grant Thornton, supra note 42 (“We
believe that a similar objective can be met by either designating an individual on a firm’s board as an ‘audit quality
expert’ (similar to audit committee requirements for a ‘financial expert’) or by having independent external advisors
outside of the board construct, to focus on and advise firms regarding audit quality or their systems of quality
control.”).
51 Letter from NYSSCPA, supra note 45 (“Also, we believe that the size, composition and qualifications of
members of a body designated with responsibility for overseeing a firm’s internal QC function might best be similar
to those of audit committees – with independent members and at least one representative who represents a wider
scope of stakeholders, for example, someone who is not a CPA or an auditor.”).
52 See Letter from PwC, supra note 42 (“Requirements for firms to have mechanisms for independent
oversight over their QC system could make it challenging, especially for smaller firms, to attract suitable candidates
– whether due to an inability to remunerate them competitively with other firms or difficulty finding individuals
willing to be subject to relevant aspects of a firm’s independence requirements.”). See also Letter from KPMG,
supra note 42 (“While there is value to including an element of independent oversight to support the QC system, we
also acknowledge that it is challenging to identify qualified, diverse and independent individuals that can fulfill this
role. These challenges may impact the scalability of a future PCAOB QC standard to all firms; and, therefore, we do
not recommend that a future Quality Control standard require a mechanism for independent oversight.”).
14
be mandated except perhaps for the largest firms.”53 Some commenters favored increased
disclosure about “the composition and activities of the firm’s governance structure… ”54 All of
these concerns are important and deserve serious consideration.
In addition to concerns over scalability and flexibility, at least two other reasons have
been suggested for omitting independent oversight from any future QC standard. Let me briefly
discuss these reasons and what I understand so far.
First, the inclusion of an independent oversight requirement in a future PCAOB standard
may result in differences in approach between the IAASB and the PCAOB, and therefore, should
not be implemented.
The PCAOB’s Concept Release described the IAASB’s approach as a possible “starting
point”55 but indicated a goal of minimizing the differences between the two approaches.56 The
IAASB is considering adopting standards this week that may not include any requirements for
independent oversight.
The goal of minimalizing differences as a justification for leaving out independent
oversight has a number of flaws. The reasoning does not adequately take into account the
differences between the PCAOB and the IAASB in connection with standard setting. While the
IAASB’s proposed standard does provide useful input for the Board’s consideration, differences
in the two organizations may make one universal standard on quality control difficult to achieve
and not necessarily desirable.
For one thing, the IAASB’s standards are intended to be implemented across the globe
and, therefore they must, by their nature, be general enough to suit a wide array of stakeholders,
including the varied legal and cultural needs in other countries. Many jurisdictions that
implement IAASB standards can, and sometimes do, add additional requirements in order to
reflect specific local needs.57 The PCAOB, in contrast, is in a position to include those “local
needs” suggested by investors in the comment process directly in any revised QC standard.
53 See Letter from NYSSCPA, supra note 45.
54 See Letter from FEI, supra note 42 (“It is likely too soon, however, to know which type of independent
oversight mechanism, if any, is most effective in promoting quality audits. Thus, at this time, we would not support
either a required certain composition of a firm oversight body, or requirements for the duties of those providing
oversight. On the other hand, we would support disclosure of the composition and activities of the firm's governance
structure, such as in the audit quality reports the largest firms now issue annually, in order to allow the market to
drive best practice in this area.”). See also Letter from IMA, supra note 31 (“We would support disclosure of the
composition and the general responsibilities of such independent audit oversight activities in the quality control
reports mentioned in Question 39 below.”).
55 See supra note 15.
56 See Concept Release, supra note 7 (“Due to the foundational nature of QC systems, we believe that it
would not be practical to require firms to comply with fundamentally different QC standards.”).
57 Japan has adopted requirements designed to “clarify audit procedures to address the risks of material
misstatements due to fraud. . . .” See Opinion on the Standard Setting to Address Risks of Fraud in an Audit,
15
Further, the mission of the PCAOB specifically emphasizes the interests of investors,
something that reflects both the particular concerns present with respect to the U.S. capital
markets and the deficiencies that arose during the period when the auditing profession engaged
in self-regulation.58 The PCAOB’s standard-setting activities therefore must give significant
weight to this mission in connection with its oversight of auditors for both issuers and brokerdealers, as well as any other current and emerging issues applicable to the U.S. capital markets.59
In fulfilling this mission, the PCAOB has, at least historically, considered the
perspectives of an advisory group that consisted entirely of investors and their representatives.60
One out of every five comment letters received on the PCAOB’s Concept Release came from the
investor community.
The views of these commenters on the relationship between the IAASB proposal and the
PCAOB’s approach to a future QC standard are instructive. They did not see the IAASB
proposal as a limit. One letter characterized the use of the IAASB’s approach as a “starting
point” as premature.61 Others supported coordination, but did not view it as restricting potential
incremental additions, such as independent oversight. All of this suggests that the goal of
international alignment should not be elevated above the specific concerns and interests of
investors and the public.
Business Accounting Council (Mar. 26, 2013) (available at https://www.fsa.go.jp/en/news/2013/20130411-
1/01.pdf).
58 Our mission specifically references investors. See Section 101 of the Sarbanes-Oxley Act (15 USC § 7211)
(“There is established the Public Company Accounting Oversight Board, to oversee the audit of public companies
that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the
public interest in the preparation of informative, accurate, and independent audit reports for companies the securities
of which are sold to, and held by and for, public investors.”). The IAASB mission references the public which
includes but does not specifically emphasize investors. See IAASB, About IAASB (available at
https://www.iaasb.org/about-iaasb) (“The International Auditing and Assurance Standards Board (IAASB) is an
independent standard-setting body that serves the public interest by setting high-quality international standards for
auditing, quality control, review, other assurance, and related services, and by facilitating the convergence of
international and national standards.”).
59 While this is good policy, it is also legally required. The PCAOB standards cannot take effect unless and
until approved by the SEC pursuant to Rule 19b-4 under the Securities Exchange Act of 1934. 17 CFR § 240.19b-4.
The failure to adequately consider a statutorily mandated requirement would be a basis for non-approval or a
possible legal challenge to the final standard.
60 See PCAOB, Investor Advisory Group Members (available at
https://pcaobus.org/About/Advisory/Pages/Investor_Advisory_Group_Members.aspx). The IAG has not held a
public meeting since November 2018. See PCAOB, Investor Advisory Group Meeting (available at
https://pcaobus.org/News/Events/Pages/PCAOB-IAG-Meeting.aspx). Both organizations have advisory groups that
include representatives of multiple stakeholders. The membership varies, significantly, particularly with respect to
the number of investors and investor groups. Compare PCAOB, Standing Advisory Group Members (available at
https://pcaobus.org/Standards/SAG/Pages/Current.aspx) with IAASB, Consultative Advisory Group, (available at
https://www.iaasb.org/consultative-advisory-group).
61 See Letter from Consumer Federation, supra note 20 (describing use of IAASB proposal as “starting point”
as “premature at best”).
16
And let’s be clear. Not all “differences” in standards are the same. Given the global
nature of the audit profession, inconsistencies may sometimes present unique challenges with
respect to implementation. Adding additional, more detailed requirements, however, do not raise
the same concerns. Independent oversight and other matters sought by investors commenting on
our Concept Release do not appear to result in inconsistencies with, but for the most part are
additions to, the QC approach of the IAASB.62
Second, some say that independent oversight as an element of the standard may be
unnecessary because of the role of the PCAOB.63 This is a complement when you think about it.
Some may be suggesting that a regulatory body can effectively replace an internal system of
independent oversight. Complement though it is, I am concerned that this view misconceives the
function of the PCAOB.
PCAOB inspections of audit firms can include a review of the system of quality control
for conformity with established standards.64 Accordingly, these inspections do sometimes
identify instances where the system does not meet these standards. The PCAOB cannot do this if
a requirement is not in our standards, nor will we be able to enforce what that is not there.
Without a requirement for independent oversight in an audit firm’s system of quality
control, the PCAOB has limited ability to ensure that commercial interests are not unduly
62 The IAASB approach also permits differences in approach. The IAASB QC proposed standard does not,
for example, require all firms to issue transparency reports. In response to legal and regulatory requirements in
certain jurisdictions, many audit firms are required to issue transparency reports generally containing information on
audit firm’s governance, including the firm’s internal quality control system, independence practices, compensation
and remuneration, among other things. Some firms have also chosen to issue transparency reports voluntarily, when
not mandated by regulations. See European statutory audit regulations (Article 13 of Regulation (EU) 537/2014),
Australian law (Sections 332 to 332G of the Corporations Act 2001 and Regulation 2M.4A and Part 3 of Schedule
7A in the Corporations Regulations 2001), Korean law (Regulation on External Audit and Accounting, Article
22(2)). The IAASB observed that there are still many jurisdictions where transparency reporting is not required or
common practice, largely because there is a lack of demand from stakeholders in those regions for such information.
While “certain respondents, mostly investors, did call for the IAASB to more specifically address transparency
reports in the IAASB’s standards…,” the IAASB is considering adopting a standard that does not require a firm
transparency report. See supra note 6.
63 See Letter from Deloitte & Touche LLP to PCAOB, PCAOB Concept Release on Potential Approach to
Revisions to PCAOB Quality Control Standards (PCAOB Release No. 2019-003; Rulemaking Docket No. 046)
(Mar. 16, 2020) (available at https://pcaobus.org/Rulemaking/Docket046/031_DT.pdf ) (“Though not an aspect
within a firm’s system of quality control, mechanisms for independent oversight over firms’ systems of quality
control exist today via the PCAOB’s inspection program (which includes a review of the firm’s quality control
system) as well as inspections or similar programs in other jurisdictions or by other regulators or standard setters
(e.g., the AICPA’s peer review program).”).
64 PCAOB Inspection Procedures: What Does the PCAOB Inspect and How Are Inspections Conducted?
(available at
https://pcaobus.org/Inspections/Pages/PCAOB-inspection-procedures-what-does-PCAOB-inspect-how-inspectionsconducted.aspx) (“A PCAOB inspection is designed to assess the firm’s compliance with PCAOB standards and
rules, and other applicable regulatory and professional requirements in the firm’s system of quality control and in
the portions of audits selected for inspection. Inspections do not involve a review of all aspects of a firm’s quality
control system.”).
17
influencing or negatively impacting audit quality.65 Granted, the problem may become so severe
that it can be identified through deficient engagements. But this will be rare. And the view
fundamentally conflicts with the goal that the system of quality control should be designed to
ensure that the problems or concerns do not occur in the first instance.
On the other hand, should a requirement of independent oversight be added to any
resulting standard, the PCAOB can play an active role in ensuring adequate implementation and
enforcement. PCAOB inspections can make sure the element is present and appropriately
integrated into the firms’ system of quality control. The PCAOB can also facilitate public
accountability through disclosure. As I have said in the past, I believe that we have the authority
to include in the public portion of the inspection report a description of a firm’s QC system,
something that would presumably include the implementation of independent oversight.66
These issues clearly need to be considered, debated and addressed in determining
whether independent oversight should or should not be included in a future QC standard. Some
of these concerns were at most touched upon lightly in the comment process and would benefit
from additional insight. Moreover, there may be ways to address commercial influences. We
would benefit from further insight on this topic. I look forward to hearing those views.
III. Conclusion
So where does this leave us?
Quality control is essential for trust.67 Like consumers of food, medicine, and
transportation, those relying on audits expect regulators to require, and audit firms to implement,
a rigorous system of quality control. On that, there is, I think, agreement.
The importance of independent oversight is really one piece of that broader debate.
There may be multiple ways to construct a QC system that adequately promotes audit
quality without independent oversight. Investors have, however, advanced the view that
65 Of course, to the extent there are ways to protect audit quality from commercial interests other than
independent oversight and they are included in any revised standard, they will be subject to inspection and
enforcement.
66 J. Robert Brown, Jr., Seeing Through the Regulatory Looking Glass: PCAOB Inspection Reports, CFA
Institute’s Corporate Disclosure Policy Council and Capital Markets Policy Council, July 23, 2020 (available at
https://pcaobus.org/News/Speech/Pages/Brown-Seeing-Through-Regulatory-Looking-Glass-PCAOB-InspectionReports.aspx).
67 Competition & Markets Authority, Statutory audit and services market study (Apr. 18, 2019) (available at
https://assets.publishing.service.gov.uk/media/5d03667d40f0b609ad3158c3/audit_final_report_02.pdf) (“Lack of
trust in the provision of audits will undermine credibility and confidence in the quality of audits and the accuracy of
financial statements published by large companies. These will prevent investors, customers and suppliers from being
able to identify the companies that have more effective and those that have less effective audits (other than in the
extreme case of corporate failure).”).
18
independent oversight can improve quality,68 result in greater accountability69 and increase the
confidence placed by investors and the public in the quality of audits.70 These are important
points that warrant serious consideration.
Nonetheless, the debate is far from resolved. I very much look forward to hearing and
carefully considering any additional thoughts on this issue. I am particularly interested in views
that either support or challenge the positions taken by parties submitting comments on the
Concept Release. All of this will help develop a more fulsome record that will be useful in
determining whether independent oversight should or should not be a requirement in any
standard addressing QC systems.
I encourage everyone here to participate in the debate. Give us your thoughts on
independent oversight and anything else you think may help improve our standards on quality
control. Your participation is important. The letters we received on the Concept Release were
extremely helpful. While sometimes the interests of investors and the public can be discerned,
nothing is better than hearing from you directly.
Write to us, email us, or meet with us. I’m happy to arrange a conversation, whether with
me, our staff or other Board members.71
Should the PCAOB issue a proposed standard in the area, be prepared to give us your
feedback. I expect the issue will generate a spirited debate during any notice and comment
period over whether an independent oversight requirement should be included in the standard
and, if so, how it should be implemented.
If past history is any indication, the differences in commenter views will be significant.
The auditing profession has traditionally favored a principles-based approach that uses general
language applicable to all firms, irrespective of their differences in size, resources and number of
clients. Investors tend to favor an approach that involves a mix of principles and specific
requirements.72
68 See supra note 34. See also Securities Research: Additional Actions Could Improve Regulatory Oversight
of Analyst Conflicts of Interest, GAO-12-209 (Jan. 2012) (available at thttps://www.gao.gov/assets/590/587613.pdf
) (“Two studies found that the relationship between analyst recommendations and valuation estimates strengthened
after the regulatory reforms, indicating that the reforms improved analyst independence.”).
69 See supra note 35.
70 Letter from CalPERS, supra note 33 (“having independence within the governance structure strengthens
investor trust in the system.”)
71 My email address is brownj@pcaobus.org.
72 See Modernization of Regulation S-K, Items 101, 103, and 105, Exchange Act Release No. 86614 n. 17
(Aug. 8, 2019) (supporting disclosure standards that were “some combination of both principles-based and
prescriptive rules.”). Standards that are too general can raise accountability concerns. See supra note 13 (testimony
of Lynn Turner, Chief Accountant, SEC) (stating that standards were “so general that, as a practical matter, it is
difficult to hold anyone accountable for not following them.”).
19
And remember, your views are essential to the PCAOB. Our mission is to act in the
interests of investors and the public. To do this, we need you to tell us what those interests are.
PUBLIC
EMPLOYEE
RETIREMENT
ADMINISTR ATION
COMMISSION
DOMESTIC EQUITY
INTERNATIONAL EQUITY
FIXED INCOME
REAL ESTATE
BALANCED
ALTERNATIVE INVESTMENTS
& OTHER
FUNDAMENTALS OF ASSET ALLOCATION
FUNDAMENTALS OF ASSET ALLOCATION
FIRST EDITION | FEBRUARY, 2000
PUBLISHED BY THE PERAC COMMUNICATIONS UNIT
5 MIDDLESEX AVE., THIRD FLOOR | SOMERVILLE, MA | 02145
PH:617.666.4446 | FAX:617.628.4002
WEB:WWW.STATE.MA.US/PERAC
PRINTED IN THE USA
PUBLIC
EMPLOYEE
RETIREMENT
ADMINISTRATION
COMMISSION
ELIZABETH E. LAING
CHAIRMAN
A . JOSEPH D E NUCCI
VICE CHAIRMAN
JOHN R. ABBOTT
MICHAEL J. DIRRANE
KENNETH J. DONNELLY
DONALD R. MARQUIS
ANDREW S. NATSIOS
JOSEPH E. CONNARTON
EXECUTIVE DIRECTOR
ROBERT A. DENNIS, C.F.A.
INVESTMENT DIRECTOR
CONTENTS
“DON’T PUT ALL YOUR EGGS IN ONE BASKET” 5
HISTORIC RETURNS 7
MARKET TIMING AS A STRATEGY 9
INVESTMENT RISK 1 0
CORRELATION 1 3
OPTIMIZATION 1 4
ON THE OTHER HAND … 1 6
INTERNATIONAL INVESTING 1 7
OTHER CONSIDERATIONS IN ASSET ALLOCATION 2 0
SUMMARY 2 2
THE REAL WORLD 2 3
4
“DON’T PUT ALL YOUR EGGS IN ONE BASKET.”
That timeless proverb not only carries an important message for many aspects
of everyday life but is also the guiding principle behind a successful long-term
investment program.
Indeed, the most important determinant behind success or failure in
investment management is not individual security selection or trading by
investment managers. Research shows that about 90% of the
variance in a portfolio’s investment returns over time is Research
explained by asset allocation, the process of determining the shows that
percentage of portfolio assets allocated to specific asset classes about 90% of
such as stocks, bonds, real estate, venture capital, et al. Asset
allocation has its intellectual roots in the 1950s when econo the variance in
mist Harry Markowitz, who was later awarded the Nobel Prize a portfolio’s
for his work, began developing what became known as mod- investment
ern portfolio theory. returns over The goal of asset allocation is to maximize returns at a
prudent level of risk or to minimize the risk involved in time is explained
achieving a certain return. The process of determining the by asset
appropriate asset allocation involves an analysis not only of allocation. available investment asset classes but also of the liabilities of
an entity such as a retirement system. The needs and preferences of the
investor are the basic building blocks of an asset allocation.
In the case of a pension fund, board members have the exclusive purpose as
fiduciaries to provide benefits for members and survivors through a program of
prudent, expert investing. Their responsibility is to develop an investment program where expected returns meet their system’s projected financial liabilities.
Retirement board members must be sure their actuarial assumptions are sound,
and they must assess the sensitivity of their portfolio to severe market declines
FUNDAMENTALS
OF ASSET
ALLOCATION
5
and whether the portfolio provides sufficient protection against inflation.
The primary goal in constructing a portfolio is that the expected return be
sufficient to satisfy an investor’s financial objectives and be commensurate with
a level of risk that the investor is comfortable with. There are several asset classes, or groups of investment securities whose behavior is similar in response to
changes in economic circumstances, and each class (i.e., stocks) has several
subclasses (large capitalization, midcap, small cap; growth and value). The
major inputs to an asset allocation process are the historical and expected
returns for each distinct asset class or subclasses, the volatility of those returns
over time, and the correlation of returns among the asset classes or subclasses.
Risk means different things to different people. To a bungee jumper, it’s
the possibility that the cord might break. For an investor, risk means the possibility of losing money and not meeting one’s financial objectives. Similarly,
asset allocation is like wearing protective gear in athletics. A competitor might
perform better if not hampered by protective gear, but without it, a blow to an
unprotected part of the body could prove disastrous. Someone investing over
the past few years might conclude that large cap growth stocks are the only
asset class needed for a successful portfolio. Although those stocks have indeed
been by far the best performing asset class in recent years, a prudently constructed portfolio will also have assets in currently underperforming sectors like
bonds, small stocks, and real estate. These sectors currently serve as hedges that
may inhibit maximum performance today but should cushion the portfolio to
some degree when the high-flying growth stocks cool off, as history and logic
tells us they inevitably will.
Thus, an asset allocation process today should properly include a number
of different asset classes. It’s not unusual for one asset class or investment style
to dominate returns for four consecutive years as U.S. large cap growth stocks
recently did (1995-98), but other classes—including small caps, international
stocks, and real estate—have enjoyed similar extended periods of superior performance over the past quarter century. If we examine historical returns of
large U.S. stocks, small U.S. stocks, international stocks, and high grade U.S.
6
bonds over the twenty years through 1998, there was only one year prior to 1995
that large stocks provided the best performance among these four asset classes.
An effective portfolio is not just the sum of its parts but should incorporate
the expected interaction among those parts. Correlation measures the likelihood
that two asset classes will move in the same direction, and selecting asset classes
that have as little correlation with each other as possible should reduce risk and
volatility in a portfolio while helping to achieve expected returns.
A guiding principle of asset allocation is that a portfolio diversified among
asset classes will never match the performance of the best asset class each year
but it will also never equal the worst. The past few years, during which
performance has been concentrated in a select group of U.S. stocks, have
presented a serious challenge to proponents of asset allocation. Nevertheless,
results from 1999 did show some distinct benefits from diversification among
asset classes.
HISTORIC RETURNS
Historical data from 1926-98 compiled by Ibbotson Associates (a firm well
known for its collection and analysis of investment returns) gives the compound annual returns of various classes of domestic stocks and bonds over this
period, including large-cap stocks (11.2%), small cap stocks (11.8%), longterm corporate bonds (5.8%), and long-term government bonds (5.3%). Data
from shorter periods indicates the annual returns from additional classes, such
as international stocks (12.7% since 1970) and real estate (9.0% since 1978).
Stocks have indeed been the best performing asset historically. Over the
ten years ending 1998, the outperformance of stocks over bonds was even
greater than in the above-noted 1926-98 period as the S&P 500 gained 19.2%
annually compared to 9.3% for investment grade bonds. Furthermore, since
1926, the 1930s have been the only decade when bonds (long-term
FUNDAMENTALS
OF ASSET
ALLOCATION
7
governments) outperformed stocks (large or small caps). Returns on stocks are
certainly volatile; more than one quarter of the time since 1926, annual returns
have been negative. (Actually, the same observation holds for long government
bonds although, as will be discussed, the magnitudes of gains and losses for
bonds have been much smaller than those of stocks.)
The advantages of stocks are seen over time; over the 64 overlapping
10-year periods from 1926-98, large cap stock returns were positive 62 times,
and they have been positive for every fifteen-year period over time. Stocks have
outperformed bonds 61% of the time over one-year periods but 92% of the
time over 20-year periods and 99% of the time over 30-year Stocks & periods. Thus, the longer an investor’s time horizon, the more
bonds have both the portfolio should be biased toward equities. The advantages
of equities are even more important after considering taxes performed poorly and inflation. (Taxes, of course, are not a factor in pension in periods of high fund investing.)
inflation & well U.S. stocks clearly have a very favorable and impressive
long-term return record, but one must be cautious when using in periods of low
either the widely-publicized Ibbotson numbers or any other inflation. historic returns as projections for future returns. Of the 54
overlapping 20-year calendar periods since 1926, stocks have returned less than
10% nearly 40% of the time. More ominously, additional research shows that
the best equity market returns were achieved from investments made during
periods when the price-to-earnings ratios were generally within the long-term
historic average range of 14 to g16. Investments made when P/E ratios were 20
or higher (they are at all-time high of close to 30 today) resulted in typical
annual returns of just 5% over the following 10 years. (As explained in the
PERAC investment education presentation, Understanding Investments, the P/E
ratio—a company’s stock price divided by its earnings per share—is one of the
most traditional measures of assessing the value of a stock.)
Some other observations about historical returns include the fact that
stocks and bonds have both performed poorly in periods of high inflation and
8
well in periods of low inflation. Indeed, inflation is one of the worst enemies
of pension funds; during periods of high inflation, pension benefits tend to rise
while investment returns are declining. The effect of business cycles is less
clear; not every stock market downturn has corresponded with an economic
recession and not every recession resulted in poor stock market performance.
MARKET TIMING AS A STRATEGY
Before examining the basic principles of asset allocation, there is an offshoot of
the traditional process called “tactical asset allocation” which involves aggressive
movement in or out of asset classes depending on current perceptions of their
attractiveness. Looking at historical returns, a strategy that favors “tactical”
short-term swings into or out of markets, as opposed to a strategy of disciplined asset allocation, appears unlikely to succeed. In general, investment
strategies that worked in the past often don’t carry into the future. It is difficult
to predict short-term swings in the market and in attempting to do so, market
timers expose the portfolio to additional risk. This is because returns have been
often concentrated in short periods.
Illustrating the concentration of returns, Ibbotson data show that if an
investor had been out of the market during the S&P 500’s 40 best months from
1926 through 1998, he would have a return less than that of Treasury bills. If
one had invested in an instrument replicating the S&P 500 at year-end 1925
and held it through the end of 1998, he would have amassed $2,351. If he had
instead invested in Treasury bills continuously over this period, he would have
had only $15. Pity the hapless market timer who was out of the market during
the S&P’s 40 best months over that time; he would have had only $14!
Adding to the futility—and the substantial risks involved—in trying to
predict market swings is the burden of transaction costs.
FUNDAMENTALS
OF ASSET
ALLOCATION
9
INVESTMENT RISK
Consideration of investment risk is a vital component of the asset allocation
process but it is not the only risk that fiduciaries must be aware of.
Operational risk refers to the possibility that an investment manager will fail
to fulfill its mandate due to violation of guidelines, trading errors, inadequate
risk controls, or outright fraud. Counterparty risk refers to problems that may
Just as arise from irregularities pertaining to a particular exchange,
broker, or other financial intermediary.
combinations of The investment risk of an asset consists of two parts: 1)
Systematic risk, also known as market risk or beta, which risky stocks springs from general economic factors (such as a sharp interest exhibit less risk rate rise) that affects all companies in a similar fashion,
than individual although with different magnitudes, and 2) Unsystematic
risk, which is unique to a particular asset (such as a potential- securities,
ly adverse ruling from a product liability case) and unrelated combinations of to the overall movement of the capital markets.
asset classes can Another way of looking at the different types of risks is to
have less risk than consider systematic risk the market risk that investors are given
and unsystematic risk the active risk that investors take. individual
asset classes. Diversification eliminates unsystematic risk because the
positive and negative results of specific companies within the
portfolio tend to offset one another in a random fashion.
Therefore, portfolios that are not well diversified are subject to increased volatility. Portfolio risk decreases as the number of stocks increases. Portfolios of 30
stocks or more will have most of the unsystematic risk eliminated, particularly if
they are priced in the same range and held in similar amounts. Similarly, just as
combinations of risky stocks exhibit less risk than individual securities,
combinations of asset classes can have less risk than individual asset classes.
10
A traditional way of looking at investment risk is to compare the ranges of
annual asset class returns over time. Those with wider ranges of returns are
considered to have greater volatility. Risk measures the possibility of losing
money and, although both large-cap stocks and government bonds have lost
money on an annual basis almost one quarter of the time since 1926, the magnitude of swings has generally been much greater for stocks. The S&P 500
returned 34.1% in 1995 while long-term bonds have never done better than
the 18.2% registered by Treasuries in 1993. The S&P suffered a 26.5% loss in
1974, while the worst year for bonds has been the 7.8% loss in 1994. In terms
of quarterly performance, the differences are even more dramatic; since 1926,
the worst quarterly return for bonds was –6.4% while that for large stocks was
–37.7% and for small stocks -41.6%. Bonds often serve as a cushion against
steep equity losses, as seen most recently in August 1998 when bonds had a
positive return of 1.5% while stocks plummeted by 14.5%.
There are a number of ways to communicate investment risk. Volatility,
or the uncertainty of an asset’s return, is effective as a relative statistical measure. If an asset’s returns over time are plotted on a graph, the arithmetic mean
is the center of the distribution and the standard deviation (a number derived
from a mathematical formula) measures the spread. If returns have a normal
(bell-shaped) distribution, 68% of all returns are expected to be within plus or
minus one standard deviation of the mean and 95% of all returns are expected
to be within plus or minus two standard deviations of the mean. For example,
using statistics from 36 monthly returns, an investor considers two investments
which both had average monthly returns of 5%. The first, with a standard
deviation of 2%, would have had a typical range of returns (two standard
deviations) over the 36 months of between 1% (5%-4%) and 9% (5%+4%).
The second investment, with a standard deviation of 4% for the same period,
would have experienced more volatile returns, with fluctuations between -3%
(5%-8%) and 13% (5%+8%).
As previously noted, annual returns on large cap stocks have been more
than twice those of long-term government bonds since 1926, but the standard
FUNDAMENTALS
OF ASSET
ALLOCATION
11
deviation of those returns is also more than twice that of bonds. This
significantly greater volatility explains the “risk premium” that investors have
traditionally demanded of stocks relative to bonds.
Data compiled by Ibbotson since 1926 show that both government and
corporate bonds have had standard deviation of returns of about 9% while that
of large cap stocks has been about 20% and that of small cap stocks (which had
returns only slightly higher than those of large caps) was 30%. Looking at the
figure for large caps, this means that with a compound annual return of slightly
over 11% over this period, returns would have been within the range of –9%
(11%-20%) and 31% (11% +20%) two thirds of the time. (Chart One shows
the historical risk and return relationships between stocks and bonds.)
Among other asset classes, intermediate bonds have shown about 60% of
the risk of long-terms, and returns on real estate over the past 20 years indicate
a relatively low standard deviation of about 7%.
The value of stocks as long-term investments is seen in their declining risk
measures over time. The standard deviation of stock returns over a one-year
period is 18% but drops to a very low 2% over 30-year holding periods,
demonstrating that investors who can live with high variability of annual
returns can expect a healthy composite return over long periods with a great
deal of certainty.
After recovering from the Great Depression, annual volatility of large cap
stock returns has changed very little from 1940 to the present. Indeed, the
recent four-year period 1993-96 was the least volatile since 1963-66. On the
other hand, volatility in bonds has increased substantially, first reflecting the
higher inflation of the 1960s and 1970s and then reflecting the Federal
Reserve’s new policy of targeting money supply growth that it adopted in 1979.
12
CORRELATION
The next step in asset allocation is to incorporate a measure of how various
investments are expected to act relative to one another. The traditional input
here is correlation, a measure of the degree to which two series move together.
Correlation ranges from –1, where if one rises in value, the other will fall
(inverse correlation) to +1, where if one rises in value, the other will also (perfect correlation) with 0 representing a totally random relationship. Ideally,
investment portfolios would consist of negatively correlated assets but most
assets exhibit moderately positive correlation. For example, Ibbotson data indicate that government bonds and corporate bonds have a positive correlation of
0.94, German bonds and Japanese stocks have –0.06 (no correlation), and
commodities and small stocks have a negative correlation of -0.40.
Correlation can change over time in reaction to economic or political
events. For example, largely reflecting the Federal Reserve’s changed monetary
policy, the five-year rolling correlation between long-term bonds and large cap
stocks—which was negative between 1956-66—has risen to the 0.30-0.60
range in recent years. The correlations between Spain’s stock market and those
of the European Economic Community have risen from 0.35-0.50 to in excess
of 0.75 since Spain joined the EEC in 1986.
By combining two assets into a portfolio, the expected return is an
arithmetic average of the individual returns but the risk is dependent on the
correlation between the two assets. If the assets are perfectly correlated (+1),
there is no diversification gain and the portfolio risk is the average of those of
the two assets. If the assets are negatively correlated, then all risk can be eliminated. If the assets are not correlated (the most likely case), some risk can be
eliminated by combining them. Thus, the standard deviation of a portfolio
constructed by combining assets that are uncorrelated will typically be lower
than that of either of the component assets.
FUNDAMENTALS
OF ASSET
ALLOCATION
13
History shows that small caps move together with large caps about three
quarters of the time while the corresponding measures relative to large caps are
about two-thirds for foreign equities, about 40% for real estate, and less than
one third for bonds. Thus, bonds are seen as the best diversifying asset relative
to large-cap equities and small caps the least effective in that regard.
OPTIMIZATION
Optimization in asset allocation is creating a portfolio that will achieve a
particular return objective with the least amount of risk or a particular risk
objective with as high a return as possible. An investor can theoretically choose
from portfolios that consist not only of 100% allotments to specific classes
(i.e., stocks) but also every possible combination of these asset classes to make
up a total portfolio (e.g., 40% bonds, 60% stocks). Graphing expected returns
versus standard deviation for each of these combinations, one derives an
“efficient frontier” of “optimal” portfolios that maximize expected return for
each level of risk. Theoretically, adding more asset classes to the process will
extend the frontier higher, producing higher returns for no additional risk.
If one were to construct the above-noted graph with expected investment
returns on the vertical axis and risk on the horizontal axis, this graph would
have an entry for an all-stocks portfolio in the upper right sector (high return,
high risk) of the chart and for all-bonds in the lower left (lower return, lower
risk) of the chart. (The absolute lowest risk, lowest return entry would represent Treasury bills in the far bottom left of the chart.) The practice of asset
allocation, in its most basic depiction, involves drawing a line between the two
extreme points and determining what combination of stocks and bonds strikes
the right balance between an investor’s required return and the level of risk
he/she is comfortable with. In reality, the choice will involve more than just
two broad asset classes because both the stock and bond markets consist of
14
several distinct styles and sectors and there also are the options of investing
internationally as well as in additional asset classes such as real estate. Also, the
“efficient frontier” of optimal asset combinations will typically be graphically
represented by a curve whose points represent greater returns for a given level
of risk than would be found on a straight line connecting the theoretical
all-stocks, all-bonds, or similar points; this portrays the diversification gains
that are achieved by combining asset classes that are not highly correlated.
(Chart Two portrays the construction of a simplified efficient frontier using
stocks and bonds.)
Investment manager Roger Gibson, in a recent book on asset allocation,
analyzed the returns of four major asset classes since 1972 on a year-by-year
basis. Analyzing volatility levels and returns for all possible portfolio combinations (including single asset investments and equally balanced combinations)
using these asset categories, he concluded, “The pattern is clear. The more asset
categories one includes in a portfolio, the higher the … investment’s
risk-adjusted rate of return.”
An important consideration in asset allocation is that, in order to produce
portfolios that will be optimal, not that were optimal, the process of
optimization requires forecasted expected returns, forecasted volatilities, and
forecasted correlations. Historical data can, nevertheless, be very useful in the
process of forecasting.
Many investment consulting firms have optimization software that produce
recommended asset allocations based on modeling of asset class characteristics
and inputs based on client needs and preferences. Confirming that computers
cannot substitute for human judgement, consultants acknowledge that these
optimizers might produce a recommended asset allocation that may appear
extreme in the context of conventional investing practice. Thus, the end result
of an asset allocation process is usually not the output of a predominantly quantitative model but is the result of a process in which the consultant and the
client determine a combination of assets that not only should help the client
achieve his/her goals over time but also satisfies the comfort level of the client.
FUNDAMENTALS
OF ASSET
ALLOCATION
15
ON THE OTHER HAND…
There are some vocal dissenting voices to the theoretical frameworks governing
the search for today’s most efficient portfolios. First of all, some of the
prominent research that inspired today’s basic principles of asset allocation is
questioned. Critics claim that it is wrong to focus on portfolio volatility rather
than portfolio returns and that investors should be more concerned about the
range of likely outcomes over the investment planning horiThey see zon than with the volatility of those returns. Also, the role of
the large risk using largely historical returns to determine fixed allocations is
questioned because historical returns are not necessarily premium reliable indicators of future returns. Indeed, historical returns traditionally could actually be perverse indicators since they are the highest
attached to stocks after market tops. Another complaint is that attributing such a
dominant role to asset allocation in determining portfolio out- relative to bonds
comes serves to unfairly minimize the importance of costs. diminishing. Particularly for individual investors but also for institutional
ones, differences in costs—operating expenses, management
fees, brokerage commissions, custodial fees, et. al.—can play an important role
in portfolio performance over time.
Also, some scholars question the emphasis on the historically far greater
short-term volatility of stocks relative to bonds. They see the large risk
premium traditionally attached to stocks relative to bonds diminishing as the
differential in volatility between the two classes appears to be narrowing in
recent years. For bonds, interest rates have become more volatile in recent years
as the Fed fine tunes monetary policy in order to keep the economy growing at
a sustainable pace. At the same time, stock investors may be perceiving less risk
as a result of better investment education, new tax laws that have lowered
capital gains taxation rates and have encouraged long-term holding in IRA
16
accounts, better governmental monetary and fiscal policy, less governmental
economic regulation, and diminished foreign threats which give hope to an
extended period of peace. As the historic bull market of the past decade has
dramatically driven home the fact that stocks do outperform bonds over time,
the “risk premium”, or extra return demanded by investors to compensate for
the fact that stock returns are considerably more volatile than those of bonds,
may be declining.
INTERNATIONAL INVESTING The breakdown
of trade barriers
One of the most contentious areas of debate concerns the value and advances in
of international diversification. By placing a portion of assets in communications
markets thought to be not correlated with the U.S. market, can technology have an investor really reduce the volatility of the portfolio while
maintaining and sometimes increasing returns? The world’s meant that
markets, particularly those of the developed countries, seem to previously
be moving more in the same direction (if not in the same mag- independent nitude) in recent years. As investors in the fallen hedge fund
Long-Term Capital Management painfully learned in August economies are
1998, diversification won’t dampen volatility when global becoming more
markets move together. Looking at one important recent correlated to
development, the monetary union in Europe that began in
our own. 1999 will likely further the trend of making the characteristics
of —and the returns from—markets on that continent
increasingly similar.
The debate over the benefits of international diversification won’t be
resolved anytime soon, but it may indeed turn out that the benefits from that
strategy may be overestimated because of the slow but steady trend towards an
increasingly homogenized global economy. The breakdown of trade barriers
FUNDAMENTALS
OF ASSET
ALLOCATION
17
and advances in communications technology have meant that previously
independent economies are becoming more correlated to our own.
Certainly, there is no other major economy that has been firing on all
cylinders like the U.S. over the past several years, a fact that has been reflected
in our booming stock market. No other country is at the forefront of the
technological revolution and also enjoys sound and stable economic and
political leadership. The trouble with this argument against international
diversification is that ten years ago investors were similarly drooling over Japan
as the world’s invincible economy. Until a turnaround in 1999, after several
years of stalled economic growth and failed political leadership, Japan’s
economic and financial market performance turned out to be nothing short of
disastrous during the 1990s.
Furthermore, the U.S. recently entered the tenth year of an economic
expansion, with joblessness at a 30-year low, and a stock market that has been
rising steadily and is valued at historic highs according to most traditional
measures. By contrast, Europe and Asia are several years behind in the growth
boom and generally have much more capacity to expand, as seen in much higher unemployment rates and other measures. The U.S. has spent the past ten
years merging, restructuring, and deregulating as well as transforming itself into
an information economy, while Europe has made only about half the strides as
the U.S. and Asia (particularly Japan) is just beginning. Investors in foreign
equity markets were generally well rewarded relative to U.S. stocks in 1999.
Aside from the economic arguments, analysis by Ibbotson Associates
shows that the addition of international stocks to a simple portfolio of U.S.
stocks, bonds, and cash slightly improves the risk/return tradeoff; that is, it
slightly raises the frontier of efficient portfolios offering modestly better returns
for a given level of risk. Looking at dollar-denominated returns over 1970-98
for the countries in the Morgan Stanley Europe Australasia Far East (EAFE)
Index, the composite annual return was found to be 12.5% vs. 13.0% for the
U.S. while the standard deviation was 19.2% compared to 17.3% for the U.S.
A good number of the individual countries in EAFE had compound annual
18
returns higher than that of the U.S., including Ireland (19.5%), Hong Kong
(18.8%), and the Netherlands (17.1%). Every country, however, exhibited
greater volatility than the U.S., particularly Hong Kong (51.8%), South Africa
(41.6%), and Norway (31.3%).
The major reason justifying the use of international stocks is the fact that
many non-U.S. stocks have relatively low correlation with U.S. stocks as well
as with each other. Nearly every developed country has a historical correlation
of less than 0.50 versus the U.S., with the exception of Canada, whose correlation of 0.73 reflects its strong economic ties to the U.S.
In response to those who say that increased economic globalization has
lessened the value of international investing, Ibbotson research indicates that
international equity correlations with the U.S. over the ten-year period 1989
98 were only slightly higher than those for the period 1979-88, but the trend
is surely upward.
Historical data on emerging market stocks has been compiled since 1985,
and, through 1998, the record has not been very compelling. These markets do
have low correlation with the U.S., but the compound annual returns of 19
countries in Asia, Latin America, and elsewhere were only half that of the U.S.
while their composite standard deviation was 50% higher than that of the U.S.
A number of countries, including The Phillippines, Chile, Columbia,
Argentina, and Mexico did post superior dollar-denominated returns but
several had volatilities that have been truly staggering, such as Argentina
(175%), Brazil (105%), and Turkey (103%).
As previously noted, however, asset allocation involves not just historical
analyses but utilizes projections of future returns, volatilities, and correlations.
If one adopts a more optimistic case for performance of emerging markets,
then the addition of international and emerging markets stocks to a traditional
U.S. portfolio could significantly improve the risk/return tradeoff.
In a non-quantitative context, it is undeniable that the global economy is
becoming more developed and that international investing is justified by the
simple observation that the U.S. share of the world economic product has been
FUNDAMENTALS
OF ASSET
ALLOCATION
19
steadily declining and that an increasing number of the world’s most important
corporations are based overseas. Similar to restricting one’s portfolio to a
particular industry or style, limiting one’s investments to a particular region or
country serves to severely constrict one’s opportunities in today’s world economy. On the other hand, disadvantages of international investing include greater
political and economic risk, currency risk, different accounting standards, and
less efficient markets.
OTHER CONSIDERATIONS IN ASSET ALLOCATION
Some of the most important decisions in the asset allocation process occur after
the basic asset class decisions are made. Increasingly, the next step in the process
is not to directly commence an investment manager search but to decide what
portion of the assets should be earmarked for Active vs. Passive management.
Evaluating the advantages and disadvantages of each style can involve many
factors and competing arguments but the choice ultimately comes down to the
chance for added value over a benchmark in an active approach versus a lower
cost, more tax-effective (for non-pension investors) indexing approach (assuming an appropriate index product is available for a particular asset class).
Another frequent issue in asset allocation is rebalancing, or what to do
when the allocation to a particular asset class goes above or below pre-determined ranges as a result of changed market values or other reasons. Factors
that enter into rebalancing decisions include transaction costs, liquidity, risk
tolerance, and taxation (where applicable).
Among the typical disciplines for rebalancing are 1) to do it on a set
schedule but at least annually, or 2) when an allocation is more than 5% away
from its target. An option for retirement systems that do periodic cash flow
investing is to rebalance by investing in the assets with allocations that are currently too low. Another option is for retirement systems to work with their
20
consultants to consider a revision of their asset allocation.
An effective rebalancing program is one that serves not only to reduce as
asset class after an advance but also to buy one on weakness. Asymmetrical
rebalancing is a variation where the allowable upside drift is greater than the
allowable downside drift. For instance, an asymmetric range might let stocks
drift up by 6% above the current range but down by only 3% before a
rebalance is triggered. Using this scheme, holdings of domestic stocks in a
portfolio with a targeted range of 35-45% for this asset class could go as high
as 51% or as low as 32%. Since the average magnitude of equity bull markets
is about twice that of bear markets, this type of strategy would
allow investors to capture more of a bull market before a An effective
rebalancing is triggered but also to take advantage of an asset rebalancing
class’s weakness. program is one
In addition to market-driven events that could lead to a that serves not rebalancing, asset allocation policies must be considered when
an investor’s circumstances change. For individual investors, only to reduce as
revisiting asset allocation would follow changes in lifestyle asset class after an
(children, marriage status, death, etc.) or change in income advance but also (promotion, career change, unemployment, or a major
inheritance), or changes in investment objectives arising from
to buy one on
time to retirement, real estate purchase, or education expense. weakness.
For a pension fund, revised actuarial assumptions are one
of the most likely triggers for asset allocation rebalancing. Also, it might be
reasonable for the risk level assumed by a portfolio to be determined by the
degree of funding; a retirement fund with a large unfunded liability and long
funding period might be justified in an asset allocation dominated by equities
while one that is fully funded or close to it might adopt a more conservative,
income-oriented strategy.
Whatever the methodology used, there are no regulatory obstacles to
rebalancing for Massachusetts retirement systems since PERAC regulations no
longer establish permitted percentage ranges for major investment asset classes.
FUNDAMENTALS
OF ASSET
ALLOCATION
21
SUMMARY
Asset allocation is a practice whose benefits do not enjoy universal intellectual
support among market professionals. Almost every week a new article is published proclaiming the death of traditional asset allocation models. Most
recently, an article in The Wall Street Journal of February 7, 2000 bore the
headline, “Fund Diversification Dies a Not Very Slow Death.” It noted the
Asset allocation
increasing difficulty of financial planners in defending asset
allocation in light of the continuing dominant performance of
can be seen as large cap and technology stocks. While it has been a glorious
market for investors with portfolios concentrated in these hot representing an
areas, it’s been “a bear market for asset allocators” in the words insurance policy of one observer. Yet, this article also noted that asset allocation
actually did fairly well in 1999. Although value stocks continued to badly lag growth stocks, international stocks outperagainst the day
when today’s
formed the S&P 500, emerging markets had a banner year, hottest sector and small cap stocks also beat the large-cap S&P 500.
cools down. A healthy debate will continue over the value of asset
allocation and the best way to implement it. Nevertheless, in
its most basic form, the objective of asset allocation remains one of prudence.
It can be seen as representing an insurance policy against the day when today’s
hottest sector cools down. Forseeing that day is difficult, and the opportunity
costs in investment returns become real and sometimes painful when one
sector such as U.S. large cap growth stocks has been dominant for so long. But
history and logic both tell us that that day will inevitably come.
At its best, asset allocation should not incorporate rigid, inflexible asset ranges
nor should it encourage aggressive, frequent market-timing bets. The most effective
use would emphasize the value of diversification among asset classes but also provide the flexibility to act when markets become clearly overvalued or undervalued.
22
In summary, the goal of asset allocation is to select a combination of assets
that will generate a return sufficiently high but also sufficiently safe in order to
meet a future financial liability. As noted at the beginning of this report, it is
simply an expression of the centuries-old axiom of “don’t put all your eggs in
one basket.” To use an even more comforting analogy, asset allocation is like a
pillow: if one part of the pillow is punched in, another will puff out, and the
benefits of portfolio diversification will provide the investor with steady
enough returns so that he or she can sleep well at night.
In reality, the world’s financial markets—and the relationships among
them—are sufficiently dynamic and constantly changing so that asset
allocation in practice does not conform to simple and cute analogies. Nor does
it lend itself to simply choosing portfolio combinations from a neatly drawn
graphical curve of “efficient portfolios”. Asset allocation remains more an art
than a science since the models and assumptions used are approximations of
the realities of an investment universe that is exceedingly complex and
constantly changing.
THE REAL WORLD
Despite the lingering controversies and the multitude of available optimization
models, there seems to be a surprising degree of uniformity in the typical asset
allocation of public pension funds across the country.
A recent analysis of data submitted by nearly all of the public retirement
systems overseen by PERAC afforded some reasonable estimates of the asset
allocation of these systems at year-end 1998. The composite allocation to
domestic equity is estimated at 47% with a range of between 30% and 65%.
Other estimated asset class holdings were international equity 6%, domestic
fixed income 31%, international fixed income 2%, domestic and international balanced funds 5%, real estate 3%, alternative investments 1%, cash
FUNDAMENTALS
OF ASSET
ALLOCATION
23
and other 5%. Once again, while these figures are reasonable estimates, they
should not be viewed as “official” because of incomplete data and the possibility that some accounts could be incorrectly categorized.
Here are the reported asset allocations of two major public pension funds
as well as an industry composite. Care should be taken in making direct
comparisons among specific asset classes in these plans because of possible
differences in classification methodology.
Mass. Pension Reserves Investment Trust (PRIT) 6-30-99
Domestic Equity 45%
International Equity 16%
Fixed Income 25%
Emerging Markets 4%
Real Estate 6%
Alternative Investments 4%
California Public Employee Retirement System (CALPERS) 10-31-99
Domestic Equity 45%
International Equity 20%
Domestic Fixed Income 22%
International Fixed Income 4%
Real Estate 5%
Alternative Investments 4%
Cash 1%
24
“Pensions & Investments” The largest public defined benefit plans 12-31-99
Domestic Equity 47%
International Equity 14%
Domestic Fixed Income 28%
International Fixed Income 2%
Real Estate 5%
Alternative Investments 2%
Other, cash 2%
FUNDAMENTALS
OF ASSET
ALLOCATION
25
EMPLOYEE
RETIREMENT
ADMINISTR ATION
COMMISSION
DOMESTIC EQUITY
INTERNATIONAL EQUITY
FIXED INCOME
REAL ESTATE
BALANCED
ALTERNATIVE INVESTMENTS
& OTHER
FUNDAMENTALS OF ASSET ALLOCATION
FUNDAMENTALS OF ASSET ALLOCATION
FIRST EDITION | FEBRUARY, 2000
PUBLISHED BY THE PERAC COMMUNICATIONS UNIT
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PRINTED IN THE USA
PUBLIC
EMPLOYEE
RETIREMENT
ADMINISTRATION
COMMISSION
ELIZABETH E. LAING
CHAIRMAN
A . JOSEPH D E NUCCI
VICE CHAIRMAN
JOHN R. ABBOTT
MICHAEL J. DIRRANE
KENNETH J. DONNELLY
DONALD R. MARQUIS
ANDREW S. NATSIOS
JOSEPH E. CONNARTON
EXECUTIVE DIRECTOR
ROBERT A. DENNIS, C.F.A.
INVESTMENT DIRECTOR
CONTENTS
“DON’T PUT ALL YOUR EGGS IN ONE BASKET” 5
HISTORIC RETURNS 7
MARKET TIMING AS A STRATEGY 9
INVESTMENT RISK 1 0
CORRELATION 1 3
OPTIMIZATION 1 4
ON THE OTHER HAND … 1 6
INTERNATIONAL INVESTING 1 7
OTHER CONSIDERATIONS IN ASSET ALLOCATION 2 0
SUMMARY 2 2
THE REAL WORLD 2 3
4
“DON’T PUT ALL YOUR EGGS IN ONE BASKET.”
That timeless proverb not only carries an important message for many aspects
of everyday life but is also the guiding principle behind a successful long-term
investment program.
Indeed, the most important determinant behind success or failure in
investment management is not individual security selection or trading by
investment managers. Research shows that about 90% of the
variance in a portfolio’s investment returns over time is Research
explained by asset allocation, the process of determining the shows that
percentage of portfolio assets allocated to specific asset classes about 90% of
such as stocks, bonds, real estate, venture capital, et al. Asset
allocation has its intellectual roots in the 1950s when econo the variance in
mist Harry Markowitz, who was later awarded the Nobel Prize a portfolio’s
for his work, began developing what became known as mod- investment
ern portfolio theory. returns over The goal of asset allocation is to maximize returns at a
prudent level of risk or to minimize the risk involved in time is explained
achieving a certain return. The process of determining the by asset
appropriate asset allocation involves an analysis not only of allocation. available investment asset classes but also of the liabilities of
an entity such as a retirement system. The needs and preferences of the
investor are the basic building blocks of an asset allocation.
In the case of a pension fund, board members have the exclusive purpose as
fiduciaries to provide benefits for members and survivors through a program of
prudent, expert investing. Their responsibility is to develop an investment program where expected returns meet their system’s projected financial liabilities.
Retirement board members must be sure their actuarial assumptions are sound,
and they must assess the sensitivity of their portfolio to severe market declines
FUNDAMENTALS
OF ASSET
ALLOCATION
5
and whether the portfolio provides sufficient protection against inflation.
The primary goal in constructing a portfolio is that the expected return be
sufficient to satisfy an investor’s financial objectives and be commensurate with
a level of risk that the investor is comfortable with. There are several asset classes, or groups of investment securities whose behavior is similar in response to
changes in economic circumstances, and each class (i.e., stocks) has several
subclasses (large capitalization, midcap, small cap; growth and value). The
major inputs to an asset allocation process are the historical and expected
returns for each distinct asset class or subclasses, the volatility of those returns
over time, and the correlation of returns among the asset classes or subclasses.
Risk means different things to different people. To a bungee jumper, it’s
the possibility that the cord might break. For an investor, risk means the possibility of losing money and not meeting one’s financial objectives. Similarly,
asset allocation is like wearing protective gear in athletics. A competitor might
perform better if not hampered by protective gear, but without it, a blow to an
unprotected part of the body could prove disastrous. Someone investing over
the past few years might conclude that large cap growth stocks are the only
asset class needed for a successful portfolio. Although those stocks have indeed
been by far the best performing asset class in recent years, a prudently constructed portfolio will also have assets in currently underperforming sectors like
bonds, small stocks, and real estate. These sectors currently serve as hedges that
may inhibit maximum performance today but should cushion the portfolio to
some degree when the high-flying growth stocks cool off, as history and logic
tells us they inevitably will.
Thus, an asset allocation process today should properly include a number
of different asset classes. It’s not unusual for one asset class or investment style
to dominate returns for four consecutive years as U.S. large cap growth stocks
recently did (1995-98), but other classes—including small caps, international
stocks, and real estate—have enjoyed similar extended periods of superior performance over the past quarter century. If we examine historical returns of
large U.S. stocks, small U.S. stocks, international stocks, and high grade U.S.
6
bonds over the twenty years through 1998, there was only one year prior to 1995
that large stocks provided the best performance among these four asset classes.
An effective portfolio is not just the sum of its parts but should incorporate
the expected interaction among those parts. Correlation measures the likelihood
that two asset classes will move in the same direction, and selecting asset classes
that have as little correlation with each other as possible should reduce risk and
volatility in a portfolio while helping to achieve expected returns.
A guiding principle of asset allocation is that a portfolio diversified among
asset classes will never match the performance of the best asset class each year
but it will also never equal the worst. The past few years, during which
performance has been concentrated in a select group of U.S. stocks, have
presented a serious challenge to proponents of asset allocation. Nevertheless,
results from 1999 did show some distinct benefits from diversification among
asset classes.
HISTORIC RETURNS
Historical data from 1926-98 compiled by Ibbotson Associates (a firm well
known for its collection and analysis of investment returns) gives the compound annual returns of various classes of domestic stocks and bonds over this
period, including large-cap stocks (11.2%), small cap stocks (11.8%), longterm corporate bonds (5.8%), and long-term government bonds (5.3%). Data
from shorter periods indicates the annual returns from additional classes, such
as international stocks (12.7% since 1970) and real estate (9.0% since 1978).
Stocks have indeed been the best performing asset historically. Over the
ten years ending 1998, the outperformance of stocks over bonds was even
greater than in the above-noted 1926-98 period as the S&P 500 gained 19.2%
annually compared to 9.3% for investment grade bonds. Furthermore, since
1926, the 1930s have been the only decade when bonds (long-term
FUNDAMENTALS
OF ASSET
ALLOCATION
7
governments) outperformed stocks (large or small caps). Returns on stocks are
certainly volatile; more than one quarter of the time since 1926, annual returns
have been negative. (Actually, the same observation holds for long government
bonds although, as will be discussed, the magnitudes of gains and losses for
bonds have been much smaller than those of stocks.)
The advantages of stocks are seen over time; over the 64 overlapping
10-year periods from 1926-98, large cap stock returns were positive 62 times,
and they have been positive for every fifteen-year period over time. Stocks have
outperformed bonds 61% of the time over one-year periods but 92% of the
time over 20-year periods and 99% of the time over 30-year Stocks & periods. Thus, the longer an investor’s time horizon, the more
bonds have both the portfolio should be biased toward equities. The advantages
of equities are even more important after considering taxes performed poorly and inflation. (Taxes, of course, are not a factor in pension in periods of high fund investing.)
inflation & well U.S. stocks clearly have a very favorable and impressive
long-term return record, but one must be cautious when using in periods of low
either the widely-publicized Ibbotson numbers or any other inflation. historic returns as projections for future returns. Of the 54
overlapping 20-year calendar periods since 1926, stocks have returned less than
10% nearly 40% of the time. More ominously, additional research shows that
the best equity market returns were achieved from investments made during
periods when the price-to-earnings ratios were generally within the long-term
historic average range of 14 to g16. Investments made when P/E ratios were 20
or higher (they are at all-time high of close to 30 today) resulted in typical
annual returns of just 5% over the following 10 years. (As explained in the
PERAC investment education presentation, Understanding Investments, the P/E
ratio—a company’s stock price divided by its earnings per share—is one of the
most traditional measures of assessing the value of a stock.)
Some other observations about historical returns include the fact that
stocks and bonds have both performed poorly in periods of high inflation and
8
well in periods of low inflation. Indeed, inflation is one of the worst enemies
of pension funds; during periods of high inflation, pension benefits tend to rise
while investment returns are declining. The effect of business cycles is less
clear; not every stock market downturn has corresponded with an economic
recession and not every recession resulted in poor stock market performance.
MARKET TIMING AS A STRATEGY
Before examining the basic principles of asset allocation, there is an offshoot of
the traditional process called “tactical asset allocation” which involves aggressive
movement in or out of asset classes depending on current perceptions of their
attractiveness. Looking at historical returns, a strategy that favors “tactical”
short-term swings into or out of markets, as opposed to a strategy of disciplined asset allocation, appears unlikely to succeed. In general, investment
strategies that worked in the past often don’t carry into the future. It is difficult
to predict short-term swings in the market and in attempting to do so, market
timers expose the portfolio to additional risk. This is because returns have been
often concentrated in short periods.
Illustrating the concentration of returns, Ibbotson data show that if an
investor had been out of the market during the S&P 500’s 40 best months from
1926 through 1998, he would have a return less than that of Treasury bills. If
one had invested in an instrument replicating the S&P 500 at year-end 1925
and held it through the end of 1998, he would have amassed $2,351. If he had
instead invested in Treasury bills continuously over this period, he would have
had only $15. Pity the hapless market timer who was out of the market during
the S&P’s 40 best months over that time; he would have had only $14!
Adding to the futility—and the substantial risks involved—in trying to
predict market swings is the burden of transaction costs.
FUNDAMENTALS
OF ASSET
ALLOCATION
9
INVESTMENT RISK
Consideration of investment risk is a vital component of the asset allocation
process but it is not the only risk that fiduciaries must be aware of.
Operational risk refers to the possibility that an investment manager will fail
to fulfill its mandate due to violation of guidelines, trading errors, inadequate
risk controls, or outright fraud. Counterparty risk refers to problems that may
Just as arise from irregularities pertaining to a particular exchange,
broker, or other financial intermediary.
combinations of The investment risk of an asset consists of two parts: 1)
Systematic risk, also known as market risk or beta, which risky stocks springs from general economic factors (such as a sharp interest exhibit less risk rate rise) that affects all companies in a similar fashion,
than individual although with different magnitudes, and 2) Unsystematic
risk, which is unique to a particular asset (such as a potential- securities,
ly adverse ruling from a product liability case) and unrelated combinations of to the overall movement of the capital markets.
asset classes can Another way of looking at the different types of risks is to
have less risk than consider systematic risk the market risk that investors are given
and unsystematic risk the active risk that investors take. individual
asset classes. Diversification eliminates unsystematic risk because the
positive and negative results of specific companies within the
portfolio tend to offset one another in a random fashion.
Therefore, portfolios that are not well diversified are subject to increased volatility. Portfolio risk decreases as the number of stocks increases. Portfolios of 30
stocks or more will have most of the unsystematic risk eliminated, particularly if
they are priced in the same range and held in similar amounts. Similarly, just as
combinations of risky stocks exhibit less risk than individual securities,
combinations of asset classes can have less risk than individual asset classes.
10
A traditional way of looking at investment risk is to compare the ranges of
annual asset class returns over time. Those with wider ranges of returns are
considered to have greater volatility. Risk measures the possibility of losing
money and, although both large-cap stocks and government bonds have lost
money on an annual basis almost one quarter of the time since 1926, the magnitude of swings has generally been much greater for stocks. The S&P 500
returned 34.1% in 1995 while long-term bonds have never done better than
the 18.2% registered by Treasuries in 1993. The S&P suffered a 26.5% loss in
1974, while the worst year for bonds has been the 7.8% loss in 1994. In terms
of quarterly performance, the differences are even more dramatic; since 1926,
the worst quarterly return for bonds was –6.4% while that for large stocks was
–37.7% and for small stocks -41.6%. Bonds often serve as a cushion against
steep equity losses, as seen most recently in August 1998 when bonds had a
positive return of 1.5% while stocks plummeted by 14.5%.
There are a number of ways to communicate investment risk. Volatility,
or the uncertainty of an asset’s return, is effective as a relative statistical measure. If an asset’s returns over time are plotted on a graph, the arithmetic mean
is the center of the distribution and the standard deviation (a number derived
from a mathematical formula) measures the spread. If returns have a normal
(bell-shaped) distribution, 68% of all returns are expected to be within plus or
minus one standard deviation of the mean and 95% of all returns are expected
to be within plus or minus two standard deviations of the mean. For example,
using statistics from 36 monthly returns, an investor considers two investments
which both had average monthly returns of 5%. The first, with a standard
deviation of 2%, would have had a typical range of returns (two standard
deviations) over the 36 months of between 1% (5%-4%) and 9% (5%+4%).
The second investment, with a standard deviation of 4% for the same period,
would have experienced more volatile returns, with fluctuations between -3%
(5%-8%) and 13% (5%+8%).
As previously noted, annual returns on large cap stocks have been more
than twice those of long-term government bonds since 1926, but the standard
FUNDAMENTALS
OF ASSET
ALLOCATION
11
deviation of those returns is also more than twice that of bonds. This
significantly greater volatility explains the “risk premium” that investors have
traditionally demanded of stocks relative to bonds.
Data compiled by Ibbotson since 1926 show that both government and
corporate bonds have had standard deviation of returns of about 9% while that
of large cap stocks has been about 20% and that of small cap stocks (which had
returns only slightly higher than those of large caps) was 30%. Looking at the
figure for large caps, this means that with a compound annual return of slightly
over 11% over this period, returns would have been within the range of –9%
(11%-20%) and 31% (11% +20%) two thirds of the time. (Chart One shows
the historical risk and return relationships between stocks and bonds.)
Among other asset classes, intermediate bonds have shown about 60% of
the risk of long-terms, and returns on real estate over the past 20 years indicate
a relatively low standard deviation of about 7%.
The value of stocks as long-term investments is seen in their declining risk
measures over time. The standard deviation of stock returns over a one-year
period is 18% but drops to a very low 2% over 30-year holding periods,
demonstrating that investors who can live with high variability of annual
returns can expect a healthy composite return over long periods with a great
deal of certainty.
After recovering from the Great Depression, annual volatility of large cap
stock returns has changed very little from 1940 to the present. Indeed, the
recent four-year period 1993-96 was the least volatile since 1963-66. On the
other hand, volatility in bonds has increased substantially, first reflecting the
higher inflation of the 1960s and 1970s and then reflecting the Federal
Reserve’s new policy of targeting money supply growth that it adopted in 1979.
12
CORRELATION
The next step in asset allocation is to incorporate a measure of how various
investments are expected to act relative to one another. The traditional input
here is correlation, a measure of the degree to which two series move together.
Correlation ranges from –1, where if one rises in value, the other will fall
(inverse correlation) to +1, where if one rises in value, the other will also (perfect correlation) with 0 representing a totally random relationship. Ideally,
investment portfolios would consist of negatively correlated assets but most
assets exhibit moderately positive correlation. For example, Ibbotson data indicate that government bonds and corporate bonds have a positive correlation of
0.94, German bonds and Japanese stocks have –0.06 (no correlation), and
commodities and small stocks have a negative correlation of -0.40.
Correlation can change over time in reaction to economic or political
events. For example, largely reflecting the Federal Reserve’s changed monetary
policy, the five-year rolling correlation between long-term bonds and large cap
stocks—which was negative between 1956-66—has risen to the 0.30-0.60
range in recent years. The correlations between Spain’s stock market and those
of the European Economic Community have risen from 0.35-0.50 to in excess
of 0.75 since Spain joined the EEC in 1986.
By combining two assets into a portfolio, the expected return is an
arithmetic average of the individual returns but the risk is dependent on the
correlation between the two assets. If the assets are perfectly correlated (+1),
there is no diversification gain and the portfolio risk is the average of those of
the two assets. If the assets are negatively correlated, then all risk can be eliminated. If the assets are not correlated (the most likely case), some risk can be
eliminated by combining them. Thus, the standard deviation of a portfolio
constructed by combining assets that are uncorrelated will typically be lower
than that of either of the component assets.
FUNDAMENTALS
OF ASSET
ALLOCATION
13
History shows that small caps move together with large caps about three
quarters of the time while the corresponding measures relative to large caps are
about two-thirds for foreign equities, about 40% for real estate, and less than
one third for bonds. Thus, bonds are seen as the best diversifying asset relative
to large-cap equities and small caps the least effective in that regard.
OPTIMIZATION
Optimization in asset allocation is creating a portfolio that will achieve a
particular return objective with the least amount of risk or a particular risk
objective with as high a return as possible. An investor can theoretically choose
from portfolios that consist not only of 100% allotments to specific classes
(i.e., stocks) but also every possible combination of these asset classes to make
up a total portfolio (e.g., 40% bonds, 60% stocks). Graphing expected returns
versus standard deviation for each of these combinations, one derives an
“efficient frontier” of “optimal” portfolios that maximize expected return for
each level of risk. Theoretically, adding more asset classes to the process will
extend the frontier higher, producing higher returns for no additional risk.
If one were to construct the above-noted graph with expected investment
returns on the vertical axis and risk on the horizontal axis, this graph would
have an entry for an all-stocks portfolio in the upper right sector (high return,
high risk) of the chart and for all-bonds in the lower left (lower return, lower
risk) of the chart. (The absolute lowest risk, lowest return entry would represent Treasury bills in the far bottom left of the chart.) The practice of asset
allocation, in its most basic depiction, involves drawing a line between the two
extreme points and determining what combination of stocks and bonds strikes
the right balance between an investor’s required return and the level of risk
he/she is comfortable with. In reality, the choice will involve more than just
two broad asset classes because both the stock and bond markets consist of
14
several distinct styles and sectors and there also are the options of investing
internationally as well as in additional asset classes such as real estate. Also, the
“efficient frontier” of optimal asset combinations will typically be graphically
represented by a curve whose points represent greater returns for a given level
of risk than would be found on a straight line connecting the theoretical
all-stocks, all-bonds, or similar points; this portrays the diversification gains
that are achieved by combining asset classes that are not highly correlated.
(Chart Two portrays the construction of a simplified efficient frontier using
stocks and bonds.)
Investment manager Roger Gibson, in a recent book on asset allocation,
analyzed the returns of four major asset classes since 1972 on a year-by-year
basis. Analyzing volatility levels and returns for all possible portfolio combinations (including single asset investments and equally balanced combinations)
using these asset categories, he concluded, “The pattern is clear. The more asset
categories one includes in a portfolio, the higher the … investment’s
risk-adjusted rate of return.”
An important consideration in asset allocation is that, in order to produce
portfolios that will be optimal, not that were optimal, the process of
optimization requires forecasted expected returns, forecasted volatilities, and
forecasted correlations. Historical data can, nevertheless, be very useful in the
process of forecasting.
Many investment consulting firms have optimization software that produce
recommended asset allocations based on modeling of asset class characteristics
and inputs based on client needs and preferences. Confirming that computers
cannot substitute for human judgement, consultants acknowledge that these
optimizers might produce a recommended asset allocation that may appear
extreme in the context of conventional investing practice. Thus, the end result
of an asset allocation process is usually not the output of a predominantly quantitative model but is the result of a process in which the consultant and the
client determine a combination of assets that not only should help the client
achieve his/her goals over time but also satisfies the comfort level of the client.
FUNDAMENTALS
OF ASSET
ALLOCATION
15
ON THE OTHER HAND…
There are some vocal dissenting voices to the theoretical frameworks governing
the search for today’s most efficient portfolios. First of all, some of the
prominent research that inspired today’s basic principles of asset allocation is
questioned. Critics claim that it is wrong to focus on portfolio volatility rather
than portfolio returns and that investors should be more concerned about the
range of likely outcomes over the investment planning horiThey see zon than with the volatility of those returns. Also, the role of
the large risk using largely historical returns to determine fixed allocations is
questioned because historical returns are not necessarily premium reliable indicators of future returns. Indeed, historical returns traditionally could actually be perverse indicators since they are the highest
attached to stocks after market tops. Another complaint is that attributing such a
dominant role to asset allocation in determining portfolio out- relative to bonds
comes serves to unfairly minimize the importance of costs. diminishing. Particularly for individual investors but also for institutional
ones, differences in costs—operating expenses, management
fees, brokerage commissions, custodial fees, et. al.—can play an important role
in portfolio performance over time.
Also, some scholars question the emphasis on the historically far greater
short-term volatility of stocks relative to bonds. They see the large risk
premium traditionally attached to stocks relative to bonds diminishing as the
differential in volatility between the two classes appears to be narrowing in
recent years. For bonds, interest rates have become more volatile in recent years
as the Fed fine tunes monetary policy in order to keep the economy growing at
a sustainable pace. At the same time, stock investors may be perceiving less risk
as a result of better investment education, new tax laws that have lowered
capital gains taxation rates and have encouraged long-term holding in IRA
16
accounts, better governmental monetary and fiscal policy, less governmental
economic regulation, and diminished foreign threats which give hope to an
extended period of peace. As the historic bull market of the past decade has
dramatically driven home the fact that stocks do outperform bonds over time,
the “risk premium”, or extra return demanded by investors to compensate for
the fact that stock returns are considerably more volatile than those of bonds,
may be declining.
INTERNATIONAL INVESTING The breakdown
of trade barriers
One of the most contentious areas of debate concerns the value and advances in
of international diversification. By placing a portion of assets in communications
markets thought to be not correlated with the U.S. market, can technology have an investor really reduce the volatility of the portfolio while
maintaining and sometimes increasing returns? The world’s meant that
markets, particularly those of the developed countries, seem to previously
be moving more in the same direction (if not in the same mag- independent nitude) in recent years. As investors in the fallen hedge fund
Long-Term Capital Management painfully learned in August economies are
1998, diversification won’t dampen volatility when global becoming more
markets move together. Looking at one important recent correlated to
development, the monetary union in Europe that began in
our own. 1999 will likely further the trend of making the characteristics
of —and the returns from—markets on that continent
increasingly similar.
The debate over the benefits of international diversification won’t be
resolved anytime soon, but it may indeed turn out that the benefits from that
strategy may be overestimated because of the slow but steady trend towards an
increasingly homogenized global economy. The breakdown of trade barriers
FUNDAMENTALS
OF ASSET
ALLOCATION
17
and advances in communications technology have meant that previously
independent economies are becoming more correlated to our own.
Certainly, there is no other major economy that has been firing on all
cylinders like the U.S. over the past several years, a fact that has been reflected
in our booming stock market. No other country is at the forefront of the
technological revolution and also enjoys sound and stable economic and
political leadership. The trouble with this argument against international
diversification is that ten years ago investors were similarly drooling over Japan
as the world’s invincible economy. Until a turnaround in 1999, after several
years of stalled economic growth and failed political leadership, Japan’s
economic and financial market performance turned out to be nothing short of
disastrous during the 1990s.
Furthermore, the U.S. recently entered the tenth year of an economic
expansion, with joblessness at a 30-year low, and a stock market that has been
rising steadily and is valued at historic highs according to most traditional
measures. By contrast, Europe and Asia are several years behind in the growth
boom and generally have much more capacity to expand, as seen in much higher unemployment rates and other measures. The U.S. has spent the past ten
years merging, restructuring, and deregulating as well as transforming itself into
an information economy, while Europe has made only about half the strides as
the U.S. and Asia (particularly Japan) is just beginning. Investors in foreign
equity markets were generally well rewarded relative to U.S. stocks in 1999.
Aside from the economic arguments, analysis by Ibbotson Associates
shows that the addition of international stocks to a simple portfolio of U.S.
stocks, bonds, and cash slightly improves the risk/return tradeoff; that is, it
slightly raises the frontier of efficient portfolios offering modestly better returns
for a given level of risk. Looking at dollar-denominated returns over 1970-98
for the countries in the Morgan Stanley Europe Australasia Far East (EAFE)
Index, the composite annual return was found to be 12.5% vs. 13.0% for the
U.S. while the standard deviation was 19.2% compared to 17.3% for the U.S.
A good number of the individual countries in EAFE had compound annual
18
returns higher than that of the U.S., including Ireland (19.5%), Hong Kong
(18.8%), and the Netherlands (17.1%). Every country, however, exhibited
greater volatility than the U.S., particularly Hong Kong (51.8%), South Africa
(41.6%), and Norway (31.3%).
The major reason justifying the use of international stocks is the fact that
many non-U.S. stocks have relatively low correlation with U.S. stocks as well
as with each other. Nearly every developed country has a historical correlation
of less than 0.50 versus the U.S., with the exception of Canada, whose correlation of 0.73 reflects its strong economic ties to the U.S.
In response to those who say that increased economic globalization has
lessened the value of international investing, Ibbotson research indicates that
international equity correlations with the U.S. over the ten-year period 1989
98 were only slightly higher than those for the period 1979-88, but the trend
is surely upward.
Historical data on emerging market stocks has been compiled since 1985,
and, through 1998, the record has not been very compelling. These markets do
have low correlation with the U.S., but the compound annual returns of 19
countries in Asia, Latin America, and elsewhere were only half that of the U.S.
while their composite standard deviation was 50% higher than that of the U.S.
A number of countries, including The Phillippines, Chile, Columbia,
Argentina, and Mexico did post superior dollar-denominated returns but
several had volatilities that have been truly staggering, such as Argentina
(175%), Brazil (105%), and Turkey (103%).
As previously noted, however, asset allocation involves not just historical
analyses but utilizes projections of future returns, volatilities, and correlations.
If one adopts a more optimistic case for performance of emerging markets,
then the addition of international and emerging markets stocks to a traditional
U.S. portfolio could significantly improve the risk/return tradeoff.
In a non-quantitative context, it is undeniable that the global economy is
becoming more developed and that international investing is justified by the
simple observation that the U.S. share of the world economic product has been
FUNDAMENTALS
OF ASSET
ALLOCATION
19
steadily declining and that an increasing number of the world’s most important
corporations are based overseas. Similar to restricting one’s portfolio to a
particular industry or style, limiting one’s investments to a particular region or
country serves to severely constrict one’s opportunities in today’s world economy. On the other hand, disadvantages of international investing include greater
political and economic risk, currency risk, different accounting standards, and
less efficient markets.
OTHER CONSIDERATIONS IN ASSET ALLOCATION
Some of the most important decisions in the asset allocation process occur after
the basic asset class decisions are made. Increasingly, the next step in the process
is not to directly commence an investment manager search but to decide what
portion of the assets should be earmarked for Active vs. Passive management.
Evaluating the advantages and disadvantages of each style can involve many
factors and competing arguments but the choice ultimately comes down to the
chance for added value over a benchmark in an active approach versus a lower
cost, more tax-effective (for non-pension investors) indexing approach (assuming an appropriate index product is available for a particular asset class).
Another frequent issue in asset allocation is rebalancing, or what to do
when the allocation to a particular asset class goes above or below pre-determined ranges as a result of changed market values or other reasons. Factors
that enter into rebalancing decisions include transaction costs, liquidity, risk
tolerance, and taxation (where applicable).
Among the typical disciplines for rebalancing are 1) to do it on a set
schedule but at least annually, or 2) when an allocation is more than 5% away
from its target. An option for retirement systems that do periodic cash flow
investing is to rebalance by investing in the assets with allocations that are currently too low. Another option is for retirement systems to work with their
20
consultants to consider a revision of their asset allocation.
An effective rebalancing program is one that serves not only to reduce as
asset class after an advance but also to buy one on weakness. Asymmetrical
rebalancing is a variation where the allowable upside drift is greater than the
allowable downside drift. For instance, an asymmetric range might let stocks
drift up by 6% above the current range but down by only 3% before a
rebalance is triggered. Using this scheme, holdings of domestic stocks in a
portfolio with a targeted range of 35-45% for this asset class could go as high
as 51% or as low as 32%. Since the average magnitude of equity bull markets
is about twice that of bear markets, this type of strategy would
allow investors to capture more of a bull market before a An effective
rebalancing is triggered but also to take advantage of an asset rebalancing
class’s weakness. program is one
In addition to market-driven events that could lead to a that serves not rebalancing, asset allocation policies must be considered when
an investor’s circumstances change. For individual investors, only to reduce as
revisiting asset allocation would follow changes in lifestyle asset class after an
(children, marriage status, death, etc.) or change in income advance but also (promotion, career change, unemployment, or a major
inheritance), or changes in investment objectives arising from
to buy one on
time to retirement, real estate purchase, or education expense. weakness.
For a pension fund, revised actuarial assumptions are one
of the most likely triggers for asset allocation rebalancing. Also, it might be
reasonable for the risk level assumed by a portfolio to be determined by the
degree of funding; a retirement fund with a large unfunded liability and long
funding period might be justified in an asset allocation dominated by equities
while one that is fully funded or close to it might adopt a more conservative,
income-oriented strategy.
Whatever the methodology used, there are no regulatory obstacles to
rebalancing for Massachusetts retirement systems since PERAC regulations no
longer establish permitted percentage ranges for major investment asset classes.
FUNDAMENTALS
OF ASSET
ALLOCATION
21
SUMMARY
Asset allocation is a practice whose benefits do not enjoy universal intellectual
support among market professionals. Almost every week a new article is published proclaiming the death of traditional asset allocation models. Most
recently, an article in The Wall Street Journal of February 7, 2000 bore the
headline, “Fund Diversification Dies a Not Very Slow Death.” It noted the
Asset allocation
increasing difficulty of financial planners in defending asset
allocation in light of the continuing dominant performance of
can be seen as large cap and technology stocks. While it has been a glorious
market for investors with portfolios concentrated in these hot representing an
areas, it’s been “a bear market for asset allocators” in the words insurance policy of one observer. Yet, this article also noted that asset allocation
actually did fairly well in 1999. Although value stocks continued to badly lag growth stocks, international stocks outperagainst the day
when today’s
formed the S&P 500, emerging markets had a banner year, hottest sector and small cap stocks also beat the large-cap S&P 500.
cools down. A healthy debate will continue over the value of asset
allocation and the best way to implement it. Nevertheless, in
its most basic form, the objective of asset allocation remains one of prudence.
It can be seen as representing an insurance policy against the day when today’s
hottest sector cools down. Forseeing that day is difficult, and the opportunity
costs in investment returns become real and sometimes painful when one
sector such as U.S. large cap growth stocks has been dominant for so long. But
history and logic both tell us that that day will inevitably come.
At its best, asset allocation should not incorporate rigid, inflexible asset ranges
nor should it encourage aggressive, frequent market-timing bets. The most effective
use would emphasize the value of diversification among asset classes but also provide the flexibility to act when markets become clearly overvalued or undervalued.
22
In summary, the goal of asset allocation is to select a combination of assets
that will generate a return sufficiently high but also sufficiently safe in order to
meet a future financial liability. As noted at the beginning of this report, it is
simply an expression of the centuries-old axiom of “don’t put all your eggs in
one basket.” To use an even more comforting analogy, asset allocation is like a
pillow: if one part of the pillow is punched in, another will puff out, and the
benefits of portfolio diversification will provide the investor with steady
enough returns so that he or she can sleep well at night.
In reality, the world’s financial markets—and the relationships among
them—are sufficiently dynamic and constantly changing so that asset
allocation in practice does not conform to simple and cute analogies. Nor does
it lend itself to simply choosing portfolio combinations from a neatly drawn
graphical curve of “efficient portfolios”. Asset allocation remains more an art
than a science since the models and assumptions used are approximations of
the realities of an investment universe that is exceedingly complex and
constantly changing.
THE REAL WORLD
Despite the lingering controversies and the multitude of available optimization
models, there seems to be a surprising degree of uniformity in the typical asset
allocation of public pension funds across the country.
A recent analysis of data submitted by nearly all of the public retirement
systems overseen by PERAC afforded some reasonable estimates of the asset
allocation of these systems at year-end 1998. The composite allocation to
domestic equity is estimated at 47% with a range of between 30% and 65%.
Other estimated asset class holdings were international equity 6%, domestic
fixed income 31%, international fixed income 2%, domestic and international balanced funds 5%, real estate 3%, alternative investments 1%, cash
FUNDAMENTALS
OF ASSET
ALLOCATION
23
and other 5%. Once again, while these figures are reasonable estimates, they
should not be viewed as “official” because of incomplete data and the possibility that some accounts could be incorrectly categorized.
Here are the reported asset allocations of two major public pension funds
as well as an industry composite. Care should be taken in making direct
comparisons among specific asset classes in these plans because of possible
differences in classification methodology.
Mass. Pension Reserves Investment Trust (PRIT) 6-30-99
Domestic Equity 45%
International Equity 16%
Fixed Income 25%
Emerging Markets 4%
Real Estate 6%
Alternative Investments 4%
California Public Employee Retirement System (CALPERS) 10-31-99
Domestic Equity 45%
International Equity 20%
Domestic Fixed Income 22%
International Fixed Income 4%
Real Estate 5%
Alternative Investments 4%
Cash 1%
24
“Pensions & Investments” The largest public defined benefit plans 12-31-99
Domestic Equity 47%
International Equity 14%
Domestic Fixed Income 28%
International Fixed Income 2%
Real Estate 5%
Alternative Investments 2%
Other, cash 2%
FUNDAMENTALS
OF ASSET
ALLOCATION
25
Norwood
March 21, 2024
Compliance Overview
John Galvin | Compliance Officer | PERAC
Table of Contents
§ Overview of Chapter 32, Section 23B which governs Board
procurement of actuarial, investment, accounting, and legal
services
§ Contents of a Request for Proposal (“RFP”)
§ 5th Member Posting requirements
§ Board & Staff Updates / PROSPER
§ Board Members Annual Filings and Education
2
Section 23B
§ Enacted by Chapter 176 of the Acts of 2011
§ Established an open and competitive procurement process to be followed
by boards when soliciting investment, actuarial, legal, or accounting services
§ The Board must maintain a procurement file for every investment, legal,
actuarial and accounting service contract
§ All written procurement documents must be retained by the retirement
board for six years from the final payment of the contract
§ No contract can exceed a term of 7 years, including any renewal or
extension, the Board must go back out to bid
3
Required Board Actions for Proper Procurement
Pursuant to Section 23B
4
§ Notice of RFP posting
§ RFP issuance
§ Register of bids from opening of proposals
§ Written initial evaluation of proposals
§ Interviews
§ Written determination of most advantageous proposal
Required Board Actions for Proper Procurement
Pursuant to Section 23B (Cont’d)
5
§ Awarded service contracts
§ Vendor and Retirement Board certification forms
§ Disclosures by investment vendors
§ Placement agent statement
§ PERAC Acknowledgement
§ Actual written contract with mandatory terms and conditions
Content of Notice of RFP Posting
§ PERAC posts these notices on our website
§ Notice must contain the terms and deadline for RFP bid period
§ Type of service must be on the notice
§ Evidence of minimum two week posting in a publication of
interest of those who may respond
§ Notice in a publication established by the Massachusetts
Secretary of State for the advertisement of such procurements
6
Request for Proposal (“RFP”) Requirements
§ Specific date, location and time for receipt of advertised proposal
§ Include description of service purchased desired
§ Evaluation criteria for the basis of the contract award
§ All contractual terms and conditions
§ Notice that retirement board has the right to cancel or reject in
whole or part any or all proposals in the best interest of the
retirement system
7
Board’s Written Evaluation of Proposals
§ Each proposal to be rated in written format based solely on the
criteria established in RFP
§ Such written ratings should be based on same rating criteria
using the following standards:
• Highly advantageous
• Advantageous
• Not Advantageous
• Not Acceptable
8
Board’s Written Evaluation of Proposals (Cont’d)
§ If such evaluation is done by a consultant, each submission of
review with each retirement board member should take place and
be documented
§ Evaluation must be completed prior to interviewing process
§ The Board will determine the most advantageous proposal taking
into consideration price and the evaluation criteria set forth in the
RFP
9
PERAC’s Acknowledgment
§ Upon determination of the Most Advantageous Proposal, the
retirement board must submit all RFP required documents to
PERAC for review.
§ PERAC acknowledges the receipt of the RFP documents and then
has 10 days to review and either issue an acknowledgement or
put the procurement “under review”
10
PERAC’s Acknowledgment (Cont’d)
§ It is the responsibility of each retirement board to assure that all
investments are made in a prudent and responsible manner
consistent with the retirement board’s fiduciary responsibility and
in accordance with the statutory changes made by Chapter 176
of the Acts of 2011.
§ In providing the acknowledgement, PERAC does not pass
judgement on the fiduciary propriety of an allocation, investment
or investment manager. Our focus is on the procurement process
and its compliance with Section 23B.
11
What Does the Compliance Unit See on PROSPER?
§ Business and Contact Info
§ Forms Checklist
• Vendor Certification
• Vendor Disclosure
• Vendor Contact Information
• Placement Agent Statement
• Retirement Board Evaluation
§ Board member signatures
12
What Does the Compliance Unit See on PROSPER? (Cont’d)
§ Board submits the procurement documents through PROSPER
§ PERAC has 10 days to review
§ Procurement can either by acknowledged or put under review if
further documents or information is required
13
Board 5th Member
§ In a city or town, the fifth member shall not be an employee, a retiree, or
official of the governmental unit and shall be chosen by the other four
retirement board members for a three-year term
§ If the fifth member is not chosen by the four within 30 days after the
expiration of the term of the fifth member, said member shall be appointed
in a city by mayor subject to confirmation of city council or in a town by the
board of selectman
• Local option: PERAC choses the fifth member
§ In a county, the fifth member shall be elected by majority of the county
retirement board advisory council at a public meeting of said council
14
Updating Board Member Info & PROSPER
§ Retirement Board Change Form
§ PROSPER Application
15
Annual Filings
§ Term Pledge
• Pledge
• Conduct of Public Officials and Employees
• Retirement Systems and Pensions
• Fiduciary Standards
16
Annual Filings (Cont’d)
§ Annual Eligibility Certification
§ Statement of Financial Interest
• Retirement Board Member SFI
• 268B Filer
• SFI Online Submission
17
Board Member Education
§ G.L. c. 32, Section 20(7)
§ 18 credits over the course of 3-year term
§ At least 3 credits in each year, no more than 9 credits per year
18
Board Member Education (Cont’d)
§ G.L. c. 32, Section 20(7)
• Education Memo issued quarterly
• Language in PROSPER will read:
Minimum Credits Met.
OR
Credits Needed. Please refer to the courses offered under Education
Registrations.
19
Questions?
§ My email: John.P.Galvin@mass.gov
§ Feel free to reach out with compliance questions, procurement,
education, or general questions — happy to help!
20
March 21, 2024
Compliance Overview
John Galvin | Compliance Officer | PERAC
Table of Contents
§ Overview of Chapter 32, Section 23B which governs Board
procurement of actuarial, investment, accounting, and legal
services
§ Contents of a Request for Proposal (“RFP”)
§ 5th Member Posting requirements
§ Board & Staff Updates / PROSPER
§ Board Members Annual Filings and Education
2
Section 23B
§ Enacted by Chapter 176 of the Acts of 2011
§ Established an open and competitive procurement process to be followed
by boards when soliciting investment, actuarial, legal, or accounting services
§ The Board must maintain a procurement file for every investment, legal,
actuarial and accounting service contract
§ All written procurement documents must be retained by the retirement
board for six years from the final payment of the contract
§ No contract can exceed a term of 7 years, including any renewal or
extension, the Board must go back out to bid
3
Required Board Actions for Proper Procurement
Pursuant to Section 23B
4
§ Notice of RFP posting
§ RFP issuance
§ Register of bids from opening of proposals
§ Written initial evaluation of proposals
§ Interviews
§ Written determination of most advantageous proposal
Required Board Actions for Proper Procurement
Pursuant to Section 23B (Cont’d)
5
§ Awarded service contracts
§ Vendor and Retirement Board certification forms
§ Disclosures by investment vendors
§ Placement agent statement
§ PERAC Acknowledgement
§ Actual written contract with mandatory terms and conditions
Content of Notice of RFP Posting
§ PERAC posts these notices on our website
§ Notice must contain the terms and deadline for RFP bid period
§ Type of service must be on the notice
§ Evidence of minimum two week posting in a publication of
interest of those who may respond
§ Notice in a publication established by the Massachusetts
Secretary of State for the advertisement of such procurements
6
Request for Proposal (“RFP”) Requirements
§ Specific date, location and time for receipt of advertised proposal
§ Include description of service purchased desired
§ Evaluation criteria for the basis of the contract award
§ All contractual terms and conditions
§ Notice that retirement board has the right to cancel or reject in
whole or part any or all proposals in the best interest of the
retirement system
7
Board’s Written Evaluation of Proposals
§ Each proposal to be rated in written format based solely on the
criteria established in RFP
§ Such written ratings should be based on same rating criteria
using the following standards:
• Highly advantageous
• Advantageous
• Not Advantageous
• Not Acceptable
8
Board’s Written Evaluation of Proposals (Cont’d)
§ If such evaluation is done by a consultant, each submission of
review with each retirement board member should take place and
be documented
§ Evaluation must be completed prior to interviewing process
§ The Board will determine the most advantageous proposal taking
into consideration price and the evaluation criteria set forth in the
RFP
9
PERAC’s Acknowledgment
§ Upon determination of the Most Advantageous Proposal, the
retirement board must submit all RFP required documents to
PERAC for review.
§ PERAC acknowledges the receipt of the RFP documents and then
has 10 days to review and either issue an acknowledgement or
put the procurement “under review”
10
PERAC’s Acknowledgment (Cont’d)
§ It is the responsibility of each retirement board to assure that all
investments are made in a prudent and responsible manner
consistent with the retirement board’s fiduciary responsibility and
in accordance with the statutory changes made by Chapter 176
of the Acts of 2011.
§ In providing the acknowledgement, PERAC does not pass
judgement on the fiduciary propriety of an allocation, investment
or investment manager. Our focus is on the procurement process
and its compliance with Section 23B.
11
What Does the Compliance Unit See on PROSPER?
§ Business and Contact Info
§ Forms Checklist
• Vendor Certification
• Vendor Disclosure
• Vendor Contact Information
• Placement Agent Statement
• Retirement Board Evaluation
§ Board member signatures
12
What Does the Compliance Unit See on PROSPER? (Cont’d)
§ Board submits the procurement documents through PROSPER
§ PERAC has 10 days to review
§ Procurement can either by acknowledged or put under review if
further documents or information is required
13
Board 5th Member
§ In a city or town, the fifth member shall not be an employee, a retiree, or
official of the governmental unit and shall be chosen by the other four
retirement board members for a three-year term
§ If the fifth member is not chosen by the four within 30 days after the
expiration of the term of the fifth member, said member shall be appointed
in a city by mayor subject to confirmation of city council or in a town by the
board of selectman
• Local option: PERAC choses the fifth member
§ In a county, the fifth member shall be elected by majority of the county
retirement board advisory council at a public meeting of said council
14
Updating Board Member Info & PROSPER
§ Retirement Board Change Form
§ PROSPER Application
15
Annual Filings
§ Term Pledge
• Pledge
• Conduct of Public Officials and Employees
• Retirement Systems and Pensions
• Fiduciary Standards
16
Annual Filings (Cont’d)
§ Annual Eligibility Certification
§ Statement of Financial Interest
• Retirement Board Member SFI
• 268B Filer
• SFI Online Submission
17
Board Member Education
§ G.L. c. 32, Section 20(7)
§ 18 credits over the course of 3-year term
§ At least 3 credits in each year, no more than 9 credits per year
18
Board Member Education (Cont’d)
§ G.L. c. 32, Section 20(7)
• Education Memo issued quarterly
• Language in PROSPER will read:
Minimum Credits Met.
OR
Credits Needed. Please refer to the courses offered under Education
Registrations.
19
Questions?
§ My email: John.P.Galvin@mass.gov
§ Feel free to reach out with compliance questions, procurement,
education, or general questions — happy to help!
20
Compliance Overview
John Galvin, Compliance Manager | PERAC
FALL MACRS CONFERENCE | DECEMBER 11, 2024
Table of Contents
▪ Fiduciary Responsibility Of Retirement Board Members and Staff
▪ Board Members Education
▪ Board Members Filings
▪ Overview of Chapter 32, Section 23B
▪ Cybersecurity
2
What Makes a Person a Fiduciary?
▪ Actual exercise of discretion and control over plan assets.
• Investments
• Purchasing decisions for goods and services
▪ Failure to be involved or to take discretionary actions does not change
status as fiduciary.
• Cannot delegate away fiduciary status
• Even if delegate activities, still a fiduciary
3
What are the Special Duties of Fiduciaries?
▪ Impartiality - fairness to all members and beneficiaries.
▪ Avoid Conflicts.
▪ Comply with retirement laws and regulations and other applicable laws.
▪ Expend system assets reasonably and properly.
▪ Collect contributions timely and correctly.
▪ Hire and monitor competent staff and necessary experts/specialists.
4
To Whom Do Fiduciaries Owe a Duty?
▪ Duty owed solely to the members and beneficiaries of the system.
• This means current and future beneficiaries.
• Not the people who elected them or appointed them.
• Not the “taxpayers”.
• Social and political agendas must mesh with the duty to act for the sole
interest of the members and beneficiaries.
5
What Standard Must a Fiduciary Meet?
▪ Loyalty: Must exercise the highest and undivided loyalty to the trust.
▪ Prudence: Must exercise the skill, care, and diligence under the
current circumstances that a person acting in a like capacity and
familiarity with such matters would use in the conduct of an
enterprise of like character and with like aims –
“the prudent expert”.
6
What Does a Fiduciary Have to Do To Meet This Standard?
▪ Be vigilant and have strong awareness.
▪ Become and remain knowledgeable.
▪ Take advantage of education and training opportunities.
▪ Establish and follow processes and procedures for decision making.
7
What are Co-Fiduciaries and What Responsibility Does One
Have for the Acts of Another?
▪ Co-fiduciaries are other plan fiduciaries such as board members, staff, and
advisors.
▪ A co-fiduciary who knows of another fiduciary's breach of duty and fails to try to
prevent this breach can be held liable for losses.
• Exception: You have to know of the breach.
• Exception to the Exception: Should you have reasonably known of the breach?
▪ Failure to monitor co-fiduciaries may be a breach of fiduciary duty.
▪ Duty to be informed, involved and to try to prevent a breach.
8
Board Member Education
▪ G.L. c. 32, Section 20(7)
• 18 credits over the course of 3-year term
• At least 3 credits in each year
• Education Memo issued quarterly
• Language in PROSPER will read:
Minimum Credits Met.
OR
Credits Needed. Please refer to the courses offered under Education Registrations.
9
Board Members Filings
▪ Term Pledge
▪ Pledge
• Conduct of Public Officials and Employees
• Fiduciary Standards for Retirement Systems
10
Board Members Filings (Cont’d)
▪ Annual Eligibility Certification
• Old Form
11
Board Members Filings (Cont’d)
▪ Statement of Financial Interest
• Retirement Board Member SFI
• 268B Filer
• SFI Online Submission
12
Section 23B
▪ Under Chapter 32, Section 23(3) board members, as fiduciaries, must meet the
standard of a prudent expert in taking all actions related to procurement and
contracting.
▪ Established an open and competitive procurement process to be followed by
boards when soliciting investment, actuarial, legal, or accounting services
▪ A competitive process which meets that fiduciary duty must be followed in all
instances.
13
Content of Notice of RFP Posting
▪ Type of service must be on the notice
▪ Evidence of minimum two week posting in a publication of interest of
those who may respond
▪ Notice in a publication established by the Massachusetts Secretary of State
for the advertisement of such procurements
• Goods and Services Bulletin
▪ PERAC posts these notices on our website
14
Request for Proposal (“RFP”) Requirements
▪ Notice must contain the terms and deadline for RFP bid period
▪ Evaluation criteria for the basis of the contract award
▪ All contractual terms and conditions
▪ Request separate, sealed price and non-price proposals
15
Opening of Bids
▪ Not required to be a public meeting but the signature of a witness or witnesses
are needed. At least one witness is required to be at the opening of sealed bids.
▪ A register of all proposals received must be documented.
▪ The place, time and date proposals are opened must be documented.
▪ Written notice of any submitted modifications or revisions
to filed bids.
▪ A written affidavit should be used to document the requirements for the
opening of bids.
16
Retirement Board Initial Evaluation
▪ Each proposal to be rated in written format based solely on the criteria established in RFP.
▪ Ratings should be based on some rating criteria using the standards:
1) Highly Advantageous
2) Advantageous
3) Not Advantageous
4) Or Not Acceptable
If evaluation is done by consultant, each submission of review with each Retirement Board member
should take place and be documented.
▪ No sub-committees.
▪ Evaluation must be completed prior to interviewing process
▪ The Board will determine the most advantageous proposal taking into consideration price and
the evaluation criteria set forth in the RFP
17
Interviews
▪ Following the initial evaluation, the Retirement Board must
determine which applicants should be interviewed by the entire
Retirement Board (no sub-committees).
▪ Number of applicants to be interviewed dependent on two factors:
• Rankings
• Number of Applicants
▪ Time to negotiate price, discuss track record, specific concerns.
18
Written Determination Of Most Advantageous Proposal
▪ Based on price and evaluation criteria set forth in the RFP.
▪ Award is to be made in writing within the time specified in the RFP.
▪ Award may be conditioned on negotiated items.
▪ If negotiations result in a decision not to award contract to “Most
Advantageous”, the Retirement Board may negotiate with the “next Most
Advantageous” vendor and should document the need for such further
negotiations.
▪ Investment service RFP to also include certain mandatory terms and conditions.
19
Mandatory Terms and Conditions
▪ Statement that vendor is a fiduciary of such fund.
▪ Statement that vendor is not to be indemnified by the retirement
system.
▪ Vendor to submit disclosure forms to PERAC and Retirement Board
detailing compensation for services.
▪ Disclosure by vendor to PERAC of any conflict of interest.
20
Vendor and Retirement Board Member Certification Forms
▪ Any person submitting a RFP for a service contract must certify
in writing, under the penalties of perjury, that the proposals were
submitted in “good faith” and without collusion or fraud.
▪ Same requirement for each Retirement Board member to certify
that proposals are submitted in “good faith” and without collusion
or fraud.
21
PERAC’s Acknowledgment
▪ Upon determination of the Most Advantageous Proposal, the retirement board
must submit all RFP required documents to PERAC for review.
▪ PERAC acknowledges the receipt of the RFP documents and then has 10 days
to review and either issue an acknowledgement or put the procurement
“under review”
▪ In providing the acknowledgement, PERAC does not pass judgement on the
quality of the vendor. Our focus is on the procurement process and its
compliance with Section 23B.
22
Awarded Service Contracts
▪ No contract is valid without PERAC acknowledgement.
▪ Each awarded contract must be executed in writing.
▪ No payment for service rendered prior to execution
of the contract.
▪ No contract shall exceed a term of seven years, including any
renewal, extension or option.
▪ Exceptions to the seven-year term are any limited investment
partnership or trust.
23
Cybersecurity
▪ Cybersecurity Framework
• Identify
• Protect
• Detect
• Respond
• Recover/Post-Incident Activities
24
Questions?
▪ My email: John.P.Galvin@mass.gov
▪ Feel free to reach out with compliance questions, procurement,
education, or general questions — happy to help!
John Galvin, Compliance Manager | PERAC
FALL MACRS CONFERENCE | DECEMBER 11, 2024
Table of Contents
▪ Fiduciary Responsibility Of Retirement Board Members and Staff
▪ Board Members Education
▪ Board Members Filings
▪ Overview of Chapter 32, Section 23B
▪ Cybersecurity
2
What Makes a Person a Fiduciary?
▪ Actual exercise of discretion and control over plan assets.
• Investments
• Purchasing decisions for goods and services
▪ Failure to be involved or to take discretionary actions does not change
status as fiduciary.
• Cannot delegate away fiduciary status
• Even if delegate activities, still a fiduciary
3
What are the Special Duties of Fiduciaries?
▪ Impartiality - fairness to all members and beneficiaries.
▪ Avoid Conflicts.
▪ Comply with retirement laws and regulations and other applicable laws.
▪ Expend system assets reasonably and properly.
▪ Collect contributions timely and correctly.
▪ Hire and monitor competent staff and necessary experts/specialists.
4
To Whom Do Fiduciaries Owe a Duty?
▪ Duty owed solely to the members and beneficiaries of the system.
• This means current and future beneficiaries.
• Not the people who elected them or appointed them.
• Not the “taxpayers”.
• Social and political agendas must mesh with the duty to act for the sole
interest of the members and beneficiaries.
5
What Standard Must a Fiduciary Meet?
▪ Loyalty: Must exercise the highest and undivided loyalty to the trust.
▪ Prudence: Must exercise the skill, care, and diligence under the
current circumstances that a person acting in a like capacity and
familiarity with such matters would use in the conduct of an
enterprise of like character and with like aims –
“the prudent expert”.
6
What Does a Fiduciary Have to Do To Meet This Standard?
▪ Be vigilant and have strong awareness.
▪ Become and remain knowledgeable.
▪ Take advantage of education and training opportunities.
▪ Establish and follow processes and procedures for decision making.
7
What are Co-Fiduciaries and What Responsibility Does One
Have for the Acts of Another?
▪ Co-fiduciaries are other plan fiduciaries such as board members, staff, and
advisors.
▪ A co-fiduciary who knows of another fiduciary's breach of duty and fails to try to
prevent this breach can be held liable for losses.
• Exception: You have to know of the breach.
• Exception to the Exception: Should you have reasonably known of the breach?
▪ Failure to monitor co-fiduciaries may be a breach of fiduciary duty.
▪ Duty to be informed, involved and to try to prevent a breach.
8
Board Member Education
▪ G.L. c. 32, Section 20(7)
• 18 credits over the course of 3-year term
• At least 3 credits in each year
• Education Memo issued quarterly
• Language in PROSPER will read:
Minimum Credits Met.
OR
Credits Needed. Please refer to the courses offered under Education Registrations.
9
Board Members Filings
▪ Term Pledge
▪ Pledge
• Conduct of Public Officials and Employees
• Fiduciary Standards for Retirement Systems
10
Board Members Filings (Cont’d)
▪ Annual Eligibility Certification
• Old Form
11
Board Members Filings (Cont’d)
▪ Statement of Financial Interest
• Retirement Board Member SFI
• 268B Filer
• SFI Online Submission
12
Section 23B
▪ Under Chapter 32, Section 23(3) board members, as fiduciaries, must meet the
standard of a prudent expert in taking all actions related to procurement and
contracting.
▪ Established an open and competitive procurement process to be followed by
boards when soliciting investment, actuarial, legal, or accounting services
▪ A competitive process which meets that fiduciary duty must be followed in all
instances.
13
Content of Notice of RFP Posting
▪ Type of service must be on the notice
▪ Evidence of minimum two week posting in a publication of interest of
those who may respond
▪ Notice in a publication established by the Massachusetts Secretary of State
for the advertisement of such procurements
• Goods and Services Bulletin
▪ PERAC posts these notices on our website
14
Request for Proposal (“RFP”) Requirements
▪ Notice must contain the terms and deadline for RFP bid period
▪ Evaluation criteria for the basis of the contract award
▪ All contractual terms and conditions
▪ Request separate, sealed price and non-price proposals
15
Opening of Bids
▪ Not required to be a public meeting but the signature of a witness or witnesses
are needed. At least one witness is required to be at the opening of sealed bids.
▪ A register of all proposals received must be documented.
▪ The place, time and date proposals are opened must be documented.
▪ Written notice of any submitted modifications or revisions
to filed bids.
▪ A written affidavit should be used to document the requirements for the
opening of bids.
16
Retirement Board Initial Evaluation
▪ Each proposal to be rated in written format based solely on the criteria established in RFP.
▪ Ratings should be based on some rating criteria using the standards:
1) Highly Advantageous
2) Advantageous
3) Not Advantageous
4) Or Not Acceptable
If evaluation is done by consultant, each submission of review with each Retirement Board member
should take place and be documented.
▪ No sub-committees.
▪ Evaluation must be completed prior to interviewing process
▪ The Board will determine the most advantageous proposal taking into consideration price and
the evaluation criteria set forth in the RFP
17
Interviews
▪ Following the initial evaluation, the Retirement Board must
determine which applicants should be interviewed by the entire
Retirement Board (no sub-committees).
▪ Number of applicants to be interviewed dependent on two factors:
• Rankings
• Number of Applicants
▪ Time to negotiate price, discuss track record, specific concerns.
18
Written Determination Of Most Advantageous Proposal
▪ Based on price and evaluation criteria set forth in the RFP.
▪ Award is to be made in writing within the time specified in the RFP.
▪ Award may be conditioned on negotiated items.
▪ If negotiations result in a decision not to award contract to “Most
Advantageous”, the Retirement Board may negotiate with the “next Most
Advantageous” vendor and should document the need for such further
negotiations.
▪ Investment service RFP to also include certain mandatory terms and conditions.
19
Mandatory Terms and Conditions
▪ Statement that vendor is a fiduciary of such fund.
▪ Statement that vendor is not to be indemnified by the retirement
system.
▪ Vendor to submit disclosure forms to PERAC and Retirement Board
detailing compensation for services.
▪ Disclosure by vendor to PERAC of any conflict of interest.
20
Vendor and Retirement Board Member Certification Forms
▪ Any person submitting a RFP for a service contract must certify
in writing, under the penalties of perjury, that the proposals were
submitted in “good faith” and without collusion or fraud.
▪ Same requirement for each Retirement Board member to certify
that proposals are submitted in “good faith” and without collusion
or fraud.
21
PERAC’s Acknowledgment
▪ Upon determination of the Most Advantageous Proposal, the retirement board
must submit all RFP required documents to PERAC for review.
▪ PERAC acknowledges the receipt of the RFP documents and then has 10 days
to review and either issue an acknowledgement or put the procurement
“under review”
▪ In providing the acknowledgement, PERAC does not pass judgement on the
quality of the vendor. Our focus is on the procurement process and its
compliance with Section 23B.
22
Awarded Service Contracts
▪ No contract is valid without PERAC acknowledgement.
▪ Each awarded contract must be executed in writing.
▪ No payment for service rendered prior to execution
of the contract.
▪ No contract shall exceed a term of seven years, including any
renewal, extension or option.
▪ Exceptions to the seven-year term are any limited investment
partnership or trust.
23
Cybersecurity
▪ Cybersecurity Framework
• Identify
• Protect
• Detect
• Respond
• Recover/Post-Incident Activities
24
Questions?
▪ My email: John.P.Galvin@mass.gov
▪ Feel free to reach out with compliance questions, procurement,
education, or general questions — happy to help!
PATRICE LOOBY, RN — Mgr. Medical Services
CARYN SHEA, CPA — Director of Audits SANDRA KING — Fraud Prevention Manager
JUDITH CORRIGAN, ESQ — General Counsel TOM O’DONNELL — Compliance Director
JOHN GALVIN — Compliance Analyst
PATRICK CHARLES, ESQ — Sr. Assoc. General Counsel
BILL KEEFE — Assistant Deputy Director JOHN BOORACK — Actuary
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Fiduciary Duty
§ A fiduciary’s duty, your role as a member of the retirement board,
is owed solely to the members and beneficiaries of the system.
71
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Procurement
Procurement — Explains the procurement process
§ Documentation Requirements
§ Required Actions for Proper Procurement (M.G.L. c. 32, § 23B)
§ Fiduciary Responsibilities
72
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
The Competitive Bid Process
The Competitive Bid Process — Detail example of hiring an investment
consultant
§ Competitive Process
§ Open & Fair Process
§ Objective
73
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Sample Questions to Ask to Vendors
§ What services and advice can you provide?
§ Ask if they monitor the boards’ investments, including the frequency and any material limitations.
If so, indicate whether or not the services described are offered as part of your standard services.
§ How will you choose investments to recommend to the board?
§ What is your relevant experience, including your licenses, education and other qualifications?
§ What do these qualifications mean?
§ What fees will be paid?
§ Help me understand how these fees and costs might affect the investments.
74
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Sample Questions to Ask to Vendors (Continued)
§ If we give you $1,000,000 to invest, how much will go to fees and costs, and how
much will be invested for me?
§ How might your conflicts of interest affect me, and how will you address them?
§ How do you make money?
§ Do you or your firm have legal or disciplinary history?
§ Who is my primary contact person?
§ Who can I talk to if I have concerns about how this person is treating me?
§ What is the return, risk, and cost of the investment?
75
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Understanding Investments
Understanding Investments
§ Asset Classes explained
§ Selecting an Investment Manager
§ Outline of the Competitive Process
76
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Mutual Fund Fees and Expenses
Mutual Fund Fees and Expenses
§ SEC study on how investment fees and expenses impact returns
§ If you don’t understand the fees then ask!
77
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
PRIM
HOW TO INVEST WITH PRIM?
§ There are two ways to invest with PRIM, either as a participating system, meaning a retirement system
can elect to transfer all assets to PRIM, or as a purchasing retirement system, which elects to invest some
of their assets with PRIM.
§ A “Participating System” elects to transfer all its assets to PRIM. Mandatory five-year period of
participation. An affirmative decision by the Retirement Board requires notification to chief executive
officer and legislative body having jurisdiction over the Board and the PRIM Board.
§ A “Purchasing System” elects to invest some or all of its assets in the total PRIT Fund, or in the asset class
sleeves offered by PRIM through “Segmentation”. A majority vote of the Retirement Board is all that is
required to become a Purchasing System. No minimum dollar investment period. A Retirement Board
may terminate its relationship with 30 days’ notice per PRIM’s Operating Trust.
78
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Perform Regular Reviews
§ Review Investment and accounting matters
§ Review Funding and budget matters
§ Accounting reports for prior month end– Investment Statements, Cash Receipts
& Disbursements, Journal Entries, Checking account statement and reconciliation
§ Have representative from vendors — you pay for their services — they answer
to you.
§ Are they meeting your goals/their deliverables?
79
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Useful Sites
§ SEC— Investment Adviser check
§ FINRA — Broker Check
§ National Conference on Public Employee Retirement Systems Webcasts
§ PERAC Compliance and Investments
80
INVESTMENTS/COMPLIANCE
PRESENTER: JOHN GALVIN
Compliance Unit Contacts
§ Reach us by email or by phone
§ PERAC’s main number: (617) 666-4446
Compliance Unit Extensions/Email Addresses
Thomas J. O’Donnell, Compliance Director Ext. 922 TJOdonnell@per.state.ma.us
John Galvin, Compliance Analyst Ext. 927 JPGalvin@per.state.ma.us
Rose Morrison, Administrative Assistant Ext. 931 RAMorrison@per.state.ma.us
81
QUESTIONS?
Conclusion/Questions?
96
§ Conclusion/Wrap-up by John Parsons,
followed by Questions & Answers
Selecting an Investment Manager / The Basics of
Securities Lending & Commission Recapture
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
Robert E.Tierney, Chairman | A. Joseph DeNucci, Vice Chairman
C. Christopher Alberti | Stephen P. Crosby| Kenneth J. Donnelly | James M. Machado | Donald R. Marquis
Joseph E. Connarton, Executive Director
5 Middlesex Avenue, Third Floor, Somerville, MA 02145
ph 617 666 4446 | fax 617 628 4002 | tty 617 591 8917 | web www.mass.gov/perac
Published by PERAC, 2002. Printed on recycled paper.
Selecting an Investment Manager / The Basics of
Securities Lending & Commission Recapture
Robert A. Dennis, C.F.A., PERAC Investment Director
Investment Director’s Letter
This document outlines three aspects of pension fund management. One of the
most important functions of the retirement board in the investment area is the
selection of managers to actually invest the system’s assets. Such a selection must
take place in a manner that meets the board’s fiduciary duty.As a result, it is critical that in assessing the merits of various managers board members review the
items noted. Over the years, boards have been presented with a number of ways
to realize gains that are not directly related to investment of assets.Two of
these are securities lending and commission recapture.A brief discussion of
these practices is also provided.
In producing this material, our intent is to introduce board members and others
to general concepts.This is not an exhaustive analysis of these subjects and prior
to retaining a manager or commencing a securities lending or commission recapture program, a board must engage in more extensive research.
I hope this is helpful to you and if you have any investment related questions or
comments please contact me at (617) 666-4446 ext. 922.
Robert A. Dennis
PERAC Investment Director
ii | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Table of Contents
Topic Page
1. Selecting an Investment Manager .....................................................................................................................1
2.The Basics of Securities Lending.......................................................................................................................5
3.The Basics of Commission Recapture .............................................................................................................7
SELECTING AN INVESTMENT MANAGER / SECURITIES LENDING & COMMISSION RECAPTURE | iii
Part I: Selecting an Investment Manager
After asset allocation, the most important decision facing a plan sponsor is the
selection of money managers.This process is generally as much an art as a science and it typically takes several years to reliably determine whether the effort
has been successful.
An investment management firm should be selected not because of its relationship with a particular consultant, not because it made the glitziest presentation,
and not necessarily because it had superior performance in the recent past.
A search for an investment manager should incorporate an examination of
ownership and organizational factors pertaining to the firm, an understanding of
its investment philosophy as well as the process by which it implements that philosophy, as well as thoroughly assessing past performance and determining how
relevant it might be for anticipating future returns.Also, besides knowing exactly
who will be managing the fund’s money, it is very important to know about the
frequency and quality of client service.
Basically, a search for an investment manager begins with a decision as to how
the mandate would fit in with overall asset allocation.The process should end
with the selection of a manager in whom the board has confidence not only in
its capability to fulfill its investment mandate but also in its likelihood of treating
the fund as an important client and offering excellent client service.
Since investment styles go in and out of favor, since very few managers outperform their benchmarks year-in and year-out, and since all firms are subject to
organizational change, there are no “sure things” in investment manager selection. However, it is fair to say that the keys to a successful relationship between a
sponsor and a manager involve not just a determination of investment expertise
but also the establishment of a sense of overall comfort and mutual respect.
The Search
Process
SELECTING AN INVESTMENT MANAGER / SECURITIES LENDING & COMMISSION RECAPTURE | 1
Selection Process Questions
The following is an outline of a number of the factors that should enter into a
manager selection process.
People z What is the organizational structure of the firm, and of the specific
investment group for this mandate?
z What are the staffing levels of the firm, by department or function?
z What are the biographical highlights of key personnel?
z Who will be the primary manager assigned to this account?
- Get to know him or her!
z How many accounts does he/she manage?
z Who will be his/her backup?
z Do the staff in this investment group work as a team?
z What has been the investment staff turnover rate?
z How are key staff compensated?
Philosophy
z What is firm’s traditional overall investment philosophy?
- Top-down, bottom-up, quantitative, etc.
z What is the role of research?
- In-house staff, or street research?
- What factors are emphasized?
z For in-house research, how are analysts organized and how do they interact
with portfolio managers?
z How is investment policy determined?
- Is there an investment committee?
z What is current investment strategy in major markets?
z Has there been consistency in investment philosophy and strategy over time?
2 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
z What are the basic characteristics of the investment process? Process
z Are portfolios managed by teams or by individual managers?
z Do individual managers have discretion relative to firm’s investment strategy?
- If so, how much?
z What is the review and control system relative to managers’ performance?
z Separate account or commingled fund?
z What is the methodology of portfolio construction?
z How is security selection and trading done?
z What methodology for security evaluation is used?
z How are trades allocated among accounts?
z What are the buy/sell disciplines?
z Do portfolios typically have high or low turnover rates?
z Are portfolios typically highly concentrated or highly diversified?
z To what extent are derivatives used?
z Is there a system of risk management and control?
z How are broker/dealers for trade execution selected?
z Does the firm have a trading system that seeks to limit trading costs?
z Are timely, accurate returns regularly calculated and made available? Performance
z How has performance been relative to benchmark for this product?
z Is the benchmark appropriate?
z Is performance presented objectively and fairly?
z Has performance been consistent?
z How volatile have returns been?
SELECTING AN INVESTMENT MANAGER / SECURITIES LENDING & COMMISSION RECAPTURE | 3
The Firm
z Is there a system for detailed performance attribution?
z Is performance repeatable or has it been due to special, one-time factors?
z Is performance consistent or widely dispersed among accounts?
z Is the firm independent?
z If not, what is nature of its relationship with the parent company?
z Are there any significant company affiliations or joint ventures?
z Do employees have a stake in ownership? If so, what %?
z What is the compensation and incentive program for investment staff?
z What is the code of ethics for investment staff?
z What is the corporate culture?
z What are the overall business objectives?
z What are current assets under management, categorized by product line?
z What are recent growth trends?
z What products are “hot”?
z Is there any limit on asset growth or new clients?
z What new products or other changes are contemplated?
z Is the client base diversified?
z Is the client base stable? How many accounts gained or lost recently?
z How is client service structured? Who will be the primary contact and what
is the frequency and form of contact?
z Are portfolio managers accessible and responsive?
z Does the firm have existing public pension clients?
4 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
z Is the firm or its principals involved in any ongoing litigation or investigations?
z Is the firm strong financially?
z Are there any potential conflicts of interest?
z Recent material developments
Part 2: The Basics of Securities Lending
A lender (pension fund) transfers securities to a borrower (broker-dealer), who
needs the securities temporarily to support trading strategies (such as “short”
positions) or settlement obligations.The lender retains most economic benefits
of security ownership (except voting rights) over the term of the loan and has
the right to recall the securities within a short, stated period.The borrower puts
up collateral (usually 102% or more, marked to market daily), may pay a fee, and
promises to return the identical securities.A lending agent (custodian bank)
arranges and manages the loaning of securities and the investment of the cash
collateral.
Investment returns from the collateral are divided among the borrower, the
lender, and the lending agent bank. For the lender, returns are usually sufficient to
offset custody or other administrative program costs.
What is it?
Borrower Risk Risks
A lender will typically maintain a list of approved borrowers (broker-dealers).
Borrowers must have high grade credit ratings from Moody’s and Standard &
Poor’s and meet certain other financial criteria, such as minimum total assets.
Diversification
A lender will typically set maximum levels of lending exposure to any one
borrower
Collateral Investment Risk (if cash)
The borrower will set investment guidelines governing the collateral it holds.
Credit Risk
Permissible securities typically limited to money market instruments, repurchase
SELECTING AN INVESTMENT MANAGER / SECURITIES LENDING & COMMISSION RECAPTURE | 5
agreements, securities issued by the US or other approved sovereign entities, and
other AAA-rated instruments such as asset-backed securities.
Maturity Risk
The average life of the collateral investment portfolio should not differ from the
average life of the outstanding securities loans by more than a specific duration,
such as 60 days.A minimum percentage, such as 10% of the portfolio should be
invested in overnight instruments for liquidity purposes and a maximum effective
maturity (such as 14 months) should also pertain to permitted securities.
Operational Risk
Principals in securities lending must have strong administrative capability to
carry out all the mechanics relative to movement of securities, to continuously
monitor participating broker dealers, to effectively negotiate terms of the loans,
to receive and invest the cash collateral and mark to market daily, to handle
all aspects of broker billings, and to provide comprehensive monthly reports
to clients.
Summary While not risk-free, participation in a well managed securities lending program
is generally seen as a safe method of adding incremental income to a portfolio
without any significant impact on, or risk to, the overall investment program.
Securities lending is a huge factor in world financial markets. Governmental
studies have recognized securities lending as an important source of liquidity to
the financial markets.
6 | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
Part 3: The Basics of Commission Recapture
Commission recapture is a well established, widely used and relatively simple
concept intended to help pension funds reduce their transaction costs.
Typically, only about one fifth of a broker-dealer’s commission rate for securities
transactions relates to the actual costs of executing the trade.The balance is
intended to cover the broker-dealer’s investment research or to serve as “soft
dollars” to purchase another firm’s research or other investment-related services. Deriving from a 1986 Department of Labor ruling that stated that brokerage
commissions are an asset of the pension fund, not of the investment manager
directing the trade, commission recapture basically allows for the “unbundling”
of the two components of transaction costs.That portion of total commission
beyond the trade execution costs is rebated to the pension fund either in
periodic cash payments or as direct payments to some of the fund’s service
providers. Since paying for research and other costs through commission dollars
remains a legitimate practice, commission recapture is typically used for less than
half of total trading volume.
While a well designed and carefully executed commission recapture program can
be a clear benefit to a plan sponsor, a poorly conceived program could cost a
pension fund more than it saves. Certain structures, such as one that requires
an investment manager to segregate a pension fund’s orders from the balance
of a block trade, could result in inferior trade execution that more than offsets
the reduction in trading costs.Any commission recapture program that disrupts
the normal flow of orders across a manager’s trading desk could end up
being unsuccessful.
In addition to making sure that their commission recapture brokers are rebating
the maximum percentage of commission dollars and that the trading procedure
minimizes the risk of inferior execution, the plan sponsors must closely monitor
their investment managers to ensure their compliance with and proficiency in
carrying out the program.
SELECTING AN INVESTMENT MANAGER / SECURITIES LENDING & COMMISSION RECAPTURE | 7
Commonwealth of Massachusetts
Public Employee Retirement Administration Commission
5 Middlesex Avenue
Third Floor
Somerville, MA 02145
ph 617 666 4446
fax 617 628 4002
tty 617 591 8917
web www.mass.gov/perac
UNDERSTANDING
INVESTMENTS
PUBLIC EMPLOYEE RETIREMENT
ADMINISTRATION COMMISSION
UNDERS ANDING
INVESTMENTS
PERAC TRAINING SERVICES
FIRST EDITION | SEPTEMBER 1999
PUBLISHED BY PERAC COMMUNICATIONS
PUBLIC EMPLOYEE RETIREMENT
ADMINISTRATION COMMISSION
ELIZABETH E . LAING
Chairman
Chairman, Board of Conciliation & Arbitration
A . JOSEPH DENUCCI
Vice Chairman
State Auditor
JOHN R . ABBOTT
Sergeant, Plymouth Police Department
MICHAEL J . DIRRANE
Senior Vice President, Amerin Guaranty
KENNETH J . DONNELLY
Lieutenant, Lexington Fire Department
DONALD R . MARQUIS
Town Manager, Arlington
ANDREW S . NATSIOS
Secretary of Administration & Finance
JOSEPH E . CONNARTON
Executive Director
PUBLIC EMPLOYEE RETIREMENT
ADMINISTRATION COMMISSION
5 Middlesex Avenue
Third Floor
Somerville, MA 02145
Ph: 617.666.4446
Web: www.state.ma.us/PERAC
JOSEPH I . MARTIN
Deputy Executive Director
Ext. 920
ROBERT DENNIS
Investment Director
Ext. 922
VICTORIA MARCORELLE
Assistant Director
Ext. 928
ROSE CIPRIANI
Administrative Assistant
Ext. 931
Contents
1. THE U.S. EQUITY MARKET
3
2. THE FIXED INCOME MARKET
1 9
3. INTERN ATIONAL STOCKS 2 8
4. INTERN ATIONAL FIXED INCOME 3 0
5. REAL ESTATE 3 1
6. ALTERNATIVE INVESTMENTS 3 5
7. ASSET ALLOCATION 3 8
8. SELECTING AN INVESTMENT
MANAGER 4 3
9. OUTLINE OF THE COMPETITIVE
PROCESS 4 5
2 PERAC TRAINING SERVICES
1. The U.S.
Equity Market
WHAT ARE STOCKS?
When a company wants to raise money to
invest in something they think will be
profitable, such as a new manufacturing
process, more productive capacity, or a new
product, they can do it in a number of ways.
They can simply borrow the money or they can
sell part of the company. The latter is done by
selling “stock”in the company. Owners of this
stock have voting rights in the company’s management. Stocks are also called “equity” since
the owners have equity, or part ownership in
the company, allowing them to share in a split
of the profits from the company. A share of
company profits is regularly distributed to
shareholders in the form of dividends.
Original owners of a new company will sell
stock to friends, associates, or venture capitalists. When a company becomes large enough
to need additional funding of usually several
hundred million dollars, stock is offered in the
public market in an “initial public offering.”
Subsequently, its value is determined on the
open market, on a stock exchange, by
whatever one is willing to pay for it. The price
of a stock can be affected by exogenous factors
or temporary trends but it is typically determined by expectations of profits (or dividends)
and by expectations of future growth.
Unlike a bond, which typically represents a
legal commitment to repay interest and
principal, there is no downside limit to what a
stock can be worth if the company’s prospects
plummet. Dividends could decrease or cease
entirely during periods of corporate
unprofitability. Thus, stocks have been seen as
riskier investments than bonds, but with these
greater risks come higher expected returns.
According to Ibbotson Associates, blue-chip
stocks appreciated an average of 11.2% from
1926-98 while US government bonds returned
an average of 5.3% over the same 73-year
period. In general, stocks are seen as a wealth
building tool due to their capital appreciation
potential while bonds are seen as income
producing instruments. Stocks, offering the
prospects of both capital growth as well as
steady and possibly growing income, are seen
as the investment vehicle most likely to successfully offer a long-term edge over inflation.
VALUE VS. GROWTH
In the equity market, there are two major styles
of investing. Value stocks are those that,
considering a company’s assets and earnings
history, are attractively priced relative to
current market standards of price-to-earnings
ratios, price-to-book ratios, et al. These
companies typically pay regular dividends to
shareholders. Growth stocks derive from
companies that, due to their strong earnings
and revenue potential, offer above average
UNDERSTANDING INVESTMENTS 3
prospects for capital growth, with less miss their earnings projections or if investors
emphasis on dividend income. Over long suddenly conclude that such stocks are too
periods, value and growth stocks have provid- highly valued relative to cheaper alternatives.
ed similar historical returns, although each has In practice, stocks are not always easily
periods when it may dramatically outperform categorized as growth or value and there will
the other. Traditionally, growth usually be some overlap in the
funds appeal to investors who will portfolios of the two styles. What A value
accept more volatility in hopes of the two styles have in common is investor may
greater appreciation or who prefer that they both seek great compa be compared a higher proportion of the returns nies. Growth managers are not
to the to derive from capital gains, which afraid to pay a Tiffany-like price
consumer who are typically taxed at lower rates tag for a company they consider a
than dividend income. patiently waits diamond, and they are willing to
A value investor may be for a sale take a risk that it could turn out to
compared to the consumer who be flawed. Value investors also
patiently waits for a sale before
before buying,
or who thrills search for diamonds, but typically
buying, or who thrills at the cheaper ones where, through at the
prospect of discovering a designer patience, their eventual higher val prospect of
original on the clearance rack at ues will be realized. discovering a Filene’s. The skillful manager will As noted, performance of value
designer not just focus on price for, like and growth stocks typically
original on the holiday fruitcake after Christmas, converge over long periods but
many companies with low price clearance rack growth has dramatically outpermultiples deserve to be discount- at Filene’s. formed over the past four years
ed. Successful value managers and this trend continued through
know how to distinguish the perpetually ugly the first quarter of 1999. For the twelve months
ducklings from those likely to become swans. ending March 31, 1999, the Growth compoValue managers are not averse to companies nent of the S&P Index outperformed the Value
that are growing; they simply prefer those component by an astonishing margin of 30.7%
whose stocks are marked “clearance”. to 5.7%. There are no universally agreed upon
On the other hand, growth managers are like explanations for this, but one plausible one
those shoppers who make a beeline for trendy states that growth outperforms value when the
full-price merchandise, betting that their price overall corporate profits cycle slows. Profits
will continue to rise. These managers must growth peaked in 1995 after companies reaped
address the question of “how high is high”? At the benefits of several years of corporate
some point, stocks with high price tags could restructuring and an improved economy. As
suddenly plummet if individual companies overall earnings growth has become scarcer,
4 PERAC TRAINING SERVICES
investors have bid up the price and expanded
the multiples on those relatively few companies and sectors (such as technology) that are
maintaining their growth rates or are expected
to demonstrate healthy growth. When overall
corporate profits begin to accelerate, growth
will become increasingly abundant and value
will tend to outperform as investors become
comparison shoppers. This is what happened
during the second quarter of 1999 as the economic fears that spooked the market during the
summer of 1998 faded into memory.
Growth stocks typically do well during
periods of low inflation and declining interest
rates such as we have enjoyed over the past
few years. Reduced costs arising from these
trends help companies achieve better earnings
and to grow and expand. Also, the present
value of future earnings is greater when
inflation and interest rates are low. Value
stocks are typically concentrated in such
cyclical sectors as industrial, basic materials,
energy, and financial services and will tend to
outperform growth stocks during periods of
rapid expansion.
SIZE
Stocks are also categorized in terms of the total
value of their outstanding stock, also known as
capitalization. Large capitalization stocks are
currently loosely defined as those with total
market value exceeding $10 billion, mid-caps
are between $1.5-10 billion, and small-caps
are less than $1.5 billion. Historically, large
caps have exhibited lower volatility than mid
or small caps.
Over time, small caps have actually
outperformed large caps by 1-2% per year, but
they have badly lagged in recent years. For the
ten years ending 1998, the large-cap oriented
S&P 500 Index outperformed the major small
cap index 19.2% vs 12.9% in terms of
compound annualized return. In terms of
comparison versus large caps, 1998 was
actually the worst year ever for small caps as
indices for this sector actually declined versus
robust gains for large cap indices; the
differential in return was a startling 31%.
Indeed, without the 250 companies with the
largest market valuation, stocks overall would
have been negative last year. While small cap
stock indices showed negative returns for the
year, the fifty largest stocks rose 39%. The 415
largest stocks now represent about 77% of the
total stock market capitalization at year-end,
up from 55% in the early 1980s.
US STOCKS 1998
GROUPED BY TOTAL
CAPITALIZATION RETURN
50 Largest Stocks
by Capitalization 39.1%
Stocks Ranked 51-200 26.0%
Stocks Ranked 201-500 14.2%
Stocks Ranked 501-1000 3.3%
Stocks Ranked 1001-3000
(Russell 2000) -2.5%
Large caps benefited last year from the
world-wide flight to quality arising from the
crises in Asia and Russia. Since they’re much
more widely followed and actively traded,
large caps are much more liquid than small
caps. The dominant performance of large caps
in recent years is also attributable to the phenomenal growth in index investing, which has
UNDERSTANDING INVESTMENTS 5
seen billions of dollars chasing the large stocks market valuations than some of the economy’s
emphasized by the S&P 500. Also, larger most established blue-chip companies that
companies are perceived as better able to offer have long histories of consistent profitability,
higher and more stable earnings growth than one has to wonder to what extent speculative
before as a result of corporate restructuring fever is obscuring true value.
and globalization. Here are some of the best and worst
Historically, periods of small cap outperfor performing sectors in 1998 among industry
mance tend to coincide with troughs of major groups, according to Dow Jones:
recessions. The fact that the economy has not
experienced a serious downturn in many years
Communications Technology 102.3%
is perhaps one of the reasons for the mediocre Entertainment 90.3%
performance of small cap stocks this decade. Computers 80.4%
With the recovery in Asia and the apparent
bottoming out of the Japanese economy, Software 79.0%
indications of stronger worldwide growth Drug Retailers 68.3%
contributed to small caps (as well as mid-caps) Aerospace & Defense -18.5%
significantly outperforming large caps during
the second quarter of 1999. Lodging -24.3%
Real Estate -26.2%
INDUSTRY SECTORS
Many small investors as well as experienced Heavy Machinery -31.3%
investment managers have been shaking their Oil Drilling -58.9%
heads over the past few years when consider- With the changed economic scenario with
ing the extent to which large stocks have regard to economic growth, the second quarter
outperformed small stocks and growth stocks of 1999 saw a dramatically different list of
have outperformed value stocks. What is winners and losers:
somewhat more easily explained is why Aluminum +45.2%
different industry groups perform differently.
In the economy, there are always some
Industrial Technology +38.2%
industries or sectors that are doing better than Heavy Construction +26.6%
others, or are perceived to have much better Heavy Machinery +25.8%
prospects. Nevertheless, the differential
between top and bottom performers can be
Drug Retailers -8.1%
huge, perhaps more than seems justified. There Restaurants -8.7%
is little doubt that we are in an historic era of Savings & Loan -9.0%
technological change, but when newly-created
Consumer Services -17.3%
Internet-related companies that are years away
from even turning a profit are awarded greater Cosmetics -21.9%
6 PERAC TRAINING SERVICES
VALUATION
In many ways, the valuation of a stock is an art
not a science. As noted above, shares are worth
whatever someone is willing to pay for them,
whether or not that price conforms with what
professional investors perceive its
intrinsic value to be. In theory, a
share of stock is supposed to be
worth the present value of all
future cash flows expected from
the investment. Yet, there are a
number of widely accepted methods that are also used in the
valuation of stock.
The most common way to value
a company is to use its earnings.
The Price/Earnings ratio, sometimes referred to as the multiple, is
the stock price divided by the
company’s net income or profit
per share over the past twelve
months. For example, if the stock
of the Martin Corporation was
selling at $30 and it had earned $2
per share over the past year, its P/E
would be 15.
Other yardsticks employed
include:
Price/Sales Ratio - A measure of
the company’s ability to generate
revenue.
Cash Flow - A way to focus on the operating
business and exclude secondary items like
interest, taxes, depreciation, and amortization
Price to Book Ratio - Comparing the stock
price to the company’s actual, liquidation value,
using both its tangible and intangible assets
In many ways,
the valuation
of a stock is
an art not a
science. As
noted above,
shares
are worth
whatever
someone is
willing to pay
for them,
whether or not
that price
conforms with
what
professional
investors
perceive its
intrinsic value
to be.
Return on Equity - Assessing a company’s
earning power relative to shareholder’s equity
(liquid assets and retained earnings)
Dividend Yield - Comparing a company’s
dividend payout to its stock price is a criteria
used by income-oriented investors
Overall, however, the Price to
Earnings ratio is the most accepted
criteria for stock valuation. P/E
ratios have never been higher than
they are now, although they are far
from uniform. P/Es are extraordinarily high for high-flying
technology and Internet-related
companies but they are at or below
historical averages for a number of
out-of-favor sectors such as
machinery or commodity (i.e., oil)
based industries. The fifty largest
stocks in the S&P 500 had priceto-earnings ratios of 43 at year-end
while the 50 smallest stocks in the
index had P/Es averaging 25. Not
only are valuations higher for large
cap stocks, such as those represented by the S&P 500, than for
small cap stocks, but , even among
small caps, the larger companies in
this category are more highly
valued than the smaller ones. By a
breathtaking margin, valuations
for growth stocks far exceed those of value
stocks.
Price to earnings ratios on the S&P 500,
which averaged 10 in the late 1980s and were
less than 15 as late as 1995, have recently been
above 30, an unprecedented level. Over the
UNDERSTANDING INVESTMENTS 7
four years ending in 1998, the rise in the S&P
500 was over four times greater than the rise in
corporate earnings over that period. The doubling of P/E ratios over this period explained
almost 80% of the surge in equity values.
Thus, while many argue from historical
perspectives that many sectors of the market, if
not the market itself, are substantially
overvalued and due for a correction, others
argue that the old yardsticks of valuation no
longer apply in the current environment where
the traditional business cycle no longer seems
relevant, the world is more interdependent than
ever, inflation and interest rates are
historically low, corporate managers are more
aggressive than ever at controlling costs, and
technological changes of historic proportions
are radically improving productivity and
efficiency.
The beauty and challenge of stock investing
is that it is an art not a science. The same stock
may be simultaneously deemed overvalued,
fairly valued, or undervalued according to
criteria employed by different analysts. One
thing is for sure. Market trends will change as
will the conventional valuation levels. But a
stock will always be worth whatever someone
is willing to pay for it
PERFORMANCE MEASUREMENT
1998 was another banner year for stock market
returns. Or was it? The fact is that if one
wasn’t invested in the right size stocks, the
right type, or the right sector, then 1998 may
not have been a happy year at all for stock
investors. Beyond the flashy returns heralded
by certain widely-followed indices, the fact is
that the majority of US stocks actually lost
value in 1998. Losers outnumbered winners on
the New York Stock Exchange. More than 40%
of the S&P 500’s stocks fell. Even on the high
flying technology-laden NASDAQ, twice as
many stocks declined as rose.
Indicating the extent to which last year’s
gains were highly concentrated in large
technology growth stocks, about one fifth of
last year’s 28% gain in the S&P 500 was
accounted for by four such stocks: Microsoft,
Intel, Cisco, and Dell. 85% of the index’s
return was accounted for by only 50 of the 500
stocks in the index.
These trends continued with a vengeance as
1999 began. The 4.98% gain in the S&P 500
during the first quarter can be attributed to just
18 of the 500 stocks, and two stocks
(Microsoft and America Online) represented
one third of the gain. More than half the stocks
in the Index actually declined during the
quarter. Three of the thirty stocks in the Dow
Jones Industrial Average constituted more than
half that index’s 7.04% advance. Even more
telling, two thirds of the stocks on the NASDAQ exchange were down during the quarter
despite the composite index’s 12.3% gain.
Although the second quarter of 1999 showed
at least a temporary reversal of this trend, the
fact that stock returns have been so dispersed
and gains have been so narrowly concentrated
in recent years makes it exceedingly important
that the mandate of equity investment
managers is clear and unambiguous. It is
equally clear that returns must be monitored
relative to appropriate benchmarks and that the
subtleties and quirks of each benchmark are
well understood.
8 PERAC TRAINING SERVICES
Here are a number of major benchmark
indices and their returns for 1998 and the first
half of 1999.
INDEX 1998 1H99
Dow Jones
Industrial Average 16.1% 20.5%
Standard &
Poor’s 500 28.6% 12.4%
NASDAQ
Composite 39.6% 22.5%
Russell 2000
(Small Caps) -2.5% +9.3%
Russell Mid-Cap 10.1% 10.3%
Wilshire 5000
(Total Market
Proxy) 23.5% 11.9%
The above numbers vividly illustrate the
challenges of accurately gauging equity
performance today. Struggling to retain its
credibility in the market is the Dow Jones
Industrial Average, which tracks thirty large
industrial companies chosen according to no
specific criteria by the editors of The Wall
Street Journal. By contrast, the Standard &
Poor’s 500 is a broad-based market index comprising about 75% of the total market value of
publicly traded US equities. It is appropriate
for portfolios consisting of a combination of
large growth and value stocks. According to
S&P, the Index strives to reflect the US stock
market by including “leading companies in
leading industries”.The NASDAQ composite
is also a broad-based index tracking
performance of the more than five thousand
companies, including many of today’s leading
growth companies, that trade on this electronic exchange for over-the-counter trading.
The Dow is a price-weighted index, where a
stock priced at $100 has twice the weight of
one priced at $50, even if the latter has a much
larger total market capitalization. The S&P’s
weighting by market cap is more consistent
with how many important economic indices
are calculated. The NASDAQ composite is
also market-weighted.
From 1926 through about 1965, the Dow and
the S&P tracked each other closely since
industrial companies used to be the bellweather stocks in the economy. The Dow began to
lose its relevance in the 1960s when
service-based companies began to dominate
the economy. Now in the 90s, the Dow more
than ever seems to represent the “old
economy” while the S&P tracks the real
economy and the technology-laden NASDAQ
tracks the most dynamic companies of the
“new economy”. The S&P is itself becoming
increasingly reflective of the “new economy”;
stocks in the health care, technology, telecommunications, financial services, and consumer
services industries now constitute about three
quarters of the index, up from 60% in 1994,
while “old economy” industries such as
energy, basic materials, transportation,
utilities, and industrials now account for 16%
of the index, down from almost 30% in 1994.
If the Dow had continued to track the S&P in
the same ratio it did from 1926-65, it would
have been around 15,100 instead of the 10,971
it was on July 1.
THE STOCK MARKET:
LOOKING AHEAD
What is the greatest threat to America’s
UNDERSTANDING INVESTMENTS 9
economic health? Is it Asia? Latin America? trends that have propelled the market to its
Russia? Y2K problems? Tighter money? impressive bull run of recent years and all
Uncertainty over the 2000 elections?All these these trends may have run their course:
are factors that cannot and should not be 1. Disinflation. Inflation, as high as 5-6%
overlooked, but in the view of many, the during 1991, fell to about 1% and seems to
greatest threat to the economy is have bottomed
the US stock market, which has After an 2. Interest rates. Long Treasury
risen to such an extent over the unprecedented yields fell from 8% in 1995 to 5%
past several years that it represents at the end of 1998 and have risen
a “bubble” ready to burst. Our
fourth back to 6%. In the absence of a
economy has been the best perconsecutive clear economic slowdown, we are
forming among the major nations year of returns unlikely to see 1998’s lows again.
of the world in terms of its impres on the 3. Profitability. US corporations
sive growth and low inflation, but Standard & have become “lean and mean” and
much of the growth has been Poor’s 500 in corporate profit margins have
consumer driven, aided in part by excess of risen from around 4% to about
the “wealth effect” of sharply ris 20%, it’s not 6%. The expansion of margins and
ing equity values. If and when the difficult to of overall profits has stalled in
market declines significantly over recent years, however.
an extended period of time, the argue that 4. Valuations. Price to earnings
downward effect on consumer
stocks are now ratios on the S&P 500 have never
spending could be significant overvalued been higher. As one pundit noted,
enough to cause a meaningful and, at the at these lofty valuations, investors
economic downturn. least, are due are discounting not only future
After an unprecedented fourth for a period of earnings but those of the hereafter
consecutive year of returns on the more modest as well.
Standard & Poor’s 500 in excess of returns. If today’s high P/E ratios persist
20%, it’s not difficult to argue that but don’t increase, future stock
stocks are now overvalued and, at market returns will approximate
the least, are due for a period of more modest the rate of earnings growth, which has been at
returns. First of all, if one considers the overall single digits at best in recent years. The great
capitalization of the stock market compared to risk to the market is what would happen if
Gross Domestic Product, stocks now represent investors suddenly determine that future profit
an unprecedented 140% of GDP. This ratio growth has been vastly over-estimated and
was only 80% as recently as 1995 and was in P/Es suffer a sharp decline to more typical
the range of 40% from 1975-85. historical levels.
There are four distinct economic or market There are also a number of quantitative
10 PERAC TRAINING SERVICES
models that assess the valuation of the stock
market. Morgan Stanley Dean Witter has a dividend discount model that recently portrayed
the S&P 500 as more than 30% overvalued.
Fed Chairman Greenspan is known to employ
a model that shows a strong correlation
between the expected operating earnings yield
on the S&P 500 and the yield on the 10-year
US Treasury bond. As of early July, this model
also showed the market to be more than 30%
overvalued. When overvaluations persist, the
possible remedies are 1) interest rates falling,
2) earnings expectations increasing, or 3) stock
prices falling. Prior to last summer’s market
decline, the model had indicated a 25%
overvaluation.
Chairman Greenspan explicitly raised the
spectre of risk in today’s market when he
asserted in his February 23, 1999, economic
report to Congress that “Equity prices are high
enough to raise questions about whether shares
are overvalued. Investors appear to have
incorporated into equity prices both robust
profit expectations and low compensation for
risk”. He added that disappointments on either
score could ‘damp appetites for equities”,
which he warned could have a negative effect
on the economy when the “wealth effect” has
a reverse pull.
Noted market historian Prof. Jeremy Siegel
of the Wharton School has compiled data on
equity returns spanning the last two centuries.
He displays a strong trend line over almost 200
years showing equity returns averaging 6.8%
per year after inflation. Returns had been
below trend for almost 20 years through the
early 1990s but are now seen well above trend.
On the other hand, despite these compelling
historic and academic arguments for
overvaluation, there is the unmistakable law of
supply and demand to be considered. Very
simply, the baby boomers and other investors
have seized upon the stock market as the
source of their retirement security. The ratio of
equities to household portfolios, as low as 25%
in 1985 and 40% as late as 1995, is now a
record high 55%. Mutual fund investors have
allocated 56% of their assets to equities, up
from 25% in 1990.
Economist John Maynard Keynes once said
that the critical determinant of the stock
market is not the business cycle but the
psychological cycle. If investors continue to
ignore valuations and treat stocks like
commodities, then a continued upward bias
cannot be ruled out. With the proliferation of
financial market information in print, on the
Internet, and on cable television, the market
has captured the public’s imagination as never
before and the business of investing has
entered a brave new world, fraught with
opportunity and risk.
Furthermore, there are those who say that the
old yardsticks of valuation simply no longer
apply. The economic expansion has already
confounded expectations by going on longer
than any previous one. World economies are
more interdependent than ever before.
Inflation is historically low and shows scant
sign of any upward pressure. US corporate
managers have become increasingly skillful at
controlling costs and managing inventories
and productive capacity. We are in the midst of
an historic era of technological change that is
UNDERSTANDING INVESTMENTS 11
radically improving productivity and
efficiency. In light of these trends, perhaps
today’s valuations will prove correct in
anticipating a period of very impressive profit
growth.
Market bulls assert further that stock
valuations should be higher when inflation and
interest rates are as low as they are now.
During periods such as these, the chief
attributes of stocks—their potential for
long-term growth in income and capital—are
seen as more valuable than when inflation and
rates are high. When interest rates are low, the
discounting mechanism results in a higher
present value assigned to future earnings and
dividends. Also, investors—rightly or
wrongly—appear to have reduced their
traditional risk premium attached to stocks in
light of the absence of normal business cycle
pressures on growth and profits over the past
several years.
One thing we know for sure is that the stock
market has never been more important to our
economy. It used to react to events in the bond
market and to economic trends. Now it is itself
a major factor affecting interest rate
movements and plays a crucial role in
determining economic growth. Fed Chairman
Greenspan’s monetary easings of last year
were widely seen as an effort to forestall a
stock market collapse of major proportions,
mindful of the serious effect this would have
on consumer spending given the market’s
unprecedented dominant position in household
wealth levels and its captivating hold on
investor psychology.
Investors may well find that the above-trend
stock market returns of the past few years
cannot be sustained over the next few years.
On the other hand, the landscape is strewn with
economists and market strategists whose
obsession with the past has caused them to
miss out on the historic rally of the last few
years. Are we in the midst of a unique period
of economic nirvana where the old rules no
longer apply or are we about to confront the
rubble of a market bubble that bursts? Only
time will tell.
12 PERAC TRAINING SERVICES
STOCK PRICES ARE AT AN ALL-TIME HIGH RELATIVE TO EARNINGS
STOCK PRICES HAVE FAR OUTPACED EARNINGS GROWTH
UNDERSTANDING INVESTMENTS 13
SECTORS LAGGING THE MARKET
14 PERAC TRAINING SERVICES
SECTORS LAGGING THE MARKET
UNDERSTANDING INVESTMENTS 15
SECTORS OUTPERFORMING THE MARKET
16 PERAC TRAINING SERVICES
SECTORS OUTPERFORMING THE MARKET
UNDERSTANDING INVESTMENTS 17
SECTORS OUTPERFORMING THE MARKET
18 PERAC TRAINING SERVICES
2. The Fixed
Income Market
Abond is a debt security, similar to an
IOU, in which the purchaser is
lending money to a government,
municipality, corporation, or other entity. The
issuer promises to pay a specified rate of
interest during the life of the bond and to repay
the face value when it matures, or comes due.
Because bonds typically have a predictable
stream of interest payments and repayment of
principal, they have traditionally been seen as
ways for investors to preserve and increase
their capital and to receive dependable interest
income.
Among the key investment considerations for
bonds are:
1. MATURITY
The specific date on which the investors’
principal is due to be repaid. Maturity ranges
are typically characterized as short-term (up to
4 years), medium-term (5-12 years), and longterm (12 to 30 or more years).
2. REDEMPTION
Call Provisions: The issuer is allowed—or
sometimes required—to repay the principal at
specified dates prior to maturity.
Put: The investor has the option of requiring
the issuer to repurchase the bonds at a
specified date prior to maturity.
Average Life: In some cases, investors will
receive their money back at some uncertain
time before (or possibly after) the stated
maturity due to cash flow considerations of the
issuer; i.e., the effect of mortgage prepayments
on mortgage-backed bonds.
3. CREDIT QUALITY
Bond choices range from the highest credit
quality (US Treasury securities) to bonds that
are below investment grade and considered
speculative. The four major bond rating
agencies are Moody’s Investors Service,
Standard & Poor’s Corp., Fitch IBCA, and
Duff & Phelps. Bonds rated Aaa, Aa, A, or
Baa(BBB) are considered investment grade
while those rated Ba(BB) or below are considered below investment grade. The lower the
bond rating, the higher the interest rate on the
security to compensate for the credit risk.
4. INTEREST RATE
Bonds pay interest rates that can be fixed (most
are), floating (adjusted periodically to prevailing market rates), or payable at maturity
(zero-coupon bonds).
5. PRICE
Newly issued bonds typically sell at or close to
their face value, but in the secondary market,
their price fluctuates in response to changing
interest rates as well as factors affecting supply
and demand, credit quality, maturity, and tax
status. Bonds will trade at either a premium
UNDERSTANDING INVESTMENTS 19
(above face value) or at a discount (below face
value).
6. YIELD
Unless an investor purchases a bond at original
issuance, the effective yield on the
instrument will differ from the initial interest rate. Current yield is
derived by dividing the bond’s
interest rate by its purchase price.
Yield to maturity, or yield to call,
measures the total return received
by holding the bond until it matures
or is called, taking into account all
interest payments as well as the differential between the bond’s face
value and the purchase price.
Among the important concepts to
understand about bonds is the link
between price and yield. When
prevailing interest rates rise, prices
of outstanding bonds fall to bring
the yield of older bonds into line
with higher yielding new issues.
Similarly, when prevailing interest
rates fall, prices of outstanding
bonds rise, until the yield of older
bonds is low enough to match the
lower interest rate on new issues.
The link between interest rates and
maturity is also crucial. Changes in interest
rates don’t affect all bonds equally. The longer
it takes a bond to mature, the greater the risk
that prices will fluctuate along the way and
that the fluctuations will be greater. Investors
expect to be compensated for taking the extra
risk. A “normal yield curve” for a particular
issuer will show yields progressing higher from
An individual
bond’s market
value will be
determined by
its maturity,
credit quality,
and other
characteristics,
but the factor
that historical
ly is the most
crucial to
overall
interest rate
levels is
current and
anticipated
inflation levels.
short to intermediate to long-term maturities.
Depending on the market’s sentiment about the
future course of the economy, yield curves can
also be “steep”, “flat”, or “inverted”.
As noted, the longer until a bond becomes
due, the more it will fluctuate in
value according to changes in
interest rate levels. In assessing
this risk, it is important to understand the crucial distinction
between a bond’s maturity date
and its “duration”, a far better
gauge of price volatility. Duration
measures the weighted stream of
cash flows, usually semiannual
interest payments, through the life
of the bond, while maturity
merely states when the principal is
to be repaid. The more a bond’s
total cash flows consist of coupon
payments over the life of the bond,
the shorter its duration. Thus,
bonds with the same maturity can
have different durations—and thus
different levels of exposure to
market risk.
For example, the US Treasury’s
5.25% bond due November 2028 has a
duration of about 15 years, meaning that its
price will move up or down about 15% for
each percentage point move in interest rates.
However, a Treasury zero coupon bond maturing at the same time—a bond sold at a deep
discount that pays no interest over its life—has
a duration of 29 years, meaning that a
percentage point move in rates will move its
price by more than 25%.
20 PERAC TRAINING SERVICES
The key to bond investing is to successfully
balance yield and risk. An investor who buys a
bond with a higher than market level yield is
usually taking on extra risk in terms of either a
long maturity, lower credit quality, or poor call
protection. The longer the maturity, the greater
the market risk if interest rates rise. The lower
the credit quality, the greater the market risk
not only from individual security loss but from
an overall widening of credit spreads arising
from an economic downturn. Poor call
protection risks not only loss of coupon
income but also poor price performance during
periods of falling interest rates.
An individual bond’s market value will be
determined by its maturity, credit quality, and
other characteristics, but the factor that
historically is the most crucial to overall
interest rate levels is current and anticipated
inflation levels. Investors thrive on steady,
sustainable growth rates. The spectre of rising
inflation is why the bond market typically falls
(prices decline, interest rates rise) when the
government releases unexpectedly strong
economic news. Similarly, the bond market
typically acts euphorically (prices rise, interest
rates fall) when economic reports hint of a
coming slowdown or recession.
MARKET SEGMENTS
The US bond market is a huge market, consisting
of at least six major segments in addition to
money market funds. Bonds are actively traded,
with most of it done on the over-the-counter
(OTC) market that comprises hundreds of securities firms and banks that trade bonds by phone or
electronically. Some corporate bonds are listed
on the New York Stock Exchange.
U.S. TREASURY SECURITIES
$3.3 trillion outstanding
Sold in periodic auctions by the government,
Treasuries are the largest, highest quality, and
most liquid of all bond markets. Most are
issued as non-callable. The most recently
issued 30-year security is termed the “long
bond” and is used as a benchmark for the
entire long-term bond market. As the US
government has gone from chronic deficits to
surpluses in recent years, the supply of
Treasuries has begun to diminish. In fact, the
ratio of total Treasury debt to Gross Domestic
Product, which peaked at 35% in 1995, has
now fallen to 25%.
FEDERAL AGENCY DEBT
$1.1 trillion outstanding
Fannie Mae, Ginnie Mae, the Federal Home
Loan Bank, and the Student Loan Marketing
Association are among the agencies that issue
bonds at slightly higher yields than pure
Treasuries.
CORPORATE DEBT
$2.4 trillion outstanding
As are stocks, corporate bonds are generally
classified in several sectors, including
telephones, utilities, industrial, finance, and
banks. Most corporate bonds are debentures,
or unsecured obligations backed by the issuer’s
general credit and its capacity to repay debt
service out of earnings. Public utilities are the
primary issuer of mortgage bonds, where real
estate or other physical property worth more
than the bonds has been pledged as collateral.
Although bondholder protections have
increased in recent years, corporates are also
subject to event risk; when management has
UNDERSTANDING INVESTMENTS 21
tried to boost shareholder value by undertaking
leveraged buyouts, restructurings, mergers,
and recapitalization, the new layer of debt can
suddenly push bond values down significantly.
Investment grade corporate bonds typically
trade 50-150 basis points above US Treasuries,
but bonds rated below investment grade trade
in a market of their own.
High Yield or junk bonds are issued by
newer or startup companies, those in a particularly competitive or volatile market, and those
whose overall business or financial condition
is relatively weak or risky. These bonds
typically yield from 300-700 basis points
higher than US Treasuries of comparable
maturity. Because they are so credit sensitive,
they react less to general interest rate trends
than do investment grade bonds. Indeed, their
trading patterns often mirror the equity market.
Given their generous yield advantage over
Treasuries, a well diversified portfolio of junk
bonds is likely to provide attractive returns
compared to higher grade portfolios over time.
The risks are in investing in the sector when it
is trading at relatively narrow spreads to high
grades and in investing in individual companies or sectors just before their descent into
junk bond status or whose business conditions
deteriorate even further. Defaults and
bankruptcies in this sector are not uncommon.
In fact, reported default rates for this sector are
as high as 3%.
MORTGAGE-BACKED SECURITIES
$2 trillion outstanding
Mortgage securities represent an ownership
interest in mortgage loans made by financial
institutions to finance the borrower’s purchase
of a home or other real estate. These loans are
“pooled” by issuers or servicers for sale to
investors. As the underlying mortgage loans
are paid off, investors receive their payments
of interest and principal. The most basic
securities are known as “pass-throughs” or
participation certificates, representing a direct
ownership interest in a pool of mortgages.
These securities may be pooled again to create
collateral for more complex types of securities
known as Collateralized Mortgage Obligations
or Real Estate Mortgage Investment Conduits.
CMOs and REMICs both allow cash flows to
be directed so that different classes of securities with different maturities and coupons can
be created. Most mortgage securities are
issued and/or guaranteed by GNMA (Ginnie
Mae), a government-owned corporation, or by
FNMA (Fannie Mae) or the Federal Home
Loan Mortgage Corporation (Freddie Mac),
both US-chartered but privately held
corporations.
Because the timing and speed of principal
payments may vary according to economic and
interest rate conditions, the cash flow on
mortgage securities is irregular. Accordingly,
these securities are sold and traded in terms of
“average life” rather than their maturity dates.
The average life is the average amount of time
that will elapse from the date of security
purchase until the principal is repaid based on
an assumed prepayment forecast. Professional
mortgage bond investors employ complex
computer modeling in efforts to predict prepayment flows of individual mortgage pools.
Mortgage securities carry higher coupon
rates than Treasuries not only to reflect the
22 PERAC TRAINING SERVICES
rates on underlying mortgage loans which are established market. Since nearly all the bonds
always higher than governments but also to in this sector have relatively low yields
compensate investors for the level of reflecting their tax-exempt status, they are not
investment risk they are assuming in the typically used by pension funds.
context of prepayment risk. Because of the
difficulty of predicting the precise
return from a mortgage loan pool,
mortgage securities usually offer
attractive yield advantages not
only relative to Treasuries but also
in relation to other securities of
comparable quality.
ASSET-BACKED
SECURITIES
$600 billion outstanding
One of the fastest segments of the
bond market consists of the securitization of several types of pooled
consumer and business loans.
Among the most prominent issues
in this sector are bonds backed by
repayment of home equity loans,
auto loans, credit card receiveables, student loans, equipment
loans, and manufactured housing.
As in mortgage and corporate
bonds, the yield advantage of these
various types of bonds over
Treasuries will vary according to
Because of the
difficulty of
predicting the
precise return
from a
mortgage loan
pool,
mortgage
securities
usually offer
attractive yield
advantages
not only
relative to
Treasuries but
also in relation
to other
securities of
comparable
quality.
THE BOND MARKET
TODAY
An accompanying table shows
market offerings in major bond
market sectors, and in different
ranges of credit quality and
maturity, as of July 15, 1999.
Also included is a table showing
the sensitivity of total returns in
the US Treasury market to
changes in interest rates. It shows
that an investor purchasing the
actively traded 30-year Treasury
bond on July 1, 1999 would enjoy
a total return of 21.2% (15.2%
capital appreciation, 6.0%
income) if the market interest
rates on those bonds declined to
5.0% on July 1, 2000 and would
suffer a loss of –6.3% (12.3%
capital loss, 6.0% income) if rates
were to rise to 7.0%. The corresponding gain and loss would be
40.1% and -16.4% if rates were to
decline to 4.0% or rise to 8.0%
investors’ perceptions of the economic factors over that period. The chart illustrates the fact
that may affect their security as well as that bond values are affected by changing
temporary aspects of supply and demand that interest rates and that the magnitude of such
may affect market valuation. changes is a function of maturity with the
shortest maturities exhibiting the least MUNICIPAL BONDS
$1.4 trillion outstanding potential fluctuation.
The debt of states, cities, counties, and various
enterprise authorities is a large and well
UNDERSTANDING INVESTMENTS 23
U.S. TREASURY MARKET
SENSITIVITY OF TOTAL RETURNS TO INTEREST RATE CHANGES
ONE YEAR HORIZON
INTEREST RATE CHANGE
MATURITY -2% -1% 0 +1% +2%
2-YEAR 7.5% 6.5% 5.6% 4.6% 3.7%
5-YEAR 13.1% 9.3% 5.7% 2.2 % -1.1%
10-YEAR 20.9% 13.0% 5.8% -0.8% -6.9%
30-YEAR 40.1% 21.2% 6.0% -6.3% -16.4%
TOTAL RETURN IS INCOME PLUS CHANGE IN VALUE
MARKET YIELDS ON JULY 2, 1999
24 PERAC TRAINING SERVICES
FIXED INCOME MARKET YIELDS
July 15, 1999
U.S. TREASURY SECURITIES
MATURITY
2 Years 5.52%
5 Years 5.58%
10 Years 5.69%
30 Years 5.89%
YIELD
MORTGAGE-BACKED SECURITIES
ISSUER COUPON AVG. LIFE YIELD TO MATURITY
GNMA (1997) 30-year
FNMA (1997) 30 year
FHLMC (1997) 15 year
8.00%
7.00%
6.50%
5 years
6.4 years
4.8 years
7.72%
7.18%
6.83%
CORPORATE BONDS
ISSUER RATING COUPON MATURITY YIELD TO MATURITY
Bell Atlantic NJ
Johnson & Johnson
AT&T Corp
Procter & Gamble
Merrill Lynch & Co.
Coca Cola
Marriott Int'l
Ralston Purina
AAA
AAA
AA
AA
A
A
BAA
BAA
5.875%
6.73%
7.75%
6.45%
7.375%
6.75%
7.125%
7.875%
2004
2023
2007
2026
2006
2023
2007
2025
6.31%
6.82%
6.60%
7.06%
6.66%
7.19%
7.61%
7.56%
HIGH-YIELD
"JUNK" BONDS
Merrill Lynch
Composite Index 10.25%
UNDERSTANDING INVESTMENTS 25
THE YIELD CURVE HAS FLATTENED
LONG-TERM INTEREST RATES HAVE TRENDED LOWER
26 PERAC TRAINING SERVICES
TRENDS IN CORPORATE BOND QUALITY YIELD SPREADS
UNDERSTANDING INVESTMENTS 27
3. International
Stocks
I
nternational stocks have become a core
holding in most pension fund portfolios.
They are generally seen to enhance performance over time as well as reduce risk
compared to a portfolio of only domestic
stocks. Among the rationales for international
stock investing are:
1. As the world’s economies have become
more and more integrated, thousands of
companies have expanded into worldwide
markets, leading to the fact that a company’s
headquarters country has become less
important in influencing stock prices than the
industry that it’s in. For example, although
Japan’s stock market, the Nikkei, has been flat
or down over the past several years, the stock
of Honda—a very successful, profitable
company—has soared. In fact, Honda’s stock
performance over the past several years has
been much better correlated with those of
major US automakers such as Ford than with
the generally moribund Japanese stock market.
There are many similar examples, leading to
the conclusion that there are no longer foreign
or American companies, only successful or
unsuccessful companies.
2. The US no longer dominates the world
economy. America’s gross national product
represented nearly half the world’s output in
1970 but it is only one-third of it today. Also,
US stocks today account for less than half of
total world market capitalization, down from
two thirds in 1970. The largest companies in
many major industries are based overseas as
well as some of the fastest growing companies.
3. Among the major ten foreign markets
from 1980 through 1998, the US was the best
performer in only one year, 1982. From 1979
through 1994, the Morgan Stanley Capital
International EAFE Index, a widely
recognized benchmark composed of 21 major
markets in Europe, Australasia, and the Far
East, outperformed the S&P 500 every year in
terms of performance of the previous ten-year
holding period. Over the past four years,
however, the US—uniquely benefiting from a
sustained period of low inflation and strong
corporate earnings—has been the outstanding
cumulative market performer. This fact is
consistent with long-term patterns that indicate
that changes in leadership between US and
foreign stocks occur every few years.
4. Diversifying into foreign stocks is
intended not only to enhance returns over time
but also to reduce risk. Foreign stock markets
generally do not move in tandem with the US
market over the long term. The correlation
between the S&P 500 and the Morgan Stanley
EAFE Index has been less than 50%. Thus,
while it is likely that one or more foreign
markets will outperform the US each year,
diversification into international stocks will
28 PERAC TRAINING SERVICES
also likely reduce the overall volatility of a
stock portfolio.
Among the concerns and important
differences between domestic and foreign
investing are:
1. Many countries are considerably less
stable politically than the US and have much
less diverse economies. Thus, foreign investments are much more likely to be jeopardized
by sudden political or economic upheaval. The
unanticipated collapse of several Asian
economies in 1997 is a prime example of this.
2. Accounting and financial disclosure
practices can vary widely by US standards.
Original research is crucial since financial
information about specific foreign companies
can be difficult to obtain.
3. Currency translation is generally the
greatest ongoing concern. Initially, dollars
must be converted to the local currency to
purchase a foreign security. Subsequently,
share price quotations, stock dividends, and
sale or redemption proceeds must be converted
from that currency back into US dollars.
Because foreign exchange rates fluctuate
constantly, currency movements can increase
or decrease the dollar value of an investment
even if the security’s price remains unchanged.
An appreciation of a foreign currency relative
to the US dollar is positive for US investors
since each unit of the local currency will
translate into more US dollars. Portfolio
managers may use sophisticated hedging
techniques to cushion the impact of potentially
negative currency movements but such
hedging techniques will limit the possibility of
gains as well as losses.
In the long run, the effect of currency
fluctuations is usually far less important than
the profitability of individual companies and
the overall strength of local equity markets.
Given the often wide variance in economic and
market performance among countries, having a
well-diversified portfolio supported by strong
research is of paramount importance in
international investing.
The theories behind international stock
investing have become increasingly controversial in recent years. An emerging skepticism of
international stocks considers not only the
dominant performance of US stocks in recent
years but also the argument that the increasing
globalization of the world economy has
lessened the value of international stocks as a
diversifying, low correlation asset class. The
past few years have provided ample fodder for
the skeptics; indeed, over the ten years ended
December 1998, the Wilshire 5000 Index of
most regularly traded US stocks returned
18.1% a year while the Morgan Stanley EAFE
Index gained just 5.9% annually, according to
Ibbotson Associates. Nevertheless, performance is indistinguishable over the long term;
since the end of 1970, Ibbotson also reports
that the Wilshire 5000 and MS EAFE indexes
have had exactly the same return, 13.7% annually through December 1998.
UNDERSTANDING INVESTMENTS 29
4. International
Fixed Income
The rationale for international bond
investing is very similar to that for
stock investing. Foreign bond markets
have grown to represent more than half the
worldwide fixed income market and this
portion is increasing as emerging economies
issue debt at attractive yields to finance their
growing infrastructure and expanding businesses. Also, the US bond market has rarely
been the best performing among those of the
major industrialized nations.
As noted previously, returns in bond
investing are largely determined by changes in
overall interest rate levels, and rates in foreign
countries frequently do not move in tandem
with US rates. Indeed, a study of monthly
returns over a recent twelve-year period
showed that only one country—Canada—had
a correlation higher than 50% versus returns in
the US bond market. Australian government
bonds showed the lowest correlation, at less
than 10%. Thus, being invested in several
bond markets helps smooth out the volatility of
a portfolio as strong returns from some
markets will offset weaker ones from poorly
performing ones.
Historical studies have shown that an optimal
allocation of foreign bonds—-the mix that provides the highest return without significantly
increasing risk—ranges between 10% and
20% of a fixed income portfolio.
As in international stock investing, investors
in international bonds must be wary of political and economic instability, particularly in
emerging markets, and must have strong
research capability to effectively monitor
overall economic developments in the
countries as well as factors affecting specific
credits. Currency fluctuations represent the
greatest concern since these changes represent
a greater portion of foreign bond than foreign
stock returns. Changes in interest rate levels, as
well as a currency’s supply and demand
situation, directly affect the dollar’s value
relative to foreign currencies.
The recent introduction of the “euro”, the
new currency representing the economic consolidation of the eleven countries in the
European Monetary Union, will significantly
reduce but not eliminate the opportunities
available to foreign bond managers who seek
to diversify their portfolios by finding
differences in relative value between
currencies around the world.
30 PERAC TRAINING SERVICES
5. Real Estate
Pension funds invest in real estate
because the asset class is seen as a
good inflation hedge and because it
offers clear benefits of diversification.
Historical returns, while favorable, have a very
low correlation with either stock or bond
returns. Besides reducing overall portfolio
volatility, real estate can offer attractive current
returns, benefiting from the steady cash flows
from rents that derive from a portfolio of wellleased operating properties.
Investors in real estate expect to receive
returns both from income and from capital
appreciation. Expected long-term performance
is higher than that of high grade bonds but
lower than the historic returns of blue-chip
stocks. Among the various types of property
included in real estate investments are downtown office buildings, industrial parks,
research and development buildings, suburban
office buildings, hotels (full-service or limited
service), apartments, shopping centers, and
regional malls. As in other investment asset
classes, different segments will do better at
different times. The success of real estate
investments closely mirrors overall economic
conditions as well as the specific health of the
real estate market on not just a national but on
regional and also very local scales.
Besides the risks of general, regional, and
local economic and market conditions, risks of
real estate investing include fluctuations in
interest rates; overbuilding and increased
competition; increases in property taxes and
operating expenses; changes in zoning laws;
heavy cash flow dependency; possible lack of
mortgage fund availability; losses due to natural disasters; regulatory limitations on rents;
variations in market rental rates; changes in
neighborhood values; and losses due to
environmental problems. In such a complex
industry, the quality of management—its
structure, financial strength, and overall
skill—is obviously of paramount importance.
Pension funds and other institutions invest in
real estate either through direct property ownership or through pooled instruments such as
Real Estate Investment Trusts. REITs were
created by Congress in 1960 to offer investors
the real estate equivalent of mutual funds.
They pool investors’ funds for investment
primarily in income producing real estate or
real estate related loans (although not
construction financing). A REIT is not taxed
on income distributed to shareholders if it
complies with various requirements relating to
its organization, ownership, assets, and income
and the requirement that it distributes to its
shareholders at least 95% of its taxable
operating income each year. This benefit relative to taxation is also the greatest limitation of
REITs since it restricts retained earnings that
could be invested for growth.
Among the various types of REITs, equity
REITs invest directly in real property and
derive their income primarily from rents. They
can also realize capital gains by selling appreciated property. Their value is affected by
UNDERSTANDING INVESTMENTS 31
changes in the value of the underlying
property owned. Mortgage REITs invest the
majority of their assets in real estate mortgages
and derive their income from interest
payments. They are affected by defaults or
delinquencies relating to the
underlying mortgages as well as
prepayment risks. Hybrid REITs
combine the characteristics of both
types.
Equity REITs are the dominant
form of this relatively small
investment sector. As of mid-year
1999, 175 out of the 212 publicly
traded REITs were equity REITs.
Total market value of outstanding
REIT securities is about $145
billion. Roughly $135 billion were
rated by one or more rating
agency, with the average rating
being low investment grade
(Baa/BBB). About 80% of the
publicly traded REITs trade on the
New York Stock Exchange with
the rest on the American Exchange
or on NASDAQ.
Real estate is by nature an
illiquid investment, requiring large
amounts of capital, sophisticated market
knowledge, active and ongoing property management, and a commitment to long holding
periods. Aided by the development of
generally accepted valuation methodologies,
REITs are intended to offer a greater degree of
liquidity to real estate investment.
One of the generally accepted ways of
measuring a REIT’s operating performance is
As fears of an
economic
downturn were
decisively
dissipated as
the second
quarter of
1999 began
and the effects
of last year’s
flight to quali
ty were largely
reversed,
REITs (along
with small cap
stocks)
enjoyed a
powerful
recovery.
“Funds From Operations” (FFO), or price
relative to FFO. Funds from Operations is
defined as net income excluding gain or loss
from sales of property or debt restructuring
and adding back depreciation of real estate.
One of the major differences
between FFO and corporate
earnings is that commercial real
estate maintains residual value to a
much greater extent than
machinery, computers, or other
types of property.
REITs have had only five years
of negative total returns in their 38
year history, but their returns can
be very volatile. After the average
REIT lost 40% of its value in 1974
when the economy suffered from
the worst possible condition—
stagflation, the class was out of
favor with investors until the
1990s. They’ve done well during
this decade, tracking the S&P 500
in terms of cumulative return until
1998. Last year the sector had its
worst year since 1974, with
negative returns of about 17% (as
measured by the National
Association of Real Estate Investment Trusts).
The market reacted to concerns about a
slowing economy and fears about deflation,
and it ignored the sector’s average earnings
growth of 13%. The asset class went from
being overvalued to being undervalued, in the
view of many analysts, relative to the underlying property assets supporting the securities.
This trend continued into 1999 as REITs had
32 PERAC TRAINING SERVICES
negative total returns of about 5% during the
first quarter. Over the three years extending
through 1999’s first quarter, average REIT
returns had been close to those of small
capitalization stocks, with both asset classes
dramatically underperforming the S&P 500
Index of large cap stocks.
As fears of an economic downturn were
decisively dissipated as the second quarter of
1999 began and the effects of last year’s flight
to quality were largely reversed, REITs (along
with small cap stocks) enjoyed a powerful
recovery. The average REIT returned more
than 10% during the quarter. Contributing to
the stronger tone was the fact that some very
prominent institutional investors were said to
have added to their REIT holdings in light of
their intrinsic cheapness relative to actual
market value.
An important point is that REITs represent
only about 10% of institutional quality real
estate. In sharp contrast to the significant
losses suffered by REITs in 1998,
privately-held real estate actually registered a
16% positive return for the year, as measured
by the Russell Real Estate Open-End Funds
Universe Average. The startling difference
between public market and private market real
estate returns reflects the fact that changing
investor sentiments can drive securities in
public markets to extremes of over- or
undervaluation relative to underlying assets.
Since publicly-traded REITs remain a small
market subject to dramatic swings in valuation
that reflect investor psychology more than
market fundamentals, these securities do not
provide all the attributes that pension funds
expect from private real estate, such as
inflation hedging.
The National Council of Real Estate
Investment Fiduciaries (NCREIF) publishes a
widely-followed index of quarterly total
returns on commercial real estate properties
held by institutional investors such as pension
funds. Its returns are market-weighted and
divided into income and capital components of
total return. The universe includes existing
investment grade non-agricultural income
producing properties in four major categories:
Apartment, Industrial, Office, and Retail. In
each category, returns are calculated for the
four major regions of the country. The
NCREIF indicated overall total return of about
18% from its properties in 1998.
After last year’s sharp correction, REITs may
still offer good value at this time, even after the
recent recovery. As always, the challenge is to
find securities backed by high quality assets,
ample coverage of current dividends, and a
strong management team. REITs today offer
dividends in the 7-8% range (well above those
for either stocks or high grade bonds) and
anticipate annual capital appreciation in the
2-5% range.
Unless interest rates continue to rise, the
fundamentals for real estate look to be generally favorable with supply and demand in
general equilibrium in most areas. Most of the
reasons for previous excesses, such as the
Japanese buying binge or resolution of the
Savings and Loan crises, are behind us and
there are no tax proposals before Congress that
would negatively affect the market. Also, the
current mix of low inflation and low interest
UNDERSTANDING INVESTMENTS 33
rates is very favorable to real estate. The major
risks to the market remain 1) a recession that
negatively impacts demand for units or 2) a
building boom that creates oversupply and
downward price pressure.
With property owners having the ability to
raise rents over time and to grow via appreciation and property acquisition, investment in
real estate offers both an inflation hedge as
well as potential growth. Nevertheless,
returns—particularly in the publicly traded
marketable securities—can be very volatile
and the class clearly has inferior liquidity
relative to more traditional investments such as
blue chip stocks and high grade bonds.
Overall, however, US pension funds have been
allocating an increasing percentage of their
assets to various equity real estate investments
for the expected benefits of diversification and
the anticipation of reasonable returns.
34 PERAC TRAINING SERVICES
6. Alternative
Investments
Alternative investments, or investing in
private markets, has been increasing
in importance among pension and
endowment funds in recent years. Investors in
this class are paid a premium for the risk of
holding illiquid, nontradeable investments and
they have the potential to earn higher returns if
the underlying projects are run by experienced
general partners with strong strategic visions
and management skills and who can effectively exploit the inefficiencies that frequently
exist in the private markets.
Many of the nation’s largest public pension
funds invest in the private equity markets
through a limited partnership vehicle.
Managers are chosen for their expertise in a
particular field in private equity and assume
the general partner role. Investors participate
as limited partners; as such, they have very
little say in project management but their
potential liability is limited to the invested
capital.
There is no defined secondary market for
private equity and limited partners may be
unable to liquidate their entire positions over
the 8–10 year life cycles of typical partnerships. Volatility, as measured by the standard
deviation from a mean return, is generally
considered to be twice as high for private
equity than for domestic public equity.
Management fees are much higher than in
traditional investments and are often drawn
down from committed capital before money is
actually invested in the project. These fees are
essentially reimbursed to investors as capital is
returned on successful projects. The basic
compensation of the general partners derives
from the predetermined portion—usually
around 20%—they take from partnership
profits. Valuation of holdings prior to project
exit can be very subjective. Balanced against
these and other risk factors are the benefits of
diversification with an asset class that has low
correlation with others and which has expected
returns of 400-500 basis points above the S&P
500 over time horizons of ten years or more.
Private markets total about $1 trillion in
market value, or equivalent to about 10% of
the US public equity market. There are six
distinguishable sectors:
1. ACQUISITION EQUITY OR
“BUYOUTS” are when an investor seeks
financial control of a mature public or private
company. Often this will occur when an
investor attempts to bring about management
change and to create value for a company he
considers mismanaged, inefficiently operated,
or in financial disorder. Investors such as this
will use privately raised capital and borrowed
money to buy companies, “fix them up”, and
then exit, usually by selling outright using an
UNDERSTANDING INVESTMENTS 35
Initial Public Offering.
According to Private Equity Analyst, $47.3
billion out of the $85.3 billion raised by USbased private equity limited partnerships in
1998 was in acquisitions and buyouts.
2. VENTURE CAPITAL is an equity
investment in a private company that is in the
early stages of development. “Early stage”
companies seek capital to complete product
development and begin marketing. “Late
stage” companies focus on advanced business
development issues such as growth in market
share and strengthening the management team.
Venture capital investors typically have long
investment horizons, expecting low or negative
returns for the first 3-5 years and higher
returns near the end of the partnership term.
With an increasing amount of institutional
money seeking profitable investments in this
area, finding well-structured, strategically
sound partnerships that are fairly priced for
investors is a major challenge.
For the seventh straight year, venture capital
commitments increased in 1998 as 198 funds
raised a record $24.01 billion, according to the
National Venture Capital Association. Money
actually invested rose to $16.02 billion.
Companies in the computer software and
services sector received over one-third of the
total, while California and Massachusetts had
the most disbursements among the states.
3. INTERNATIONAL PRIVATE
EQUITY includes both buyouts and venture
capital for international markets. Allowing for
differences in regional and country-specific economic growth and equity market valuations,
international private equity is similar to the US
market in strategy and structure. The more
problematic area is private equity funding for
emerging markets, where the upside return is
enormous but the risks are equally impressive.
4. DISTRESSED SECURITIES are
stocks and bonds of companies in financial
distress. Investors in these securities seek capital appreciation by purchasing the securities
of companies that are distressed due to debt
overhang, poor management decisions, or
other factors that they feel can be eventually
overcome. Holders of these securities must be
willing and able to be involved in a corporate
bankruptcy process.
5. HEDGE FUNDS are portfolios that are
actively and aggressively managed to maximize total return. Among the unconventional
strategies employed by these funds are short
sales, selling securities not owned in order to
profit from a decline in value; leverage, borrowing money to increase the fund’s investable
capital and to capture the differential in return
between the cost of borrowing and the
investment return; investing in multiple types
of securities (stocks, bonds, futures, currencies, et al) in one portfolio; and not following
the usual principles of diversification. Hedge
fund managers employ sophisticated models in
an effort to uncover inefficiencies in markets
around the world and they feel that their bets
are sufficiently numerous so as to limit overall
market exposure. As was dramatically seen in
summer’s collapse of Long-Term Capital
Management, troubles can ensue when the
36 PERAC TRAINING SERVICES
market inefficiencies become larger rather than
swiftly trade back to equilibrium and when
nearly all the fund’s bets go against them in a
short time. For the Nobel Prize winners and
other “rocket scientists” behind LTCM and for
the previously high-flying managers of many
other hedge funds that lost billions last year,
1998 was truly a year of humbling enlightenment. In terms of being a factor in the markets,
hedge funds have generally not yet recovered
from last year’s debacle.
6. OTHER
Opportunistic Real Estate investments, usually involving more leverage than traditional
real estate investment funds, are popular when
the real estate market, either national or local,
is depressed, as in the early 1990s.
Energy and Natural Resources investments
would include segments such as cogeneration
facilities and other types of alternative energy
production; equity investments in energy
exploration and production and in energyrelated companies.
Mezzanine Debt is the origination of a loan
that is junior to senior debt and senior to equity in the capital structure. Such securities share
some of the characteristics—and risks—of
both equity and debt.
Flows have been increasing into private
market investments since expected returns are
as high as 7% above those of US stocks.
Performance data compiled by Wilshire
Associates shows that returns are widely
dispersed and only top quartile partnerships
achieve a return of 7% above the S&P 500.
Nevertheless, historical returns in this sector
are impressive and indicate that venture capital
is the sector offering the highest potential
returns in private equity. Venture Economics, a
division of Securities Data Corporation,
reported annualized returns of 17.2%, 27.4%.
and 17.7% for venture capital over 1, 5, and 10
year periods ending December 31, 1998.
Corresponding returns were 12.8%, 20.5%,
and 16.9% for all private equity including buyouts. An index compiled by Cambridge
Associates of Boston shows annualized returns
of 27.6%, 34.2% and 23.0% from venture
capital over the same 1,5 and 10 year periods
and 15.1%, 21.2% and 16.7% for all US
private equity.
Implementation of a successful private
market investment requires a diverse and
complex set of skills which include: identifying investment opportunities, gaining access to
superior general partners, performing due
diligence, negotiating deal terms, and monitoring partnership investments.
There are a limited number of “top-tier”
private equity firms that have consistently
excellent returns. Participation in their partnerships is often limited to existing investors,
experienced investors, and those who are able
to approve investments quickly.
While many pension funds, working with
their consultants, have been successful in
identifying and investing in alternative
investments partnerships, retirement boards
may also want to consider “fund of funds”
structures as offered by some vendors as
practical and cost-effective ways to participate
in this potentially very rewarding but also
uniquely challenging asset class.
UNDERSTANDING INVESTMENTS 37
7. Asset
Allocation
The most important determinant behind
success or failure in investment
management is not individual security
selection or trading by investment managers. It
is estimated that about 90% of the variance in
investment returns among different portfolios
is determined by asset allocation, the percentage of portfolio assets allocated to specific
asset classes such as stocks, bonds, real estate,
venture capital, et al. The goal of asset
allocation is to maximize returns at a prudent
level of risk, and the process of determining
the appropriate asset allocation should involve
an analysis not only of assets but also of the
liabilities of an organization such as a
retirement board.
The primary goal in constructing a portfolio
is that it should return enough to meet an
investor’s objectives and do so with a level of
risk that an investor is comfortable with. There
are several asset classes, or groups of
investment securities whose behavior is similar
during changes in economic circumstances,
and each class (i.e., stocks) has several
subclasses (large, midcap, small cap; growth
and value). The major inputs to an asset
allocation process are the expected historical
returns for each distinct asset class, the
volatility of those returns over time, and the
correlation of returns among the asset classes.
An effective portfolio is not just the sum of its
parts but should incorporate the expected
interaction among those parts. Considering the
likely correlation in performance among asset
classes should reduce risk and volatility in a
portfolio while helping to achieve expected
returns.
Risk means different things to different
people. To a bungee jumper, it’s the possibility
that the cord might break. For an investor, risk
means the possibility of losing money and not
meeting one’s financial objectives. Similarly,
asset allocation is like wearing protective gear
in athletics. One might perform better if not
hampered by protective gear, but without it, a
blow to an unprotected part of the body could
prove disastrous. That’s why even though large
cap growth stocks have been by far the best
performers among major asset classes for
some time, a well-constructed portfolio will
also have assets in currently underperforming
sectors like bonds, small stocks, and real
estate. These sectors currently serve as hedges
that may inhibit maximum performance today
but will likely cushion the portfolio to some
degree when the high-flying growth stocks
inevitably turn down.
Historically, stocks have returned more than
bonds. Since 1926, the annualized return on
blue chip US stocks has been slightly over
11% while that on high grade bonds has been
about 5.5%. Over the ten years ending 1998,
38 PERAC TRAINING SERVICES
the difference has been even greater as the
S&P 500 has gained 19.2% annually compared
to 9.3% for investment grade bonds. The
greater return on stocks reflects their larger
“risk premium”, or extra return demanded by
investors to compensate for the fact that stock
returns are historically about three times more
volatile than bonds in terms of variability of
periodic returns. The S&P 500 returned 34.1%
in 1995 while long term bonds have rarely
done better than the 18.2% registered by
Treasuries in 1993. But the worst year for
bonds has been the 7.8% loss in 1994, compared to the 26.5% loss suffered by the S&P in
1974. Illustrating the cushioning effect, when
the S&P plummeted 14.5% in August 1998,
bonds had a positive return of 1.5%.
Historical analysis shows that, as noted
above, returns from stocks have been about
twice those from bonds. Stocks also have
about three times as much risk as bonds,
as measured by the annualized standard
deviation of monthly returns. This traditional
measure of volatility refers to the variance
from the mean return that will be observed in
about two-thirds of sample returns.
If one were to use historical observations of
returns and risk from stocks and bonds to construct a graph with investment returns on the
vertical axis and risk on the horizontal axis,
such a graph would have an entry for stocks in
the upper right sector (high return, high risk)
of the chart and for bonds in the lower right
(lower return, lower risk) of the chart. The
practice of asset allocation involves drawing a
line between these two extreme points and
determining what combination of stocks and
bonds strikes the right balance between an
investor’s required return and the level of risk
he/she is comfortable with. In reality, the
choices will involve more than just two broad
asset classes because both the stock and bond
markets consist of several distinct styles and
sectors and there is also the option to invest
internationally as well as domestically. For
instance, small stocks historically have
returned more than large stocks but at a
significantly higher risk level. Also, the
risk/return relationships among asset classes
will not typically be represented by a straight
line because the benefits of diversification
among asset classes usually cause the expected returns for a given level of risk to be greater
than the sum of the individual returns.
An asset allocation process today should
properly include a number of different asset
classes. It’s not unusual for one asset class or
investment style to dominate returns for four
consecutive years as US large cap stocks have
recently done, but other classes—including
small caps, international stocks, and real
estate—have enjoyed similar extended periods
of superior performance over the past quarter
century. If one looked at historical returns of
large US stocks, small US stocks, international stocks, and high grade US bonds over the
twenty years through 1998, there was only one
year prior to 1995 that large US stocks provided the best performance among these four
asset classes. The lesson here is that a
portfolio diversified among asset classes will
never match the performance of the best asset
class in each year but it will also never equal
the worst.
UNDERSTANDING INVESTMENTS 39
ON THE OTHER HAND … the developed countries, seem to be moving in
There are, of course, some dissenting voices to at least the same direction (if not in the same
the theoretical frameworks governing the magnitude) to a greater extent in recent years.
search for today’s most efficient portfolios. Such an occurrence is what brought down
First of all, some scholars see the far greater Long-Term Capital Management last August.
risk premium traditionally As that failed hedge fund learned,
attached to stocks compared to The breakdown diversification won’t dampen
bonds diminishing as the of trade volatility when global markets
differential in volatility between barriers and move synchronously.
the asset classes appears to be nar- The events of last August were a
rowing in recent years. For bonds, advances in short-term phenomenon and do
interest rates have become more
communications not destroy the validity of the benvolatile in recent years as the Fed technology efits of international diversificafine tunes monetary policy in order have meant tion in the long run. Nevertheless,
to keep the economy growing at a that previously it could turn out that the benefits
sustainable pace. For stocks, independent from that strategy may be
investors may be perceiving this economies are overestimated because of the slow
sector as less risky as a result of becoming but steady trend towards an
better education, new tax laws that increasingly homogenized global
more
encourage long-term holding in economy. The breakdown of trade
IRA accounts, improved corporate
correlated to barriers and advances in commuefficiency, better governmental our own. nications technology have meant
monetary and fiscal policy, an that previously independent
improved regulatory and tax environment, and economies are becoming more correlated to
diminished foreign threats. (While volatility of our own.
stocks, as traditionally measured in terms of Certainly, there is no other major economy
variability of monthly returns, may or may not that has been firing on all cylinders like the US
be decreasing, it is generally agreed that over the past several years. No other country is
increased retail participation in the market has at the forefront of the technological revolution
served to increase day-to-day market volatility.) and also enjoys sound economic and fiscal
Also, some analysts have been questioning policy and stable political leadership. The
the value of international diversification. By trouble with this argument against internationplacing a portion of assets in markets not cor- al diversification is that ten years ago investors
related with the US market, can an investor were similarly drooling over Japan as the
really reduce the volatility of the portfolio world’s invincible economy. Today, after
while maintaining.and sometimes increasing several years of stalled economic growth and
returns? The world’s markets, at least among failed political leadership, Japan’s economic
40 PERAC TRAINING SERVICES
future is very much in question.
SUMMARY
Asset allocation is a practice whose benefits do
not enjoy universal intellectual support among
market professionals, but its basic objective
remains one of prudence. It can be seen as
representing an insurance policy against the
day when today’s hottest sector cools down.
Foreseeing such a day becomes difficult, and
the opportunity costs in investment returns
become real, when one sector such as US large
cap stocks has been dominant for so long, but
that day will inevitably come. Also, rather than
investing in various asset classes for the sake
of filling out a portfolio, a more enlightened
rationale for asset allocation would be to
emphasize those asset classes that are clearly
undervalued today but where the road to better
valuation can be unmistakeably seen on the
horizon.
In summary, the goal of asset allocation is to
select a combination of assets that will
generate a return sufficiently high but also
sufficiently safe in order to meet a future
financial liability. In the most general of terms,
it is simply an expression of the centuries-old
axiom of “don’t put all your eggs in one
basket”. To use a comforting analogy, asset
allocation is like a pillow: if one part of the
pillow is punched in, another will puff out, and
the benefits of portfolio diversification will
provide the investor with steady enough
returns so that he or she can sleep well at night.
In reality, the world’s financial markets—and
the relationships among them—are sufficiently
dynamic and constantly changing so that asset
allocation in practice does not conform to
simple and cute analogies. Nor does it lend
itself to simply choosing portfolio
combinations from a neatly drawn graphical
curve of “efficient portfolios” calculated from
past experience. Asset allocation remains more
an art than a science since the models and
assumptions used are approximations of the
realities of an investment universe that is
exceedingly complex and constantly changing.
ASSET ALLOCATION IN
PRACTICE
While there is no common “black box” or other
standard methodology employed by pension
systems and their consultants, there does appear
to be a general similarity among the asset allocations currently adopted by both public and
private pension systems. “Pension &
Investments” newspaper reported that the
largest public defined benefit plans in the US
had aggregate asset allocations as follows in
1998: Domestic Equity, 46%; International
Equity, 11%; Domestic Fixed Income, 32%;
International Fixed Income, 2%; Real Estate,
4%; Alternative Investments, 2%; Other, 1%;
and Cash 2%. Surveys that include private as
well as public plans show approximately
similar results.
An asset allocation plan will typically involve
percentage ranges (such as 35-45%) assigned to
each asset class rather than a fixed percentage. An
asset allocation plan is typically determined in the
context of an overall Statement of Investment
Objectives and Policies. This Statement will
usually begin with a Rate of Return Objective,
conventionally stated as a targeted incremental
return over inflation or over a benchmark index
(or a series of benchmarks for each asset class).
UNDERSTANDING INVESTMENTS 41
There should be a discussion of the appropriate
level of risk that is expected. Pension funds, both
public and private, need to be generally conservative in that they are managed relative to certain
future liabilities but a reasonable amount of
short-term volatility is permissable since these
liabilities are basically long-term and the need for
short-term liquidity is modest.
Policies typically included in an Investment
Statement would include diversification
guidelines such as percentage of assets in one
company (such as 5%) or in one industry (e.g.,
15%) or in the percentage held in a corporation’s
total issuance (e.g., 5%). There could be guidelines for the number of stocks held, any targets
as to market capitalization, the age or maturity of
a company, and portfolio turnover rates. For
fixed income accounts, there could be guidelines
for credit quality and duration targets. There also
could be general restrictions such as prohibition
against private placements, “short sales”,
commodities, direct real estate, et al.
42 PERAC TRAINING SERVICES
8. Selecting an
Investment
Manager
PEOPLE
What is the education and experience
level of key personnel?
Who will be the primary manager
assigned to this account? Get to know him or
her!
How many accounts does he/she manage?
Who will be his/her backup?
What is the organizational structure of the
firm, and of the specific investment group
involved?
What is the extent of cohesion among
staff in this investment group?
What has been the staff turnover rate?
How are key staff compensated?
PHILOSOPHY
What is firm’s traditional overall investment philosophy? Top-down, bottom-up,
quantitative, etc.
What is role of research? In-house staff,
or street research? What factors are emphasized?
How is investment policy determined? Is
there an investment committee?
What is current investment strategy in
major markets?
Has there been consistency in investment
philosophy and strategy?
PROCESS
How is the philosophy implemented?
Do individual managers have discretion
relative to firm’s investment strategy?
What is the review and control system relative to managers’ performance?
How is security selection and trading
done?
How are trades allocated among
accounts?
What is the buy/sell discipline?
High turnover, or buy-and-hold?
What is the methodology of portfolio construction?
Portfolios: highly concentrated or highly
diversified?
Is there a system of risk management
safeguards? How is it implemented?
PERFORMANCE
Are timely, accurate returns regularly calculated and made available?
How has performance been relative to
benchmark for this product?
Is the benchmark appropriate?
Is performance presented objectively and fairly?
UNDERSTANDING INVESTMENTS 43
Has performance been consistent?
How volatile have returns been?
Performance attribution: is there a system
for attributing performance along several criteria (i.e., cap size, industry, style, et al)?
Is performance repeatable or has it been
due to special, one-time factors?
Is performance consistent or widely dispersed among accounts?
THE FIRM
Is it independent?
If not, what is nature of relationship with
parent company?
Do employees have a stake in ownership?
If so, what %?
Compensation and incentive program
Corporate culture
Are there any significant company affiliations or joint ventures?
What are overall business objectives?
Recent growth trends
What products are “hot”?
Is there any limit on asset growth or new
clients?
What new products or other changes are
contemplated?
Is client base diversified?
Is client base stable? How many accounts
gained or lost recently?
How is client service structured?
Are portfolio managers accessible and
responsive?
How many other public pension or similar
clients are served?
Any ongoing litigation, investigations, or
financial problems?
Any potential conflicts of interest?
Recent material developments
44 PERAC TRAINING SERVICES
9. Outline of the
Competitive
Process
COMPETITIVE PROCESS
Open
Objective
Fair
RFP
Processing
Record Keeping
OPEN
Public notice - Reasonable time
Posted
Published
Secretary of State notice
May send to prospective bidders
OBJECTIVE
Evaluation based only on requirement and
criteria in RFP
Pre-established criteria
Objective and relevant criteria
Business/Technical
GFOA, PERAC, PRIM examples
PROCESSING RESPONSES
No alteration/corrections after date for
submission
Date stamped on receipt
Witness to opening RFPs
PROCUREMENT FILE
Record of procurement
Selection process
Selection criteria
RFP
Copy of minutes
Copy of responses
Disposal schedule/ 6 yrs. after contract
ends
ROLE OF CONSULTANT
Board is decision maker
Develop RFP
Data base screen
Incorporate into data base and analyze
respondents
Selection of consultant
Ability to meet fiduciary duty of board
CONTRACT
Written contract
Executed prior to assuming duties
Investment objectives
Brokerage practices
Fees
Termination
UNDERSTANDING INVESTMENTS 45
BOARD NOTICE OF
COMPETITIVE PROCESS
Prior to retention of Mger/con.
Board notify PERAC competitive process
followed
Chapter 32 provisions met
PERAC regulations met
In all cases exemption or not
No form-statement from board
VENDOR CERTIFICATION FORM
All vendors submitting bids
Selected vendor must submit to PERAC
Good faith submission
Without collusion or fraud
In all cases exemption or not
46 PERAC TRAINING SERVICES
INVESTMENTS
PUBLIC EMPLOYEE RETIREMENT
ADMINISTRATION COMMISSION
UNDERS ANDING
INVESTMENTS
PERAC TRAINING SERVICES
FIRST EDITION | SEPTEMBER 1999
PUBLISHED BY PERAC COMMUNICATIONS
PUBLIC EMPLOYEE RETIREMENT
ADMINISTRATION COMMISSION
ELIZABETH E . LAING
Chairman
Chairman, Board of Conciliation & Arbitration
A . JOSEPH DENUCCI
Vice Chairman
State Auditor
JOHN R . ABBOTT
Sergeant, Plymouth Police Department
MICHAEL J . DIRRANE
Senior Vice President, Amerin Guaranty
KENNETH J . DONNELLY
Lieutenant, Lexington Fire Department
DONALD R . MARQUIS
Town Manager, Arlington
ANDREW S . NATSIOS
Secretary of Administration & Finance
JOSEPH E . CONNARTON
Executive Director
PUBLIC EMPLOYEE RETIREMENT
ADMINISTRATION COMMISSION
5 Middlesex Avenue
Third Floor
Somerville, MA 02145
Ph: 617.666.4446
Web: www.state.ma.us/PERAC
JOSEPH I . MARTIN
Deputy Executive Director
Ext. 920
ROBERT DENNIS
Investment Director
Ext. 922
VICTORIA MARCORELLE
Assistant Director
Ext. 928
ROSE CIPRIANI
Administrative Assistant
Ext. 931
Contents
1. THE U.S. EQUITY MARKET
3
2. THE FIXED INCOME MARKET
1 9
3. INTERN ATIONAL STOCKS 2 8
4. INTERN ATIONAL FIXED INCOME 3 0
5. REAL ESTATE 3 1
6. ALTERNATIVE INVESTMENTS 3 5
7. ASSET ALLOCATION 3 8
8. SELECTING AN INVESTMENT
MANAGER 4 3
9. OUTLINE OF THE COMPETITIVE
PROCESS 4 5
2 PERAC TRAINING SERVICES
1. The U.S.
Equity Market
WHAT ARE STOCKS?
When a company wants to raise money to
invest in something they think will be
profitable, such as a new manufacturing
process, more productive capacity, or a new
product, they can do it in a number of ways.
They can simply borrow the money or they can
sell part of the company. The latter is done by
selling “stock”in the company. Owners of this
stock have voting rights in the company’s management. Stocks are also called “equity” since
the owners have equity, or part ownership in
the company, allowing them to share in a split
of the profits from the company. A share of
company profits is regularly distributed to
shareholders in the form of dividends.
Original owners of a new company will sell
stock to friends, associates, or venture capitalists. When a company becomes large enough
to need additional funding of usually several
hundred million dollars, stock is offered in the
public market in an “initial public offering.”
Subsequently, its value is determined on the
open market, on a stock exchange, by
whatever one is willing to pay for it. The price
of a stock can be affected by exogenous factors
or temporary trends but it is typically determined by expectations of profits (or dividends)
and by expectations of future growth.
Unlike a bond, which typically represents a
legal commitment to repay interest and
principal, there is no downside limit to what a
stock can be worth if the company’s prospects
plummet. Dividends could decrease or cease
entirely during periods of corporate
unprofitability. Thus, stocks have been seen as
riskier investments than bonds, but with these
greater risks come higher expected returns.
According to Ibbotson Associates, blue-chip
stocks appreciated an average of 11.2% from
1926-98 while US government bonds returned
an average of 5.3% over the same 73-year
period. In general, stocks are seen as a wealth
building tool due to their capital appreciation
potential while bonds are seen as income
producing instruments. Stocks, offering the
prospects of both capital growth as well as
steady and possibly growing income, are seen
as the investment vehicle most likely to successfully offer a long-term edge over inflation.
VALUE VS. GROWTH
In the equity market, there are two major styles
of investing. Value stocks are those that,
considering a company’s assets and earnings
history, are attractively priced relative to
current market standards of price-to-earnings
ratios, price-to-book ratios, et al. These
companies typically pay regular dividends to
shareholders. Growth stocks derive from
companies that, due to their strong earnings
and revenue potential, offer above average
UNDERSTANDING INVESTMENTS 3
prospects for capital growth, with less miss their earnings projections or if investors
emphasis on dividend income. Over long suddenly conclude that such stocks are too
periods, value and growth stocks have provid- highly valued relative to cheaper alternatives.
ed similar historical returns, although each has In practice, stocks are not always easily
periods when it may dramatically outperform categorized as growth or value and there will
the other. Traditionally, growth usually be some overlap in the
funds appeal to investors who will portfolios of the two styles. What A value
accept more volatility in hopes of the two styles have in common is investor may
greater appreciation or who prefer that they both seek great compa be compared a higher proportion of the returns nies. Growth managers are not
to the to derive from capital gains, which afraid to pay a Tiffany-like price
consumer who are typically taxed at lower rates tag for a company they consider a
than dividend income. patiently waits diamond, and they are willing to
A value investor may be for a sale take a risk that it could turn out to
compared to the consumer who be flawed. Value investors also
patiently waits for a sale before
before buying,
or who thrills search for diamonds, but typically
buying, or who thrills at the cheaper ones where, through at the
prospect of discovering a designer patience, their eventual higher val prospect of
original on the clearance rack at ues will be realized. discovering a Filene’s. The skillful manager will As noted, performance of value
designer not just focus on price for, like and growth stocks typically
original on the holiday fruitcake after Christmas, converge over long periods but
many companies with low price clearance rack growth has dramatically outpermultiples deserve to be discount- at Filene’s. formed over the past four years
ed. Successful value managers and this trend continued through
know how to distinguish the perpetually ugly the first quarter of 1999. For the twelve months
ducklings from those likely to become swans. ending March 31, 1999, the Growth compoValue managers are not averse to companies nent of the S&P Index outperformed the Value
that are growing; they simply prefer those component by an astonishing margin of 30.7%
whose stocks are marked “clearance”. to 5.7%. There are no universally agreed upon
On the other hand, growth managers are like explanations for this, but one plausible one
those shoppers who make a beeline for trendy states that growth outperforms value when the
full-price merchandise, betting that their price overall corporate profits cycle slows. Profits
will continue to rise. These managers must growth peaked in 1995 after companies reaped
address the question of “how high is high”? At the benefits of several years of corporate
some point, stocks with high price tags could restructuring and an improved economy. As
suddenly plummet if individual companies overall earnings growth has become scarcer,
4 PERAC TRAINING SERVICES
investors have bid up the price and expanded
the multiples on those relatively few companies and sectors (such as technology) that are
maintaining their growth rates or are expected
to demonstrate healthy growth. When overall
corporate profits begin to accelerate, growth
will become increasingly abundant and value
will tend to outperform as investors become
comparison shoppers. This is what happened
during the second quarter of 1999 as the economic fears that spooked the market during the
summer of 1998 faded into memory.
Growth stocks typically do well during
periods of low inflation and declining interest
rates such as we have enjoyed over the past
few years. Reduced costs arising from these
trends help companies achieve better earnings
and to grow and expand. Also, the present
value of future earnings is greater when
inflation and interest rates are low. Value
stocks are typically concentrated in such
cyclical sectors as industrial, basic materials,
energy, and financial services and will tend to
outperform growth stocks during periods of
rapid expansion.
SIZE
Stocks are also categorized in terms of the total
value of their outstanding stock, also known as
capitalization. Large capitalization stocks are
currently loosely defined as those with total
market value exceeding $10 billion, mid-caps
are between $1.5-10 billion, and small-caps
are less than $1.5 billion. Historically, large
caps have exhibited lower volatility than mid
or small caps.
Over time, small caps have actually
outperformed large caps by 1-2% per year, but
they have badly lagged in recent years. For the
ten years ending 1998, the large-cap oriented
S&P 500 Index outperformed the major small
cap index 19.2% vs 12.9% in terms of
compound annualized return. In terms of
comparison versus large caps, 1998 was
actually the worst year ever for small caps as
indices for this sector actually declined versus
robust gains for large cap indices; the
differential in return was a startling 31%.
Indeed, without the 250 companies with the
largest market valuation, stocks overall would
have been negative last year. While small cap
stock indices showed negative returns for the
year, the fifty largest stocks rose 39%. The 415
largest stocks now represent about 77% of the
total stock market capitalization at year-end,
up from 55% in the early 1980s.
US STOCKS 1998
GROUPED BY TOTAL
CAPITALIZATION RETURN
50 Largest Stocks
by Capitalization 39.1%
Stocks Ranked 51-200 26.0%
Stocks Ranked 201-500 14.2%
Stocks Ranked 501-1000 3.3%
Stocks Ranked 1001-3000
(Russell 2000) -2.5%
Large caps benefited last year from the
world-wide flight to quality arising from the
crises in Asia and Russia. Since they’re much
more widely followed and actively traded,
large caps are much more liquid than small
caps. The dominant performance of large caps
in recent years is also attributable to the phenomenal growth in index investing, which has
UNDERSTANDING INVESTMENTS 5
seen billions of dollars chasing the large stocks market valuations than some of the economy’s
emphasized by the S&P 500. Also, larger most established blue-chip companies that
companies are perceived as better able to offer have long histories of consistent profitability,
higher and more stable earnings growth than one has to wonder to what extent speculative
before as a result of corporate restructuring fever is obscuring true value.
and globalization. Here are some of the best and worst
Historically, periods of small cap outperfor performing sectors in 1998 among industry
mance tend to coincide with troughs of major groups, according to Dow Jones:
recessions. The fact that the economy has not
experienced a serious downturn in many years
Communications Technology 102.3%
is perhaps one of the reasons for the mediocre Entertainment 90.3%
performance of small cap stocks this decade. Computers 80.4%
With the recovery in Asia and the apparent
bottoming out of the Japanese economy, Software 79.0%
indications of stronger worldwide growth Drug Retailers 68.3%
contributed to small caps (as well as mid-caps) Aerospace & Defense -18.5%
significantly outperforming large caps during
the second quarter of 1999. Lodging -24.3%
Real Estate -26.2%
INDUSTRY SECTORS
Many small investors as well as experienced Heavy Machinery -31.3%
investment managers have been shaking their Oil Drilling -58.9%
heads over the past few years when consider- With the changed economic scenario with
ing the extent to which large stocks have regard to economic growth, the second quarter
outperformed small stocks and growth stocks of 1999 saw a dramatically different list of
have outperformed value stocks. What is winners and losers:
somewhat more easily explained is why Aluminum +45.2%
different industry groups perform differently.
In the economy, there are always some
Industrial Technology +38.2%
industries or sectors that are doing better than Heavy Construction +26.6%
others, or are perceived to have much better Heavy Machinery +25.8%
prospects. Nevertheless, the differential
between top and bottom performers can be
Drug Retailers -8.1%
huge, perhaps more than seems justified. There Restaurants -8.7%
is little doubt that we are in an historic era of Savings & Loan -9.0%
technological change, but when newly-created
Consumer Services -17.3%
Internet-related companies that are years away
from even turning a profit are awarded greater Cosmetics -21.9%
6 PERAC TRAINING SERVICES
VALUATION
In many ways, the valuation of a stock is an art
not a science. As noted above, shares are worth
whatever someone is willing to pay for them,
whether or not that price conforms with what
professional investors perceive its
intrinsic value to be. In theory, a
share of stock is supposed to be
worth the present value of all
future cash flows expected from
the investment. Yet, there are a
number of widely accepted methods that are also used in the
valuation of stock.
The most common way to value
a company is to use its earnings.
The Price/Earnings ratio, sometimes referred to as the multiple, is
the stock price divided by the
company’s net income or profit
per share over the past twelve
months. For example, if the stock
of the Martin Corporation was
selling at $30 and it had earned $2
per share over the past year, its P/E
would be 15.
Other yardsticks employed
include:
Price/Sales Ratio - A measure of
the company’s ability to generate
revenue.
Cash Flow - A way to focus on the operating
business and exclude secondary items like
interest, taxes, depreciation, and amortization
Price to Book Ratio - Comparing the stock
price to the company’s actual, liquidation value,
using both its tangible and intangible assets
In many ways,
the valuation
of a stock is
an art not a
science. As
noted above,
shares
are worth
whatever
someone is
willing to pay
for them,
whether or not
that price
conforms with
what
professional
investors
perceive its
intrinsic value
to be.
Return on Equity - Assessing a company’s
earning power relative to shareholder’s equity
(liquid assets and retained earnings)
Dividend Yield - Comparing a company’s
dividend payout to its stock price is a criteria
used by income-oriented investors
Overall, however, the Price to
Earnings ratio is the most accepted
criteria for stock valuation. P/E
ratios have never been higher than
they are now, although they are far
from uniform. P/Es are extraordinarily high for high-flying
technology and Internet-related
companies but they are at or below
historical averages for a number of
out-of-favor sectors such as
machinery or commodity (i.e., oil)
based industries. The fifty largest
stocks in the S&P 500 had priceto-earnings ratios of 43 at year-end
while the 50 smallest stocks in the
index had P/Es averaging 25. Not
only are valuations higher for large
cap stocks, such as those represented by the S&P 500, than for
small cap stocks, but , even among
small caps, the larger companies in
this category are more highly
valued than the smaller ones. By a
breathtaking margin, valuations
for growth stocks far exceed those of value
stocks.
Price to earnings ratios on the S&P 500,
which averaged 10 in the late 1980s and were
less than 15 as late as 1995, have recently been
above 30, an unprecedented level. Over the
UNDERSTANDING INVESTMENTS 7
four years ending in 1998, the rise in the S&P
500 was over four times greater than the rise in
corporate earnings over that period. The doubling of P/E ratios over this period explained
almost 80% of the surge in equity values.
Thus, while many argue from historical
perspectives that many sectors of the market, if
not the market itself, are substantially
overvalued and due for a correction, others
argue that the old yardsticks of valuation no
longer apply in the current environment where
the traditional business cycle no longer seems
relevant, the world is more interdependent than
ever, inflation and interest rates are
historically low, corporate managers are more
aggressive than ever at controlling costs, and
technological changes of historic proportions
are radically improving productivity and
efficiency.
The beauty and challenge of stock investing
is that it is an art not a science. The same stock
may be simultaneously deemed overvalued,
fairly valued, or undervalued according to
criteria employed by different analysts. One
thing is for sure. Market trends will change as
will the conventional valuation levels. But a
stock will always be worth whatever someone
is willing to pay for it
PERFORMANCE MEASUREMENT
1998 was another banner year for stock market
returns. Or was it? The fact is that if one
wasn’t invested in the right size stocks, the
right type, or the right sector, then 1998 may
not have been a happy year at all for stock
investors. Beyond the flashy returns heralded
by certain widely-followed indices, the fact is
that the majority of US stocks actually lost
value in 1998. Losers outnumbered winners on
the New York Stock Exchange. More than 40%
of the S&P 500’s stocks fell. Even on the high
flying technology-laden NASDAQ, twice as
many stocks declined as rose.
Indicating the extent to which last year’s
gains were highly concentrated in large
technology growth stocks, about one fifth of
last year’s 28% gain in the S&P 500 was
accounted for by four such stocks: Microsoft,
Intel, Cisco, and Dell. 85% of the index’s
return was accounted for by only 50 of the 500
stocks in the index.
These trends continued with a vengeance as
1999 began. The 4.98% gain in the S&P 500
during the first quarter can be attributed to just
18 of the 500 stocks, and two stocks
(Microsoft and America Online) represented
one third of the gain. More than half the stocks
in the Index actually declined during the
quarter. Three of the thirty stocks in the Dow
Jones Industrial Average constituted more than
half that index’s 7.04% advance. Even more
telling, two thirds of the stocks on the NASDAQ exchange were down during the quarter
despite the composite index’s 12.3% gain.
Although the second quarter of 1999 showed
at least a temporary reversal of this trend, the
fact that stock returns have been so dispersed
and gains have been so narrowly concentrated
in recent years makes it exceedingly important
that the mandate of equity investment
managers is clear and unambiguous. It is
equally clear that returns must be monitored
relative to appropriate benchmarks and that the
subtleties and quirks of each benchmark are
well understood.
8 PERAC TRAINING SERVICES
Here are a number of major benchmark
indices and their returns for 1998 and the first
half of 1999.
INDEX 1998 1H99
Dow Jones
Industrial Average 16.1% 20.5%
Standard &
Poor’s 500 28.6% 12.4%
NASDAQ
Composite 39.6% 22.5%
Russell 2000
(Small Caps) -2.5% +9.3%
Russell Mid-Cap 10.1% 10.3%
Wilshire 5000
(Total Market
Proxy) 23.5% 11.9%
The above numbers vividly illustrate the
challenges of accurately gauging equity
performance today. Struggling to retain its
credibility in the market is the Dow Jones
Industrial Average, which tracks thirty large
industrial companies chosen according to no
specific criteria by the editors of The Wall
Street Journal. By contrast, the Standard &
Poor’s 500 is a broad-based market index comprising about 75% of the total market value of
publicly traded US equities. It is appropriate
for portfolios consisting of a combination of
large growth and value stocks. According to
S&P, the Index strives to reflect the US stock
market by including “leading companies in
leading industries”.The NASDAQ composite
is also a broad-based index tracking
performance of the more than five thousand
companies, including many of today’s leading
growth companies, that trade on this electronic exchange for over-the-counter trading.
The Dow is a price-weighted index, where a
stock priced at $100 has twice the weight of
one priced at $50, even if the latter has a much
larger total market capitalization. The S&P’s
weighting by market cap is more consistent
with how many important economic indices
are calculated. The NASDAQ composite is
also market-weighted.
From 1926 through about 1965, the Dow and
the S&P tracked each other closely since
industrial companies used to be the bellweather stocks in the economy. The Dow began to
lose its relevance in the 1960s when
service-based companies began to dominate
the economy. Now in the 90s, the Dow more
than ever seems to represent the “old
economy” while the S&P tracks the real
economy and the technology-laden NASDAQ
tracks the most dynamic companies of the
“new economy”. The S&P is itself becoming
increasingly reflective of the “new economy”;
stocks in the health care, technology, telecommunications, financial services, and consumer
services industries now constitute about three
quarters of the index, up from 60% in 1994,
while “old economy” industries such as
energy, basic materials, transportation,
utilities, and industrials now account for 16%
of the index, down from almost 30% in 1994.
If the Dow had continued to track the S&P in
the same ratio it did from 1926-65, it would
have been around 15,100 instead of the 10,971
it was on July 1.
THE STOCK MARKET:
LOOKING AHEAD
What is the greatest threat to America’s
UNDERSTANDING INVESTMENTS 9
economic health? Is it Asia? Latin America? trends that have propelled the market to its
Russia? Y2K problems? Tighter money? impressive bull run of recent years and all
Uncertainty over the 2000 elections?All these these trends may have run their course:
are factors that cannot and should not be 1. Disinflation. Inflation, as high as 5-6%
overlooked, but in the view of many, the during 1991, fell to about 1% and seems to
greatest threat to the economy is have bottomed
the US stock market, which has After an 2. Interest rates. Long Treasury
risen to such an extent over the unprecedented yields fell from 8% in 1995 to 5%
past several years that it represents at the end of 1998 and have risen
a “bubble” ready to burst. Our
fourth back to 6%. In the absence of a
economy has been the best perconsecutive clear economic slowdown, we are
forming among the major nations year of returns unlikely to see 1998’s lows again.
of the world in terms of its impres on the 3. Profitability. US corporations
sive growth and low inflation, but Standard & have become “lean and mean” and
much of the growth has been Poor’s 500 in corporate profit margins have
consumer driven, aided in part by excess of risen from around 4% to about
the “wealth effect” of sharply ris 20%, it’s not 6%. The expansion of margins and
ing equity values. If and when the difficult to of overall profits has stalled in
market declines significantly over recent years, however.
an extended period of time, the argue that 4. Valuations. Price to earnings
downward effect on consumer
stocks are now ratios on the S&P 500 have never
spending could be significant overvalued been higher. As one pundit noted,
enough to cause a meaningful and, at the at these lofty valuations, investors
economic downturn. least, are due are discounting not only future
After an unprecedented fourth for a period of earnings but those of the hereafter
consecutive year of returns on the more modest as well.
Standard & Poor’s 500 in excess of returns. If today’s high P/E ratios persist
20%, it’s not difficult to argue that but don’t increase, future stock
stocks are now overvalued and, at market returns will approximate
the least, are due for a period of more modest the rate of earnings growth, which has been at
returns. First of all, if one considers the overall single digits at best in recent years. The great
capitalization of the stock market compared to risk to the market is what would happen if
Gross Domestic Product, stocks now represent investors suddenly determine that future profit
an unprecedented 140% of GDP. This ratio growth has been vastly over-estimated and
was only 80% as recently as 1995 and was in P/Es suffer a sharp decline to more typical
the range of 40% from 1975-85. historical levels.
There are four distinct economic or market There are also a number of quantitative
10 PERAC TRAINING SERVICES
models that assess the valuation of the stock
market. Morgan Stanley Dean Witter has a dividend discount model that recently portrayed
the S&P 500 as more than 30% overvalued.
Fed Chairman Greenspan is known to employ
a model that shows a strong correlation
between the expected operating earnings yield
on the S&P 500 and the yield on the 10-year
US Treasury bond. As of early July, this model
also showed the market to be more than 30%
overvalued. When overvaluations persist, the
possible remedies are 1) interest rates falling,
2) earnings expectations increasing, or 3) stock
prices falling. Prior to last summer’s market
decline, the model had indicated a 25%
overvaluation.
Chairman Greenspan explicitly raised the
spectre of risk in today’s market when he
asserted in his February 23, 1999, economic
report to Congress that “Equity prices are high
enough to raise questions about whether shares
are overvalued. Investors appear to have
incorporated into equity prices both robust
profit expectations and low compensation for
risk”. He added that disappointments on either
score could ‘damp appetites for equities”,
which he warned could have a negative effect
on the economy when the “wealth effect” has
a reverse pull.
Noted market historian Prof. Jeremy Siegel
of the Wharton School has compiled data on
equity returns spanning the last two centuries.
He displays a strong trend line over almost 200
years showing equity returns averaging 6.8%
per year after inflation. Returns had been
below trend for almost 20 years through the
early 1990s but are now seen well above trend.
On the other hand, despite these compelling
historic and academic arguments for
overvaluation, there is the unmistakable law of
supply and demand to be considered. Very
simply, the baby boomers and other investors
have seized upon the stock market as the
source of their retirement security. The ratio of
equities to household portfolios, as low as 25%
in 1985 and 40% as late as 1995, is now a
record high 55%. Mutual fund investors have
allocated 56% of their assets to equities, up
from 25% in 1990.
Economist John Maynard Keynes once said
that the critical determinant of the stock
market is not the business cycle but the
psychological cycle. If investors continue to
ignore valuations and treat stocks like
commodities, then a continued upward bias
cannot be ruled out. With the proliferation of
financial market information in print, on the
Internet, and on cable television, the market
has captured the public’s imagination as never
before and the business of investing has
entered a brave new world, fraught with
opportunity and risk.
Furthermore, there are those who say that the
old yardsticks of valuation simply no longer
apply. The economic expansion has already
confounded expectations by going on longer
than any previous one. World economies are
more interdependent than ever before.
Inflation is historically low and shows scant
sign of any upward pressure. US corporate
managers have become increasingly skillful at
controlling costs and managing inventories
and productive capacity. We are in the midst of
an historic era of technological change that is
UNDERSTANDING INVESTMENTS 11
radically improving productivity and
efficiency. In light of these trends, perhaps
today’s valuations will prove correct in
anticipating a period of very impressive profit
growth.
Market bulls assert further that stock
valuations should be higher when inflation and
interest rates are as low as they are now.
During periods such as these, the chief
attributes of stocks—their potential for
long-term growth in income and capital—are
seen as more valuable than when inflation and
rates are high. When interest rates are low, the
discounting mechanism results in a higher
present value assigned to future earnings and
dividends. Also, investors—rightly or
wrongly—appear to have reduced their
traditional risk premium attached to stocks in
light of the absence of normal business cycle
pressures on growth and profits over the past
several years.
One thing we know for sure is that the stock
market has never been more important to our
economy. It used to react to events in the bond
market and to economic trends. Now it is itself
a major factor affecting interest rate
movements and plays a crucial role in
determining economic growth. Fed Chairman
Greenspan’s monetary easings of last year
were widely seen as an effort to forestall a
stock market collapse of major proportions,
mindful of the serious effect this would have
on consumer spending given the market’s
unprecedented dominant position in household
wealth levels and its captivating hold on
investor psychology.
Investors may well find that the above-trend
stock market returns of the past few years
cannot be sustained over the next few years.
On the other hand, the landscape is strewn with
economists and market strategists whose
obsession with the past has caused them to
miss out on the historic rally of the last few
years. Are we in the midst of a unique period
of economic nirvana where the old rules no
longer apply or are we about to confront the
rubble of a market bubble that bursts? Only
time will tell.
12 PERAC TRAINING SERVICES
STOCK PRICES ARE AT AN ALL-TIME HIGH RELATIVE TO EARNINGS
STOCK PRICES HAVE FAR OUTPACED EARNINGS GROWTH
UNDERSTANDING INVESTMENTS 13
SECTORS LAGGING THE MARKET
14 PERAC TRAINING SERVICES
SECTORS LAGGING THE MARKET
UNDERSTANDING INVESTMENTS 15
SECTORS OUTPERFORMING THE MARKET
16 PERAC TRAINING SERVICES
SECTORS OUTPERFORMING THE MARKET
UNDERSTANDING INVESTMENTS 17
SECTORS OUTPERFORMING THE MARKET
18 PERAC TRAINING SERVICES
2. The Fixed
Income Market
Abond is a debt security, similar to an
IOU, in which the purchaser is
lending money to a government,
municipality, corporation, or other entity. The
issuer promises to pay a specified rate of
interest during the life of the bond and to repay
the face value when it matures, or comes due.
Because bonds typically have a predictable
stream of interest payments and repayment of
principal, they have traditionally been seen as
ways for investors to preserve and increase
their capital and to receive dependable interest
income.
Among the key investment considerations for
bonds are:
1. MATURITY
The specific date on which the investors’
principal is due to be repaid. Maturity ranges
are typically characterized as short-term (up to
4 years), medium-term (5-12 years), and longterm (12 to 30 or more years).
2. REDEMPTION
Call Provisions: The issuer is allowed—or
sometimes required—to repay the principal at
specified dates prior to maturity.
Put: The investor has the option of requiring
the issuer to repurchase the bonds at a
specified date prior to maturity.
Average Life: In some cases, investors will
receive their money back at some uncertain
time before (or possibly after) the stated
maturity due to cash flow considerations of the
issuer; i.e., the effect of mortgage prepayments
on mortgage-backed bonds.
3. CREDIT QUALITY
Bond choices range from the highest credit
quality (US Treasury securities) to bonds that
are below investment grade and considered
speculative. The four major bond rating
agencies are Moody’s Investors Service,
Standard & Poor’s Corp., Fitch IBCA, and
Duff & Phelps. Bonds rated Aaa, Aa, A, or
Baa(BBB) are considered investment grade
while those rated Ba(BB) or below are considered below investment grade. The lower the
bond rating, the higher the interest rate on the
security to compensate for the credit risk.
4. INTEREST RATE
Bonds pay interest rates that can be fixed (most
are), floating (adjusted periodically to prevailing market rates), or payable at maturity
(zero-coupon bonds).
5. PRICE
Newly issued bonds typically sell at or close to
their face value, but in the secondary market,
their price fluctuates in response to changing
interest rates as well as factors affecting supply
and demand, credit quality, maturity, and tax
status. Bonds will trade at either a premium
UNDERSTANDING INVESTMENTS 19
(above face value) or at a discount (below face
value).
6. YIELD
Unless an investor purchases a bond at original
issuance, the effective yield on the
instrument will differ from the initial interest rate. Current yield is
derived by dividing the bond’s
interest rate by its purchase price.
Yield to maturity, or yield to call,
measures the total return received
by holding the bond until it matures
or is called, taking into account all
interest payments as well as the differential between the bond’s face
value and the purchase price.
Among the important concepts to
understand about bonds is the link
between price and yield. When
prevailing interest rates rise, prices
of outstanding bonds fall to bring
the yield of older bonds into line
with higher yielding new issues.
Similarly, when prevailing interest
rates fall, prices of outstanding
bonds rise, until the yield of older
bonds is low enough to match the
lower interest rate on new issues.
The link between interest rates and
maturity is also crucial. Changes in interest
rates don’t affect all bonds equally. The longer
it takes a bond to mature, the greater the risk
that prices will fluctuate along the way and
that the fluctuations will be greater. Investors
expect to be compensated for taking the extra
risk. A “normal yield curve” for a particular
issuer will show yields progressing higher from
An individual
bond’s market
value will be
determined by
its maturity,
credit quality,
and other
characteristics,
but the factor
that historical
ly is the most
crucial to
overall
interest rate
levels is
current and
anticipated
inflation levels.
short to intermediate to long-term maturities.
Depending on the market’s sentiment about the
future course of the economy, yield curves can
also be “steep”, “flat”, or “inverted”.
As noted, the longer until a bond becomes
due, the more it will fluctuate in
value according to changes in
interest rate levels. In assessing
this risk, it is important to understand the crucial distinction
between a bond’s maturity date
and its “duration”, a far better
gauge of price volatility. Duration
measures the weighted stream of
cash flows, usually semiannual
interest payments, through the life
of the bond, while maturity
merely states when the principal is
to be repaid. The more a bond’s
total cash flows consist of coupon
payments over the life of the bond,
the shorter its duration. Thus,
bonds with the same maturity can
have different durations—and thus
different levels of exposure to
market risk.
For example, the US Treasury’s
5.25% bond due November 2028 has a
duration of about 15 years, meaning that its
price will move up or down about 15% for
each percentage point move in interest rates.
However, a Treasury zero coupon bond maturing at the same time—a bond sold at a deep
discount that pays no interest over its life—has
a duration of 29 years, meaning that a
percentage point move in rates will move its
price by more than 25%.
20 PERAC TRAINING SERVICES
The key to bond investing is to successfully
balance yield and risk. An investor who buys a
bond with a higher than market level yield is
usually taking on extra risk in terms of either a
long maturity, lower credit quality, or poor call
protection. The longer the maturity, the greater
the market risk if interest rates rise. The lower
the credit quality, the greater the market risk
not only from individual security loss but from
an overall widening of credit spreads arising
from an economic downturn. Poor call
protection risks not only loss of coupon
income but also poor price performance during
periods of falling interest rates.
An individual bond’s market value will be
determined by its maturity, credit quality, and
other characteristics, but the factor that
historically is the most crucial to overall
interest rate levels is current and anticipated
inflation levels. Investors thrive on steady,
sustainable growth rates. The spectre of rising
inflation is why the bond market typically falls
(prices decline, interest rates rise) when the
government releases unexpectedly strong
economic news. Similarly, the bond market
typically acts euphorically (prices rise, interest
rates fall) when economic reports hint of a
coming slowdown or recession.
MARKET SEGMENTS
The US bond market is a huge market, consisting
of at least six major segments in addition to
money market funds. Bonds are actively traded,
with most of it done on the over-the-counter
(OTC) market that comprises hundreds of securities firms and banks that trade bonds by phone or
electronically. Some corporate bonds are listed
on the New York Stock Exchange.
U.S. TREASURY SECURITIES
$3.3 trillion outstanding
Sold in periodic auctions by the government,
Treasuries are the largest, highest quality, and
most liquid of all bond markets. Most are
issued as non-callable. The most recently
issued 30-year security is termed the “long
bond” and is used as a benchmark for the
entire long-term bond market. As the US
government has gone from chronic deficits to
surpluses in recent years, the supply of
Treasuries has begun to diminish. In fact, the
ratio of total Treasury debt to Gross Domestic
Product, which peaked at 35% in 1995, has
now fallen to 25%.
FEDERAL AGENCY DEBT
$1.1 trillion outstanding
Fannie Mae, Ginnie Mae, the Federal Home
Loan Bank, and the Student Loan Marketing
Association are among the agencies that issue
bonds at slightly higher yields than pure
Treasuries.
CORPORATE DEBT
$2.4 trillion outstanding
As are stocks, corporate bonds are generally
classified in several sectors, including
telephones, utilities, industrial, finance, and
banks. Most corporate bonds are debentures,
or unsecured obligations backed by the issuer’s
general credit and its capacity to repay debt
service out of earnings. Public utilities are the
primary issuer of mortgage bonds, where real
estate or other physical property worth more
than the bonds has been pledged as collateral.
Although bondholder protections have
increased in recent years, corporates are also
subject to event risk; when management has
UNDERSTANDING INVESTMENTS 21
tried to boost shareholder value by undertaking
leveraged buyouts, restructurings, mergers,
and recapitalization, the new layer of debt can
suddenly push bond values down significantly.
Investment grade corporate bonds typically
trade 50-150 basis points above US Treasuries,
but bonds rated below investment grade trade
in a market of their own.
High Yield or junk bonds are issued by
newer or startup companies, those in a particularly competitive or volatile market, and those
whose overall business or financial condition
is relatively weak or risky. These bonds
typically yield from 300-700 basis points
higher than US Treasuries of comparable
maturity. Because they are so credit sensitive,
they react less to general interest rate trends
than do investment grade bonds. Indeed, their
trading patterns often mirror the equity market.
Given their generous yield advantage over
Treasuries, a well diversified portfolio of junk
bonds is likely to provide attractive returns
compared to higher grade portfolios over time.
The risks are in investing in the sector when it
is trading at relatively narrow spreads to high
grades and in investing in individual companies or sectors just before their descent into
junk bond status or whose business conditions
deteriorate even further. Defaults and
bankruptcies in this sector are not uncommon.
In fact, reported default rates for this sector are
as high as 3%.
MORTGAGE-BACKED SECURITIES
$2 trillion outstanding
Mortgage securities represent an ownership
interest in mortgage loans made by financial
institutions to finance the borrower’s purchase
of a home or other real estate. These loans are
“pooled” by issuers or servicers for sale to
investors. As the underlying mortgage loans
are paid off, investors receive their payments
of interest and principal. The most basic
securities are known as “pass-throughs” or
participation certificates, representing a direct
ownership interest in a pool of mortgages.
These securities may be pooled again to create
collateral for more complex types of securities
known as Collateralized Mortgage Obligations
or Real Estate Mortgage Investment Conduits.
CMOs and REMICs both allow cash flows to
be directed so that different classes of securities with different maturities and coupons can
be created. Most mortgage securities are
issued and/or guaranteed by GNMA (Ginnie
Mae), a government-owned corporation, or by
FNMA (Fannie Mae) or the Federal Home
Loan Mortgage Corporation (Freddie Mac),
both US-chartered but privately held
corporations.
Because the timing and speed of principal
payments may vary according to economic and
interest rate conditions, the cash flow on
mortgage securities is irregular. Accordingly,
these securities are sold and traded in terms of
“average life” rather than their maturity dates.
The average life is the average amount of time
that will elapse from the date of security
purchase until the principal is repaid based on
an assumed prepayment forecast. Professional
mortgage bond investors employ complex
computer modeling in efforts to predict prepayment flows of individual mortgage pools.
Mortgage securities carry higher coupon
rates than Treasuries not only to reflect the
22 PERAC TRAINING SERVICES
rates on underlying mortgage loans which are established market. Since nearly all the bonds
always higher than governments but also to in this sector have relatively low yields
compensate investors for the level of reflecting their tax-exempt status, they are not
investment risk they are assuming in the typically used by pension funds.
context of prepayment risk. Because of the
difficulty of predicting the precise
return from a mortgage loan pool,
mortgage securities usually offer
attractive yield advantages not
only relative to Treasuries but also
in relation to other securities of
comparable quality.
ASSET-BACKED
SECURITIES
$600 billion outstanding
One of the fastest segments of the
bond market consists of the securitization of several types of pooled
consumer and business loans.
Among the most prominent issues
in this sector are bonds backed by
repayment of home equity loans,
auto loans, credit card receiveables, student loans, equipment
loans, and manufactured housing.
As in mortgage and corporate
bonds, the yield advantage of these
various types of bonds over
Treasuries will vary according to
Because of the
difficulty of
predicting the
precise return
from a
mortgage loan
pool,
mortgage
securities
usually offer
attractive yield
advantages
not only
relative to
Treasuries but
also in relation
to other
securities of
comparable
quality.
THE BOND MARKET
TODAY
An accompanying table shows
market offerings in major bond
market sectors, and in different
ranges of credit quality and
maturity, as of July 15, 1999.
Also included is a table showing
the sensitivity of total returns in
the US Treasury market to
changes in interest rates. It shows
that an investor purchasing the
actively traded 30-year Treasury
bond on July 1, 1999 would enjoy
a total return of 21.2% (15.2%
capital appreciation, 6.0%
income) if the market interest
rates on those bonds declined to
5.0% on July 1, 2000 and would
suffer a loss of –6.3% (12.3%
capital loss, 6.0% income) if rates
were to rise to 7.0%. The corresponding gain and loss would be
40.1% and -16.4% if rates were to
decline to 4.0% or rise to 8.0%
investors’ perceptions of the economic factors over that period. The chart illustrates the fact
that may affect their security as well as that bond values are affected by changing
temporary aspects of supply and demand that interest rates and that the magnitude of such
may affect market valuation. changes is a function of maturity with the
shortest maturities exhibiting the least MUNICIPAL BONDS
$1.4 trillion outstanding potential fluctuation.
The debt of states, cities, counties, and various
enterprise authorities is a large and well
UNDERSTANDING INVESTMENTS 23
U.S. TREASURY MARKET
SENSITIVITY OF TOTAL RETURNS TO INTEREST RATE CHANGES
ONE YEAR HORIZON
INTEREST RATE CHANGE
MATURITY -2% -1% 0 +1% +2%
2-YEAR 7.5% 6.5% 5.6% 4.6% 3.7%
5-YEAR 13.1% 9.3% 5.7% 2.2 % -1.1%
10-YEAR 20.9% 13.0% 5.8% -0.8% -6.9%
30-YEAR 40.1% 21.2% 6.0% -6.3% -16.4%
TOTAL RETURN IS INCOME PLUS CHANGE IN VALUE
MARKET YIELDS ON JULY 2, 1999
24 PERAC TRAINING SERVICES
FIXED INCOME MARKET YIELDS
July 15, 1999
U.S. TREASURY SECURITIES
MATURITY
2 Years 5.52%
5 Years 5.58%
10 Years 5.69%
30 Years 5.89%
YIELD
MORTGAGE-BACKED SECURITIES
ISSUER COUPON AVG. LIFE YIELD TO MATURITY
GNMA (1997) 30-year
FNMA (1997) 30 year
FHLMC (1997) 15 year
8.00%
7.00%
6.50%
5 years
6.4 years
4.8 years
7.72%
7.18%
6.83%
CORPORATE BONDS
ISSUER RATING COUPON MATURITY YIELD TO MATURITY
Bell Atlantic NJ
Johnson & Johnson
AT&T Corp
Procter & Gamble
Merrill Lynch & Co.
Coca Cola
Marriott Int'l
Ralston Purina
AAA
AAA
AA
AA
A
A
BAA
BAA
5.875%
6.73%
7.75%
6.45%
7.375%
6.75%
7.125%
7.875%
2004
2023
2007
2026
2006
2023
2007
2025
6.31%
6.82%
6.60%
7.06%
6.66%
7.19%
7.61%
7.56%
HIGH-YIELD
"JUNK" BONDS
Merrill Lynch
Composite Index 10.25%
UNDERSTANDING INVESTMENTS 25
THE YIELD CURVE HAS FLATTENED
LONG-TERM INTEREST RATES HAVE TRENDED LOWER
26 PERAC TRAINING SERVICES
TRENDS IN CORPORATE BOND QUALITY YIELD SPREADS
UNDERSTANDING INVESTMENTS 27
3. International
Stocks
I
nternational stocks have become a core
holding in most pension fund portfolios.
They are generally seen to enhance performance over time as well as reduce risk
compared to a portfolio of only domestic
stocks. Among the rationales for international
stock investing are:
1. As the world’s economies have become
more and more integrated, thousands of
companies have expanded into worldwide
markets, leading to the fact that a company’s
headquarters country has become less
important in influencing stock prices than the
industry that it’s in. For example, although
Japan’s stock market, the Nikkei, has been flat
or down over the past several years, the stock
of Honda—a very successful, profitable
company—has soared. In fact, Honda’s stock
performance over the past several years has
been much better correlated with those of
major US automakers such as Ford than with
the generally moribund Japanese stock market.
There are many similar examples, leading to
the conclusion that there are no longer foreign
or American companies, only successful or
unsuccessful companies.
2. The US no longer dominates the world
economy. America’s gross national product
represented nearly half the world’s output in
1970 but it is only one-third of it today. Also,
US stocks today account for less than half of
total world market capitalization, down from
two thirds in 1970. The largest companies in
many major industries are based overseas as
well as some of the fastest growing companies.
3. Among the major ten foreign markets
from 1980 through 1998, the US was the best
performer in only one year, 1982. From 1979
through 1994, the Morgan Stanley Capital
International EAFE Index, a widely
recognized benchmark composed of 21 major
markets in Europe, Australasia, and the Far
East, outperformed the S&P 500 every year in
terms of performance of the previous ten-year
holding period. Over the past four years,
however, the US—uniquely benefiting from a
sustained period of low inflation and strong
corporate earnings—has been the outstanding
cumulative market performer. This fact is
consistent with long-term patterns that indicate
that changes in leadership between US and
foreign stocks occur every few years.
4. Diversifying into foreign stocks is
intended not only to enhance returns over time
but also to reduce risk. Foreign stock markets
generally do not move in tandem with the US
market over the long term. The correlation
between the S&P 500 and the Morgan Stanley
EAFE Index has been less than 50%. Thus,
while it is likely that one or more foreign
markets will outperform the US each year,
diversification into international stocks will
28 PERAC TRAINING SERVICES
also likely reduce the overall volatility of a
stock portfolio.
Among the concerns and important
differences between domestic and foreign
investing are:
1. Many countries are considerably less
stable politically than the US and have much
less diverse economies. Thus, foreign investments are much more likely to be jeopardized
by sudden political or economic upheaval. The
unanticipated collapse of several Asian
economies in 1997 is a prime example of this.
2. Accounting and financial disclosure
practices can vary widely by US standards.
Original research is crucial since financial
information about specific foreign companies
can be difficult to obtain.
3. Currency translation is generally the
greatest ongoing concern. Initially, dollars
must be converted to the local currency to
purchase a foreign security. Subsequently,
share price quotations, stock dividends, and
sale or redemption proceeds must be converted
from that currency back into US dollars.
Because foreign exchange rates fluctuate
constantly, currency movements can increase
or decrease the dollar value of an investment
even if the security’s price remains unchanged.
An appreciation of a foreign currency relative
to the US dollar is positive for US investors
since each unit of the local currency will
translate into more US dollars. Portfolio
managers may use sophisticated hedging
techniques to cushion the impact of potentially
negative currency movements but such
hedging techniques will limit the possibility of
gains as well as losses.
In the long run, the effect of currency
fluctuations is usually far less important than
the profitability of individual companies and
the overall strength of local equity markets.
Given the often wide variance in economic and
market performance among countries, having a
well-diversified portfolio supported by strong
research is of paramount importance in
international investing.
The theories behind international stock
investing have become increasingly controversial in recent years. An emerging skepticism of
international stocks considers not only the
dominant performance of US stocks in recent
years but also the argument that the increasing
globalization of the world economy has
lessened the value of international stocks as a
diversifying, low correlation asset class. The
past few years have provided ample fodder for
the skeptics; indeed, over the ten years ended
December 1998, the Wilshire 5000 Index of
most regularly traded US stocks returned
18.1% a year while the Morgan Stanley EAFE
Index gained just 5.9% annually, according to
Ibbotson Associates. Nevertheless, performance is indistinguishable over the long term;
since the end of 1970, Ibbotson also reports
that the Wilshire 5000 and MS EAFE indexes
have had exactly the same return, 13.7% annually through December 1998.
UNDERSTANDING INVESTMENTS 29
4. International
Fixed Income
The rationale for international bond
investing is very similar to that for
stock investing. Foreign bond markets
have grown to represent more than half the
worldwide fixed income market and this
portion is increasing as emerging economies
issue debt at attractive yields to finance their
growing infrastructure and expanding businesses. Also, the US bond market has rarely
been the best performing among those of the
major industrialized nations.
As noted previously, returns in bond
investing are largely determined by changes in
overall interest rate levels, and rates in foreign
countries frequently do not move in tandem
with US rates. Indeed, a study of monthly
returns over a recent twelve-year period
showed that only one country—Canada—had
a correlation higher than 50% versus returns in
the US bond market. Australian government
bonds showed the lowest correlation, at less
than 10%. Thus, being invested in several
bond markets helps smooth out the volatility of
a portfolio as strong returns from some
markets will offset weaker ones from poorly
performing ones.
Historical studies have shown that an optimal
allocation of foreign bonds—-the mix that provides the highest return without significantly
increasing risk—ranges between 10% and
20% of a fixed income portfolio.
As in international stock investing, investors
in international bonds must be wary of political and economic instability, particularly in
emerging markets, and must have strong
research capability to effectively monitor
overall economic developments in the
countries as well as factors affecting specific
credits. Currency fluctuations represent the
greatest concern since these changes represent
a greater portion of foreign bond than foreign
stock returns. Changes in interest rate levels, as
well as a currency’s supply and demand
situation, directly affect the dollar’s value
relative to foreign currencies.
The recent introduction of the “euro”, the
new currency representing the economic consolidation of the eleven countries in the
European Monetary Union, will significantly
reduce but not eliminate the opportunities
available to foreign bond managers who seek
to diversify their portfolios by finding
differences in relative value between
currencies around the world.
30 PERAC TRAINING SERVICES
5. Real Estate
Pension funds invest in real estate
because the asset class is seen as a
good inflation hedge and because it
offers clear benefits of diversification.
Historical returns, while favorable, have a very
low correlation with either stock or bond
returns. Besides reducing overall portfolio
volatility, real estate can offer attractive current
returns, benefiting from the steady cash flows
from rents that derive from a portfolio of wellleased operating properties.
Investors in real estate expect to receive
returns both from income and from capital
appreciation. Expected long-term performance
is higher than that of high grade bonds but
lower than the historic returns of blue-chip
stocks. Among the various types of property
included in real estate investments are downtown office buildings, industrial parks,
research and development buildings, suburban
office buildings, hotels (full-service or limited
service), apartments, shopping centers, and
regional malls. As in other investment asset
classes, different segments will do better at
different times. The success of real estate
investments closely mirrors overall economic
conditions as well as the specific health of the
real estate market on not just a national but on
regional and also very local scales.
Besides the risks of general, regional, and
local economic and market conditions, risks of
real estate investing include fluctuations in
interest rates; overbuilding and increased
competition; increases in property taxes and
operating expenses; changes in zoning laws;
heavy cash flow dependency; possible lack of
mortgage fund availability; losses due to natural disasters; regulatory limitations on rents;
variations in market rental rates; changes in
neighborhood values; and losses due to
environmental problems. In such a complex
industry, the quality of management—its
structure, financial strength, and overall
skill—is obviously of paramount importance.
Pension funds and other institutions invest in
real estate either through direct property ownership or through pooled instruments such as
Real Estate Investment Trusts. REITs were
created by Congress in 1960 to offer investors
the real estate equivalent of mutual funds.
They pool investors’ funds for investment
primarily in income producing real estate or
real estate related loans (although not
construction financing). A REIT is not taxed
on income distributed to shareholders if it
complies with various requirements relating to
its organization, ownership, assets, and income
and the requirement that it distributes to its
shareholders at least 95% of its taxable
operating income each year. This benefit relative to taxation is also the greatest limitation of
REITs since it restricts retained earnings that
could be invested for growth.
Among the various types of REITs, equity
REITs invest directly in real property and
derive their income primarily from rents. They
can also realize capital gains by selling appreciated property. Their value is affected by
UNDERSTANDING INVESTMENTS 31
changes in the value of the underlying
property owned. Mortgage REITs invest the
majority of their assets in real estate mortgages
and derive their income from interest
payments. They are affected by defaults or
delinquencies relating to the
underlying mortgages as well as
prepayment risks. Hybrid REITs
combine the characteristics of both
types.
Equity REITs are the dominant
form of this relatively small
investment sector. As of mid-year
1999, 175 out of the 212 publicly
traded REITs were equity REITs.
Total market value of outstanding
REIT securities is about $145
billion. Roughly $135 billion were
rated by one or more rating
agency, with the average rating
being low investment grade
(Baa/BBB). About 80% of the
publicly traded REITs trade on the
New York Stock Exchange with
the rest on the American Exchange
or on NASDAQ.
Real estate is by nature an
illiquid investment, requiring large
amounts of capital, sophisticated market
knowledge, active and ongoing property management, and a commitment to long holding
periods. Aided by the development of
generally accepted valuation methodologies,
REITs are intended to offer a greater degree of
liquidity to real estate investment.
One of the generally accepted ways of
measuring a REIT’s operating performance is
As fears of an
economic
downturn were
decisively
dissipated as
the second
quarter of
1999 began
and the effects
of last year’s
flight to quali
ty were largely
reversed,
REITs (along
with small cap
stocks)
enjoyed a
powerful
recovery.
“Funds From Operations” (FFO), or price
relative to FFO. Funds from Operations is
defined as net income excluding gain or loss
from sales of property or debt restructuring
and adding back depreciation of real estate.
One of the major differences
between FFO and corporate
earnings is that commercial real
estate maintains residual value to a
much greater extent than
machinery, computers, or other
types of property.
REITs have had only five years
of negative total returns in their 38
year history, but their returns can
be very volatile. After the average
REIT lost 40% of its value in 1974
when the economy suffered from
the worst possible condition—
stagflation, the class was out of
favor with investors until the
1990s. They’ve done well during
this decade, tracking the S&P 500
in terms of cumulative return until
1998. Last year the sector had its
worst year since 1974, with
negative returns of about 17% (as
measured by the National
Association of Real Estate Investment Trusts).
The market reacted to concerns about a
slowing economy and fears about deflation,
and it ignored the sector’s average earnings
growth of 13%. The asset class went from
being overvalued to being undervalued, in the
view of many analysts, relative to the underlying property assets supporting the securities.
This trend continued into 1999 as REITs had
32 PERAC TRAINING SERVICES
negative total returns of about 5% during the
first quarter. Over the three years extending
through 1999’s first quarter, average REIT
returns had been close to those of small
capitalization stocks, with both asset classes
dramatically underperforming the S&P 500
Index of large cap stocks.
As fears of an economic downturn were
decisively dissipated as the second quarter of
1999 began and the effects of last year’s flight
to quality were largely reversed, REITs (along
with small cap stocks) enjoyed a powerful
recovery. The average REIT returned more
than 10% during the quarter. Contributing to
the stronger tone was the fact that some very
prominent institutional investors were said to
have added to their REIT holdings in light of
their intrinsic cheapness relative to actual
market value.
An important point is that REITs represent
only about 10% of institutional quality real
estate. In sharp contrast to the significant
losses suffered by REITs in 1998,
privately-held real estate actually registered a
16% positive return for the year, as measured
by the Russell Real Estate Open-End Funds
Universe Average. The startling difference
between public market and private market real
estate returns reflects the fact that changing
investor sentiments can drive securities in
public markets to extremes of over- or
undervaluation relative to underlying assets.
Since publicly-traded REITs remain a small
market subject to dramatic swings in valuation
that reflect investor psychology more than
market fundamentals, these securities do not
provide all the attributes that pension funds
expect from private real estate, such as
inflation hedging.
The National Council of Real Estate
Investment Fiduciaries (NCREIF) publishes a
widely-followed index of quarterly total
returns on commercial real estate properties
held by institutional investors such as pension
funds. Its returns are market-weighted and
divided into income and capital components of
total return. The universe includes existing
investment grade non-agricultural income
producing properties in four major categories:
Apartment, Industrial, Office, and Retail. In
each category, returns are calculated for the
four major regions of the country. The
NCREIF indicated overall total return of about
18% from its properties in 1998.
After last year’s sharp correction, REITs may
still offer good value at this time, even after the
recent recovery. As always, the challenge is to
find securities backed by high quality assets,
ample coverage of current dividends, and a
strong management team. REITs today offer
dividends in the 7-8% range (well above those
for either stocks or high grade bonds) and
anticipate annual capital appreciation in the
2-5% range.
Unless interest rates continue to rise, the
fundamentals for real estate look to be generally favorable with supply and demand in
general equilibrium in most areas. Most of the
reasons for previous excesses, such as the
Japanese buying binge or resolution of the
Savings and Loan crises, are behind us and
there are no tax proposals before Congress that
would negatively affect the market. Also, the
current mix of low inflation and low interest
UNDERSTANDING INVESTMENTS 33
rates is very favorable to real estate. The major
risks to the market remain 1) a recession that
negatively impacts demand for units or 2) a
building boom that creates oversupply and
downward price pressure.
With property owners having the ability to
raise rents over time and to grow via appreciation and property acquisition, investment in
real estate offers both an inflation hedge as
well as potential growth. Nevertheless,
returns—particularly in the publicly traded
marketable securities—can be very volatile
and the class clearly has inferior liquidity
relative to more traditional investments such as
blue chip stocks and high grade bonds.
Overall, however, US pension funds have been
allocating an increasing percentage of their
assets to various equity real estate investments
for the expected benefits of diversification and
the anticipation of reasonable returns.
34 PERAC TRAINING SERVICES
6. Alternative
Investments
Alternative investments, or investing in
private markets, has been increasing
in importance among pension and
endowment funds in recent years. Investors in
this class are paid a premium for the risk of
holding illiquid, nontradeable investments and
they have the potential to earn higher returns if
the underlying projects are run by experienced
general partners with strong strategic visions
and management skills and who can effectively exploit the inefficiencies that frequently
exist in the private markets.
Many of the nation’s largest public pension
funds invest in the private equity markets
through a limited partnership vehicle.
Managers are chosen for their expertise in a
particular field in private equity and assume
the general partner role. Investors participate
as limited partners; as such, they have very
little say in project management but their
potential liability is limited to the invested
capital.
There is no defined secondary market for
private equity and limited partners may be
unable to liquidate their entire positions over
the 8–10 year life cycles of typical partnerships. Volatility, as measured by the standard
deviation from a mean return, is generally
considered to be twice as high for private
equity than for domestic public equity.
Management fees are much higher than in
traditional investments and are often drawn
down from committed capital before money is
actually invested in the project. These fees are
essentially reimbursed to investors as capital is
returned on successful projects. The basic
compensation of the general partners derives
from the predetermined portion—usually
around 20%—they take from partnership
profits. Valuation of holdings prior to project
exit can be very subjective. Balanced against
these and other risk factors are the benefits of
diversification with an asset class that has low
correlation with others and which has expected
returns of 400-500 basis points above the S&P
500 over time horizons of ten years or more.
Private markets total about $1 trillion in
market value, or equivalent to about 10% of
the US public equity market. There are six
distinguishable sectors:
1. ACQUISITION EQUITY OR
“BUYOUTS” are when an investor seeks
financial control of a mature public or private
company. Often this will occur when an
investor attempts to bring about management
change and to create value for a company he
considers mismanaged, inefficiently operated,
or in financial disorder. Investors such as this
will use privately raised capital and borrowed
money to buy companies, “fix them up”, and
then exit, usually by selling outright using an
UNDERSTANDING INVESTMENTS 35
Initial Public Offering.
According to Private Equity Analyst, $47.3
billion out of the $85.3 billion raised by USbased private equity limited partnerships in
1998 was in acquisitions and buyouts.
2. VENTURE CAPITAL is an equity
investment in a private company that is in the
early stages of development. “Early stage”
companies seek capital to complete product
development and begin marketing. “Late
stage” companies focus on advanced business
development issues such as growth in market
share and strengthening the management team.
Venture capital investors typically have long
investment horizons, expecting low or negative
returns for the first 3-5 years and higher
returns near the end of the partnership term.
With an increasing amount of institutional
money seeking profitable investments in this
area, finding well-structured, strategically
sound partnerships that are fairly priced for
investors is a major challenge.
For the seventh straight year, venture capital
commitments increased in 1998 as 198 funds
raised a record $24.01 billion, according to the
National Venture Capital Association. Money
actually invested rose to $16.02 billion.
Companies in the computer software and
services sector received over one-third of the
total, while California and Massachusetts had
the most disbursements among the states.
3. INTERNATIONAL PRIVATE
EQUITY includes both buyouts and venture
capital for international markets. Allowing for
differences in regional and country-specific economic growth and equity market valuations,
international private equity is similar to the US
market in strategy and structure. The more
problematic area is private equity funding for
emerging markets, where the upside return is
enormous but the risks are equally impressive.
4. DISTRESSED SECURITIES are
stocks and bonds of companies in financial
distress. Investors in these securities seek capital appreciation by purchasing the securities
of companies that are distressed due to debt
overhang, poor management decisions, or
other factors that they feel can be eventually
overcome. Holders of these securities must be
willing and able to be involved in a corporate
bankruptcy process.
5. HEDGE FUNDS are portfolios that are
actively and aggressively managed to maximize total return. Among the unconventional
strategies employed by these funds are short
sales, selling securities not owned in order to
profit from a decline in value; leverage, borrowing money to increase the fund’s investable
capital and to capture the differential in return
between the cost of borrowing and the
investment return; investing in multiple types
of securities (stocks, bonds, futures, currencies, et al) in one portfolio; and not following
the usual principles of diversification. Hedge
fund managers employ sophisticated models in
an effort to uncover inefficiencies in markets
around the world and they feel that their bets
are sufficiently numerous so as to limit overall
market exposure. As was dramatically seen in
summer’s collapse of Long-Term Capital
Management, troubles can ensue when the
36 PERAC TRAINING SERVICES
market inefficiencies become larger rather than
swiftly trade back to equilibrium and when
nearly all the fund’s bets go against them in a
short time. For the Nobel Prize winners and
other “rocket scientists” behind LTCM and for
the previously high-flying managers of many
other hedge funds that lost billions last year,
1998 was truly a year of humbling enlightenment. In terms of being a factor in the markets,
hedge funds have generally not yet recovered
from last year’s debacle.
6. OTHER
Opportunistic Real Estate investments, usually involving more leverage than traditional
real estate investment funds, are popular when
the real estate market, either national or local,
is depressed, as in the early 1990s.
Energy and Natural Resources investments
would include segments such as cogeneration
facilities and other types of alternative energy
production; equity investments in energy
exploration and production and in energyrelated companies.
Mezzanine Debt is the origination of a loan
that is junior to senior debt and senior to equity in the capital structure. Such securities share
some of the characteristics—and risks—of
both equity and debt.
Flows have been increasing into private
market investments since expected returns are
as high as 7% above those of US stocks.
Performance data compiled by Wilshire
Associates shows that returns are widely
dispersed and only top quartile partnerships
achieve a return of 7% above the S&P 500.
Nevertheless, historical returns in this sector
are impressive and indicate that venture capital
is the sector offering the highest potential
returns in private equity. Venture Economics, a
division of Securities Data Corporation,
reported annualized returns of 17.2%, 27.4%.
and 17.7% for venture capital over 1, 5, and 10
year periods ending December 31, 1998.
Corresponding returns were 12.8%, 20.5%,
and 16.9% for all private equity including buyouts. An index compiled by Cambridge
Associates of Boston shows annualized returns
of 27.6%, 34.2% and 23.0% from venture
capital over the same 1,5 and 10 year periods
and 15.1%, 21.2% and 16.7% for all US
private equity.
Implementation of a successful private
market investment requires a diverse and
complex set of skills which include: identifying investment opportunities, gaining access to
superior general partners, performing due
diligence, negotiating deal terms, and monitoring partnership investments.
There are a limited number of “top-tier”
private equity firms that have consistently
excellent returns. Participation in their partnerships is often limited to existing investors,
experienced investors, and those who are able
to approve investments quickly.
While many pension funds, working with
their consultants, have been successful in
identifying and investing in alternative
investments partnerships, retirement boards
may also want to consider “fund of funds”
structures as offered by some vendors as
practical and cost-effective ways to participate
in this potentially very rewarding but also
uniquely challenging asset class.
UNDERSTANDING INVESTMENTS 37
7. Asset
Allocation
The most important determinant behind
success or failure in investment
management is not individual security
selection or trading by investment managers. It
is estimated that about 90% of the variance in
investment returns among different portfolios
is determined by asset allocation, the percentage of portfolio assets allocated to specific
asset classes such as stocks, bonds, real estate,
venture capital, et al. The goal of asset
allocation is to maximize returns at a prudent
level of risk, and the process of determining
the appropriate asset allocation should involve
an analysis not only of assets but also of the
liabilities of an organization such as a
retirement board.
The primary goal in constructing a portfolio
is that it should return enough to meet an
investor’s objectives and do so with a level of
risk that an investor is comfortable with. There
are several asset classes, or groups of
investment securities whose behavior is similar
during changes in economic circumstances,
and each class (i.e., stocks) has several
subclasses (large, midcap, small cap; growth
and value). The major inputs to an asset
allocation process are the expected historical
returns for each distinct asset class, the
volatility of those returns over time, and the
correlation of returns among the asset classes.
An effective portfolio is not just the sum of its
parts but should incorporate the expected
interaction among those parts. Considering the
likely correlation in performance among asset
classes should reduce risk and volatility in a
portfolio while helping to achieve expected
returns.
Risk means different things to different
people. To a bungee jumper, it’s the possibility
that the cord might break. For an investor, risk
means the possibility of losing money and not
meeting one’s financial objectives. Similarly,
asset allocation is like wearing protective gear
in athletics. One might perform better if not
hampered by protective gear, but without it, a
blow to an unprotected part of the body could
prove disastrous. That’s why even though large
cap growth stocks have been by far the best
performers among major asset classes for
some time, a well-constructed portfolio will
also have assets in currently underperforming
sectors like bonds, small stocks, and real
estate. These sectors currently serve as hedges
that may inhibit maximum performance today
but will likely cushion the portfolio to some
degree when the high-flying growth stocks
inevitably turn down.
Historically, stocks have returned more than
bonds. Since 1926, the annualized return on
blue chip US stocks has been slightly over
11% while that on high grade bonds has been
about 5.5%. Over the ten years ending 1998,
38 PERAC TRAINING SERVICES
the difference has been even greater as the
S&P 500 has gained 19.2% annually compared
to 9.3% for investment grade bonds. The
greater return on stocks reflects their larger
“risk premium”, or extra return demanded by
investors to compensate for the fact that stock
returns are historically about three times more
volatile than bonds in terms of variability of
periodic returns. The S&P 500 returned 34.1%
in 1995 while long term bonds have rarely
done better than the 18.2% registered by
Treasuries in 1993. But the worst year for
bonds has been the 7.8% loss in 1994, compared to the 26.5% loss suffered by the S&P in
1974. Illustrating the cushioning effect, when
the S&P plummeted 14.5% in August 1998,
bonds had a positive return of 1.5%.
Historical analysis shows that, as noted
above, returns from stocks have been about
twice those from bonds. Stocks also have
about three times as much risk as bonds,
as measured by the annualized standard
deviation of monthly returns. This traditional
measure of volatility refers to the variance
from the mean return that will be observed in
about two-thirds of sample returns.
If one were to use historical observations of
returns and risk from stocks and bonds to construct a graph with investment returns on the
vertical axis and risk on the horizontal axis,
such a graph would have an entry for stocks in
the upper right sector (high return, high risk)
of the chart and for bonds in the lower right
(lower return, lower risk) of the chart. The
practice of asset allocation involves drawing a
line between these two extreme points and
determining what combination of stocks and
bonds strikes the right balance between an
investor’s required return and the level of risk
he/she is comfortable with. In reality, the
choices will involve more than just two broad
asset classes because both the stock and bond
markets consist of several distinct styles and
sectors and there is also the option to invest
internationally as well as domestically. For
instance, small stocks historically have
returned more than large stocks but at a
significantly higher risk level. Also, the
risk/return relationships among asset classes
will not typically be represented by a straight
line because the benefits of diversification
among asset classes usually cause the expected returns for a given level of risk to be greater
than the sum of the individual returns.
An asset allocation process today should
properly include a number of different asset
classes. It’s not unusual for one asset class or
investment style to dominate returns for four
consecutive years as US large cap stocks have
recently done, but other classes—including
small caps, international stocks, and real
estate—have enjoyed similar extended periods
of superior performance over the past quarter
century. If one looked at historical returns of
large US stocks, small US stocks, international stocks, and high grade US bonds over the
twenty years through 1998, there was only one
year prior to 1995 that large US stocks provided the best performance among these four
asset classes. The lesson here is that a
portfolio diversified among asset classes will
never match the performance of the best asset
class in each year but it will also never equal
the worst.
UNDERSTANDING INVESTMENTS 39
ON THE OTHER HAND … the developed countries, seem to be moving in
There are, of course, some dissenting voices to at least the same direction (if not in the same
the theoretical frameworks governing the magnitude) to a greater extent in recent years.
search for today’s most efficient portfolios. Such an occurrence is what brought down
First of all, some scholars see the far greater Long-Term Capital Management last August.
risk premium traditionally As that failed hedge fund learned,
attached to stocks compared to The breakdown diversification won’t dampen
bonds diminishing as the of trade volatility when global markets
differential in volatility between barriers and move synchronously.
the asset classes appears to be nar- The events of last August were a
rowing in recent years. For bonds, advances in short-term phenomenon and do
interest rates have become more
communications not destroy the validity of the benvolatile in recent years as the Fed technology efits of international diversificafine tunes monetary policy in order have meant tion in the long run. Nevertheless,
to keep the economy growing at a that previously it could turn out that the benefits
sustainable pace. For stocks, independent from that strategy may be
investors may be perceiving this economies are overestimated because of the slow
sector as less risky as a result of becoming but steady trend towards an
better education, new tax laws that increasingly homogenized global
more
encourage long-term holding in economy. The breakdown of trade
IRA accounts, improved corporate
correlated to barriers and advances in commuefficiency, better governmental our own. nications technology have meant
monetary and fiscal policy, an that previously independent
improved regulatory and tax environment, and economies are becoming more correlated to
diminished foreign threats. (While volatility of our own.
stocks, as traditionally measured in terms of Certainly, there is no other major economy
variability of monthly returns, may or may not that has been firing on all cylinders like the US
be decreasing, it is generally agreed that over the past several years. No other country is
increased retail participation in the market has at the forefront of the technological revolution
served to increase day-to-day market volatility.) and also enjoys sound economic and fiscal
Also, some analysts have been questioning policy and stable political leadership. The
the value of international diversification. By trouble with this argument against internationplacing a portion of assets in markets not cor- al diversification is that ten years ago investors
related with the US market, can an investor were similarly drooling over Japan as the
really reduce the volatility of the portfolio world’s invincible economy. Today, after
while maintaining.and sometimes increasing several years of stalled economic growth and
returns? The world’s markets, at least among failed political leadership, Japan’s economic
40 PERAC TRAINING SERVICES
future is very much in question.
SUMMARY
Asset allocation is a practice whose benefits do
not enjoy universal intellectual support among
market professionals, but its basic objective
remains one of prudence. It can be seen as
representing an insurance policy against the
day when today’s hottest sector cools down.
Foreseeing such a day becomes difficult, and
the opportunity costs in investment returns
become real, when one sector such as US large
cap stocks has been dominant for so long, but
that day will inevitably come. Also, rather than
investing in various asset classes for the sake
of filling out a portfolio, a more enlightened
rationale for asset allocation would be to
emphasize those asset classes that are clearly
undervalued today but where the road to better
valuation can be unmistakeably seen on the
horizon.
In summary, the goal of asset allocation is to
select a combination of assets that will
generate a return sufficiently high but also
sufficiently safe in order to meet a future
financial liability. In the most general of terms,
it is simply an expression of the centuries-old
axiom of “don’t put all your eggs in one
basket”. To use a comforting analogy, asset
allocation is like a pillow: if one part of the
pillow is punched in, another will puff out, and
the benefits of portfolio diversification will
provide the investor with steady enough
returns so that he or she can sleep well at night.
In reality, the world’s financial markets—and
the relationships among them—are sufficiently
dynamic and constantly changing so that asset
allocation in practice does not conform to
simple and cute analogies. Nor does it lend
itself to simply choosing portfolio
combinations from a neatly drawn graphical
curve of “efficient portfolios” calculated from
past experience. Asset allocation remains more
an art than a science since the models and
assumptions used are approximations of the
realities of an investment universe that is
exceedingly complex and constantly changing.
ASSET ALLOCATION IN
PRACTICE
While there is no common “black box” or other
standard methodology employed by pension
systems and their consultants, there does appear
to be a general similarity among the asset allocations currently adopted by both public and
private pension systems. “Pension &
Investments” newspaper reported that the
largest public defined benefit plans in the US
had aggregate asset allocations as follows in
1998: Domestic Equity, 46%; International
Equity, 11%; Domestic Fixed Income, 32%;
International Fixed Income, 2%; Real Estate,
4%; Alternative Investments, 2%; Other, 1%;
and Cash 2%. Surveys that include private as
well as public plans show approximately
similar results.
An asset allocation plan will typically involve
percentage ranges (such as 35-45%) assigned to
each asset class rather than a fixed percentage. An
asset allocation plan is typically determined in the
context of an overall Statement of Investment
Objectives and Policies. This Statement will
usually begin with a Rate of Return Objective,
conventionally stated as a targeted incremental
return over inflation or over a benchmark index
(or a series of benchmarks for each asset class).
UNDERSTANDING INVESTMENTS 41
There should be a discussion of the appropriate
level of risk that is expected. Pension funds, both
public and private, need to be generally conservative in that they are managed relative to certain
future liabilities but a reasonable amount of
short-term volatility is permissable since these
liabilities are basically long-term and the need for
short-term liquidity is modest.
Policies typically included in an Investment
Statement would include diversification
guidelines such as percentage of assets in one
company (such as 5%) or in one industry (e.g.,
15%) or in the percentage held in a corporation’s
total issuance (e.g., 5%). There could be guidelines for the number of stocks held, any targets
as to market capitalization, the age or maturity of
a company, and portfolio turnover rates. For
fixed income accounts, there could be guidelines
for credit quality and duration targets. There also
could be general restrictions such as prohibition
against private placements, “short sales”,
commodities, direct real estate, et al.
42 PERAC TRAINING SERVICES
8. Selecting an
Investment
Manager
PEOPLE
What is the education and experience
level of key personnel?
Who will be the primary manager
assigned to this account? Get to know him or
her!
How many accounts does he/she manage?
Who will be his/her backup?
What is the organizational structure of the
firm, and of the specific investment group
involved?
What is the extent of cohesion among
staff in this investment group?
What has been the staff turnover rate?
How are key staff compensated?
PHILOSOPHY
What is firm’s traditional overall investment philosophy? Top-down, bottom-up,
quantitative, etc.
What is role of research? In-house staff,
or street research? What factors are emphasized?
How is investment policy determined? Is
there an investment committee?
What is current investment strategy in
major markets?
Has there been consistency in investment
philosophy and strategy?
PROCESS
How is the philosophy implemented?
Do individual managers have discretion
relative to firm’s investment strategy?
What is the review and control system relative to managers’ performance?
How is security selection and trading
done?
How are trades allocated among
accounts?
What is the buy/sell discipline?
High turnover, or buy-and-hold?
What is the methodology of portfolio construction?
Portfolios: highly concentrated or highly
diversified?
Is there a system of risk management
safeguards? How is it implemented?
PERFORMANCE
Are timely, accurate returns regularly calculated and made available?
How has performance been relative to
benchmark for this product?
Is the benchmark appropriate?
Is performance presented objectively and fairly?
UNDERSTANDING INVESTMENTS 43
Has performance been consistent?
How volatile have returns been?
Performance attribution: is there a system
for attributing performance along several criteria (i.e., cap size, industry, style, et al)?
Is performance repeatable or has it been
due to special, one-time factors?
Is performance consistent or widely dispersed among accounts?
THE FIRM
Is it independent?
If not, what is nature of relationship with
parent company?
Do employees have a stake in ownership?
If so, what %?
Compensation and incentive program
Corporate culture
Are there any significant company affiliations or joint ventures?
What are overall business objectives?
Recent growth trends
What products are “hot”?
Is there any limit on asset growth or new
clients?
What new products or other changes are
contemplated?
Is client base diversified?
Is client base stable? How many accounts
gained or lost recently?
How is client service structured?
Are portfolio managers accessible and
responsive?
How many other public pension or similar
clients are served?
Any ongoing litigation, investigations, or
financial problems?
Any potential conflicts of interest?
Recent material developments
44 PERAC TRAINING SERVICES
9. Outline of the
Competitive
Process
COMPETITIVE PROCESS
Open
Objective
Fair
RFP
Processing
Record Keeping
OPEN
Public notice - Reasonable time
Posted
Published
Secretary of State notice
May send to prospective bidders
OBJECTIVE
Evaluation based only on requirement and
criteria in RFP
Pre-established criteria
Objective and relevant criteria
Business/Technical
GFOA, PERAC, PRIM examples
PROCESSING RESPONSES
No alteration/corrections after date for
submission
Date stamped on receipt
Witness to opening RFPs
PROCUREMENT FILE
Record of procurement
Selection process
Selection criteria
RFP
Copy of minutes
Copy of responses
Disposal schedule/ 6 yrs. after contract
ends
ROLE OF CONSULTANT
Board is decision maker
Develop RFP
Data base screen
Incorporate into data base and analyze
respondents
Selection of consultant
Ability to meet fiduciary duty of board
CONTRACT
Written contract
Executed prior to assuming duties
Investment objectives
Brokerage practices
Fees
Termination
UNDERSTANDING INVESTMENTS 45
BOARD NOTICE OF
COMPETITIVE PROCESS
Prior to retention of Mger/con.
Board notify PERAC competitive process
followed
Chapter 32 provisions met
PERAC regulations met
In all cases exemption or not
No form-statement from board
VENDOR CERTIFICATION FORM
All vendors submitting bids
Selected vendor must submit to PERAC
Good faith submission
Without collusion or fraud
In all cases exemption or not
46 PERAC TRAINING SERVICES
PERAC PERAC Memo 30/2021
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chairman JOHN W. PARSONS, ESQ., Executive Director
Auditor SUZANNE M. BUMP | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES M. MACHADO | RICHARD MACKINNON, JR. | JENNIFER F. SULLIVAN
МЕМORANDUM
TO: All Retirement Boards
FROM: AadaW en ie, Titie iese
RE: Investment Fraud Alert
DATE: October 26, 2021
Retirement Boards should be alert to a recent phishing scheme involving the transfer of assets from
Board investment accounts. PERAC has become aware that one of the Retirement Boards was the
victim of a fraudulent transfer of assets, after a former employee's Board email account was hacked
and then used to initiate a transfer of funds into a non-board account.
PERAC is sending this memo to alert boards to take precautionary measures to prevent a similar
situation.
Please review your IT user access authorizations to ensure only current authorized users have
access to your network and email. Additionally, please review your protocols for reviewing IT
user access and removing staff or board members as they leave the organization.
Additionally, please review and confirm your security processes with your vendors (consultants,
managers, custodians) for authorizing transactions and establishing and using properly authorized
bank accounts. All Boards should ensure their managers have wire instructions in place and they
should not be deviated from.
Lastly, please ensure there is diligent scrutiny by vendors and the Board of all periodic bank and
investment statements.
We will be working with all parties involved to address this situation and will transmit further
information as warranted.
JWP/dmd
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
.pdf.jpg)
PERAC PERAC Memo # 11 / 2018
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chairman JOSEPH E. CONNARTON, Executive Director
JENNIFER F. SULLIVAN Auditor SUZANNE M. BUMP | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES M. MACHADO | ROBERT B. McCARTHY |
MЕМORANDUM
TO: All Retirement Boards
FROM: psaphe Conmaч Joseph E. Connarton, Executive Director
RE: Investment Related Issues and Concerns
DATE: January 31, 2018
The Public Employee Retirement Administration Commission (“PERAC”) is issuing this Memo
to provide retirement boards with a review of several investment related issues and concerns.
Limit on Contract Length
As you know, the original limit on the time frame for contracts set forth in Section 23B was
expanded from five years to seven years by Chapter 46 of the Acts of 2015. That period is now
coming to an end and boards should review the existing time frames for contracts and institute a
program to conduct and complete searches before the new deadline. April 2019 will mark the
outer limit for existing relationships as seven years will have elapsed since the effective date of
Chapter 176 of the Acts of 2011.
SEC Vendor Disclosures
Pursuant to Section 23B of Chapter 32 of the General Laws, investment service providers to
retirement boards must provide the board with Vendor Disclosures as part of the RFP process
and each year during a contractual relationship. In the former case, the board submits these
disclosures to PERAC as part of the Acknowledgement Process.
In the event that a vendor has a relationship with another person in connection with offering its
services, disclosures must be made directly to the board in accordance with Rule 206(4)-3(b) of
the Investment Advisers Act of 1940. In addition, that Rule mandates that any person that has
such a relationship with a vendor make disclosures to the retirement board regarding any
relationship with another person to assist that person in fulfilling the duties provided to the
vendor.
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
MEMORANDUM - Page Two
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph I. Martin, Deputy Executive Director
Investment Related Issues and Concerns
January 31, 2018
In conjunction with reviewing the Vendor Disclosures, as part of the Acknowledgement Process,
the Commission must be able to review any such disclosures. Consequently, copies of such
disclosures must be submitted to the Commission by the board for review prior to the issuance of
any Acknowledgement. Submission can take place as an attachment in the PROSPER system.
Boards should also review those submissions as part of the RFP process.
For more details as well as examples of the SEC Solicitor Written Disclosure Statement and
Acknowledgement and the SEC Solicitor Written Disclosure Statement and Acknowledgement -
Sub-Solicitor please see PERAC Memo #29/2017.
Annual Disclosure Reviews
Investment service providers have been submitting Annual Vendor Disclosures to retirement
boards and PERAC for several years. The Commission reminds retirement boards that, in order
to protect against future controversy and to comply with fiduciary duty, boards must formally
acknowledge receipt of and review these disclosures at a board meeting. In addition, the review
process must be reflected in the minutes. This will assure that a record exists of the retirement
board assessing the disclosures and protect the board from criticism and/or litigation.
Accounting
Consistent with the need to insure accurate recordkeeping by retirement boards, PERAC has
made several revisions to its accounting procedures that will be applicable beginning in calendar
2018. These include accounting for fees paid in conjunction with investment activity as well as
the tracking of "carried interest", "catch up payments" and "ancillary expenses" related to private
equity, hedge fund, real estate, and similar investment vehicles.
Retirement boards are also reminded of their duty to submit complete and accurate cash books to
PERAC on a timely basis. Accounting standards require that transactions be accurately
identified and properly classified. The parties to whom payments are made, or from whom
payments are received, must be identified and all transactions must be classified in the proper
account.
Investment Objectives/Asset Allocation
Retirement boards that are investing assets themselves should, with the assistance of their
consultant, review and if necessary, revise investment objectives, asset allocation, and
investment plans each year. These documents should be submitted to PERAC
annually. Generally, that submission can take place through filing the relevant information from
the consultant report electronically.
MEMORANDU M - Page Three
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph I. Martin, Deputy Executive Director
Investment Related Issues and Concerns
January 31, 2018
There has been some confusion as to how to accomplish this review for systems that are invested
in the Pension Reserves Investment Trust ("PRIT") Fund or have committed assets to an
Outsourced Chief Investment Officer ("OCIO") strategy.
In the case of PRIT systems, a board "participating" in PRIT effectively adopts the PRIT
investment objectives, asset allocation, and investment plan when it transfers assets to PRIT. It is
suggested that "participating" systems also conduct periodic reviews of PRIT's approach to these
matters.
However, a retirement board that has "purchased shares" of the PRIT Fund and committed all of
its assets to various sleeves of PRIT, must adopt investment objectives as well as asset allocation
and investment plans. Thus, in that circumstance, the annual review noted above must be
conducted.
an Similarly, in the case of retirement boards that have committed all or nearly all assets to
OCIO strategy, the board must adopt and annually review and submit investment objectives,
asset allocations, and investment plans.
Competitive Process
The competitive process, mandated by Section 23B and the fiduciary duty owed by the
retirement board to system members and beneficiaries, requires that Requests for Proposals
("RFP") and notices relative to the search ensure the broadest response from potential service
providers possible. Restrictions on participation, such as not accepting submissions from service
providers that are not active in the Massachusetts public pension fund arena, violate that statute
and that duty. Points may be awarded for such experience in grading the responses, however,
that criteria must not be a barrier to entry.
Reports
Submission of and/or access to manager, consultant, and custodian reports is critical to the
analysis that PERAC conducts to assess board activities. Please be advised that a change in staff
at the board does not necessitate the reauthorization of PERAC access or the redirection of the
manager, consultant, or custodian to submit the information to PERAC.
MEMORANDUM - Page Four
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph I. Martin, Deputy Executive Director
Investment Related Issues and Concerns
January 31, 2018
SEC Registration
A retirement board that seeks to invest funds with an entity that is not registered with the
Securities and Exchange Commission ("SEC") or, if applicable, the Massachusetts Office of the
Secretary of State ("SOS") will not receive an Acknowledgement Letter from the Commission
and therefore may not make such an investment as the Commission has made a determination
that it is in the best interest of the retirement system to withhold the Acknowledgement in
circumstances in which a retirement board seeks to invest with a non-registered entity.
Those investment advisers who do not qualify for SEC registration are required to register with
the SOS.
Fees
In order to assist the retirement boards in assessing fees related to investment service providers
we have attached "Best Practice - Investment Fee Policies for Retirement Systems". Please
review this document and consider adopting these recommendations.
Attachment
11/20/2017 Investment Fee Policies for Retirement Systems
Government Finance Officers Association
BEST PRACTICE
Investment Fee Policies for
Retirement Systems
BACKGROUND:
Investment management fees can have a major effect on a retirement system's net investment
returns. Historically, retirement systems have tried to minimize fees by: 1) using a competitive
selection process that makes fee negotiation a key factor in the procurement decision; 2) using lowcost passive index investment strategies; and 3) exploring opportunities for achieving economies of
scale. As retirement systems make increasing use of alternative investments such as hedge funds,
private equity, and real estate, procedures to identify, quantify, and negotiate all forms of investment
manager compensation are needed to minimize the effect these premium-priced investment
strategies can have on the retirement system's total returns.
RECOMMENDATION:
To minimize the impact of investment management fees on portfolio returns, the GFOA recommends
that retirement systems, especially those that use alternative investment strategies, adopt an
investment management fee policy that will allow the retirement system to negotiate the lowest
competitive fee possible while looking out for the system's long-term earning potential.
To achieve this goal, an investment management fee policy should adhere to the following
guidelines:
1. Staff and consultants should negotiate the lowest competitive fees using measures and
techniques such as:
Determining what fees similar investors are paying and making these peer comparisons part
of the negotiation process.
• Including a "most favored nation" clause (ensuring that the type and size of fees are at the
level that is being made available to other similar investors) in the agreement.
• Leveraging the consultant's knowledge of the marketplace to minimize fees for contracted
services, keeping in mind that fees are a key component of the competitive procurement
process.
2. Give a specific individual or group of employees explicit responsibility for negotiating fees, and
require that they report on the status of negotiations before the management agreement is executed.
Consult with retirement system trustees to determine their interest in alternate fee structures (e.g., a
fixed fee versus a performance fee that may have a higher or lower expected cost, based on
performance).
3. Identify where the importance of competitive fees ranks among the multiple factors analyzed when
selecting investment managers:
http://www.gfoa.org/print/3053
11/20/2017 Investment Fee Policies for Retirement Systems
• The primary factors to consider are demonstrated track records, proven investment talent,
repeatable investment processes, competitive and strategic investment advantages, and
other qualitative factors.¹
When screening investment managers, make sure fees are reasonable. Future returns are
uncertain, while fees can be determined in advance. When one manager's fees are higher
than another's, analyze the track record to determine whether the additional cost is necessary
and appropriate.
Because fees for active management can be dramatically higher than fees for passive
management, examine the fees, the investment process, and historical performance of active
managers to determine the likelihood that their performance will be better than the index
return, after fees.2
4. When investing in traditional investments, ensure that the pension system is paying a reasonable,
competitive fee by implementing the following strategies:
When using a separate account structure (whereby professional investors manage a portfolio
solely for the system), establish fee break points as the manager's mandate grows.3
Explore the possibility of excluding uninvested cash from management fees, where possible.
If exclusions aren't possible, consider a refunding arrangement.
When investing in commingled and mutual funds (investment vehicles that pool assets of
multiple investors), ask the manager to identify and quantify all levels of fees.
• Any fees that aren't directly related to the management of the portfolio should be
considered for elimination.
• Seek access to the lowest-cost share class and require that any fees related to
services provided to retail investors be refunded to the retirement system.
• Ask the investment manager to consider all the accounts it handles for your
organization when determining fees.
5. When investing in alternatives, ensure that the retirement system is not paying excessive fees by
implementing the following additional strategies:
Identify all fees. Paying a base fee is usually appropriate, but the fee policy should specify a
preference for performance-based fees, where applicable. Focus on aligning the interests of
the retirement system and the investment manager through the performance fee structure,
potentially including fulcrum fees, hurdle rates, fee caps, and clawback provisions.4
The fee policy should state a preference for performance fees that compensate the manager
for alpha rather than beta, and it should include a hard hurdle. Alternative investment
managers commonly use "carried interest," or participation fees, which are expressed as a
percentage of net returns over a specified minimum return.
Rather than entering into direct partnerships with alternative investment managers,
investigate the possibility of group purchasing arrangements such as an alternative
investment fund of a P-share class. These options allow retirement systems to realize pricing
concessions based on their meaningful economies of scale and their long-term investment
horizon.
Look for ways to "piggyback" on other institutional investors to maximize economies of scale
and increase negotiating leverage. One way of piggybacking is through a cooperative pool,
in which an investment manager makes available a separate pool that provides lower pricing,
based on the combined assets in the pool. Such "break points" are employed by mutual funds
and commingled investment trusts and can be replicated through investment pools
established for public pension funds.
• Hire an attorney to oversee alternative investment contracts.
http://www.gfoa.org/print/3053
11/20/2017 Investment Fee Policies for Retirement Systems
Notes:
1A repeatable investment processes is one that is disciplined and consistent in strategy. Competitive
and strategic investment advantages refer to an advantage that a firm has over its competitors,
allowing it to generate greater sales or margins and/or retain more customers than its competition;
this can include the firm's cost structure, product offerings, distribution network, and customer
support. Qualitative factors refer to aspects of a firm's business such as its business model,
competitive advantages, management, and corporate governance.
2 In active management, an investment manager attempts to earn more than the average market
return. In passive management, the manager simply attempts to replicate the average market return
before fees.
3Break point refers to the investment amount that qualifies the investor for a reduced sales charge.
4Performance fees are paid when an investment manager achieves an investment return that beats
a specified benchmark. Fulcrum fees are fees that are centered on a target, or "fulcrum,"
performance level, which are increased or decreased, depending on performance. Hurdle rates are
minimum rate of return required for payment of performance fees. Clawbacks are payments the
retirement system has made that the investment manager needs to return because of special
circumstances that are included in the contract, such as failure to meet a minimum investment
the
return.
Alpha refers to the portion of investment returns that is attributable to the manager's performance
and skill, while beta is a measure of an investment's volatility, or systematic risk, when compared to
the market as a whole. A soft hurdle calculates the manager's performance fee on all the fund's
investment returns, if the hurdle rate is cleared. A hard hurdle is calculated only on returns above the
hurdle rate. A hurdle is intended to ensure that a manager is rewarded only upon generating
investment returns that are greater than what the investor would have earned elsewhere in the
market.
6 A P-share class is a special pricing structure established by some investment fund companies; it
gives retirement systems access to lower fees than those paid by retail investors.
7 Pension funds can also pursue collaborative procurement strategies and other methods of lawfully
increasing the pension plan's bargaining and purchasing power. Each of the 50 states has enacted
statutes permitting intergovernmental service and procurement arrangements.
References:
Orange County Employees Retirement System Fee Policy.
• Girard Miller, "Managing Against Escalating Pension Investment Fees," Government Finance
Review, February 2014.
Applicable to Canadian Governments:
203 N. LaSalle Street - Suite 2700 | Chicago, IL 60601-1210 | Phone: (312) 977-9700- Fax: (312) 977-4806
http://www.gfo w.gfoa.org/print/3053 3/3
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
PHILIP Y. BROWN, ESQ., Chairman JOSEPH E. CONNARTON, Executive Director
JENNIFER F. SULLIVAN Auditor SUZANNE M. BUMP | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES M. MACHADO | ROBERT B. McCARTHY |
MЕМORANDUM
TO: All Retirement Boards
FROM: psaphe Conmaч Joseph E. Connarton, Executive Director
RE: Investment Related Issues and Concerns
DATE: January 31, 2018
The Public Employee Retirement Administration Commission (“PERAC”) is issuing this Memo
to provide retirement boards with a review of several investment related issues and concerns.
Limit on Contract Length
As you know, the original limit on the time frame for contracts set forth in Section 23B was
expanded from five years to seven years by Chapter 46 of the Acts of 2015. That period is now
coming to an end and boards should review the existing time frames for contracts and institute a
program to conduct and complete searches before the new deadline. April 2019 will mark the
outer limit for existing relationships as seven years will have elapsed since the effective date of
Chapter 176 of the Acts of 2011.
SEC Vendor Disclosures
Pursuant to Section 23B of Chapter 32 of the General Laws, investment service providers to
retirement boards must provide the board with Vendor Disclosures as part of the RFP process
and each year during a contractual relationship. In the former case, the board submits these
disclosures to PERAC as part of the Acknowledgement Process.
In the event that a vendor has a relationship with another person in connection with offering its
services, disclosures must be made directly to the board in accordance with Rule 206(4)-3(b) of
the Investment Advisers Act of 1940. In addition, that Rule mandates that any person that has
such a relationship with a vendor make disclosures to the retirement board regarding any
relationship with another person to assist that person in fulfilling the duties provided to the
vendor.
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
MEMORANDUM - Page Two
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph I. Martin, Deputy Executive Director
Investment Related Issues and Concerns
January 31, 2018
In conjunction with reviewing the Vendor Disclosures, as part of the Acknowledgement Process,
the Commission must be able to review any such disclosures. Consequently, copies of such
disclosures must be submitted to the Commission by the board for review prior to the issuance of
any Acknowledgement. Submission can take place as an attachment in the PROSPER system.
Boards should also review those submissions as part of the RFP process.
For more details as well as examples of the SEC Solicitor Written Disclosure Statement and
Acknowledgement and the SEC Solicitor Written Disclosure Statement and Acknowledgement -
Sub-Solicitor please see PERAC Memo #29/2017.
Annual Disclosure Reviews
Investment service providers have been submitting Annual Vendor Disclosures to retirement
boards and PERAC for several years. The Commission reminds retirement boards that, in order
to protect against future controversy and to comply with fiduciary duty, boards must formally
acknowledge receipt of and review these disclosures at a board meeting. In addition, the review
process must be reflected in the minutes. This will assure that a record exists of the retirement
board assessing the disclosures and protect the board from criticism and/or litigation.
Accounting
Consistent with the need to insure accurate recordkeeping by retirement boards, PERAC has
made several revisions to its accounting procedures that will be applicable beginning in calendar
2018. These include accounting for fees paid in conjunction with investment activity as well as
the tracking of "carried interest", "catch up payments" and "ancillary expenses" related to private
equity, hedge fund, real estate, and similar investment vehicles.
Retirement boards are also reminded of their duty to submit complete and accurate cash books to
PERAC on a timely basis. Accounting standards require that transactions be accurately
identified and properly classified. The parties to whom payments are made, or from whom
payments are received, must be identified and all transactions must be classified in the proper
account.
Investment Objectives/Asset Allocation
Retirement boards that are investing assets themselves should, with the assistance of their
consultant, review and if necessary, revise investment objectives, asset allocation, and
investment plans each year. These documents should be submitted to PERAC
annually. Generally, that submission can take place through filing the relevant information from
the consultant report electronically.
MEMORANDU M - Page Three
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph I. Martin, Deputy Executive Director
Investment Related Issues and Concerns
January 31, 2018
There has been some confusion as to how to accomplish this review for systems that are invested
in the Pension Reserves Investment Trust ("PRIT") Fund or have committed assets to an
Outsourced Chief Investment Officer ("OCIO") strategy.
In the case of PRIT systems, a board "participating" in PRIT effectively adopts the PRIT
investment objectives, asset allocation, and investment plan when it transfers assets to PRIT. It is
suggested that "participating" systems also conduct periodic reviews of PRIT's approach to these
matters.
However, a retirement board that has "purchased shares" of the PRIT Fund and committed all of
its assets to various sleeves of PRIT, must adopt investment objectives as well as asset allocation
and investment plans. Thus, in that circumstance, the annual review noted above must be
conducted.
an Similarly, in the case of retirement boards that have committed all or nearly all assets to
OCIO strategy, the board must adopt and annually review and submit investment objectives,
asset allocations, and investment plans.
Competitive Process
The competitive process, mandated by Section 23B and the fiduciary duty owed by the
retirement board to system members and beneficiaries, requires that Requests for Proposals
("RFP") and notices relative to the search ensure the broadest response from potential service
providers possible. Restrictions on participation, such as not accepting submissions from service
providers that are not active in the Massachusetts public pension fund arena, violate that statute
and that duty. Points may be awarded for such experience in grading the responses, however,
that criteria must not be a barrier to entry.
Reports
Submission of and/or access to manager, consultant, and custodian reports is critical to the
analysis that PERAC conducts to assess board activities. Please be advised that a change in staff
at the board does not necessitate the reauthorization of PERAC access or the redirection of the
manager, consultant, or custodian to submit the information to PERAC.
MEMORANDUM - Page Four
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph I. Martin, Deputy Executive Director
Investment Related Issues and Concerns
January 31, 2018
SEC Registration
A retirement board that seeks to invest funds with an entity that is not registered with the
Securities and Exchange Commission ("SEC") or, if applicable, the Massachusetts Office of the
Secretary of State ("SOS") will not receive an Acknowledgement Letter from the Commission
and therefore may not make such an investment as the Commission has made a determination
that it is in the best interest of the retirement system to withhold the Acknowledgement in
circumstances in which a retirement board seeks to invest with a non-registered entity.
Those investment advisers who do not qualify for SEC registration are required to register with
the SOS.
Fees
In order to assist the retirement boards in assessing fees related to investment service providers
we have attached "Best Practice - Investment Fee Policies for Retirement Systems". Please
review this document and consider adopting these recommendations.
Attachment
11/20/2017 Investment Fee Policies for Retirement Systems
Government Finance Officers Association
BEST PRACTICE
Investment Fee Policies for
Retirement Systems
BACKGROUND:
Investment management fees can have a major effect on a retirement system's net investment
returns. Historically, retirement systems have tried to minimize fees by: 1) using a competitive
selection process that makes fee negotiation a key factor in the procurement decision; 2) using lowcost passive index investment strategies; and 3) exploring opportunities for achieving economies of
scale. As retirement systems make increasing use of alternative investments such as hedge funds,
private equity, and real estate, procedures to identify, quantify, and negotiate all forms of investment
manager compensation are needed to minimize the effect these premium-priced investment
strategies can have on the retirement system's total returns.
RECOMMENDATION:
To minimize the impact of investment management fees on portfolio returns, the GFOA recommends
that retirement systems, especially those that use alternative investment strategies, adopt an
investment management fee policy that will allow the retirement system to negotiate the lowest
competitive fee possible while looking out for the system's long-term earning potential.
To achieve this goal, an investment management fee policy should adhere to the following
guidelines:
1. Staff and consultants should negotiate the lowest competitive fees using measures and
techniques such as:
Determining what fees similar investors are paying and making these peer comparisons part
of the negotiation process.
• Including a "most favored nation" clause (ensuring that the type and size of fees are at the
level that is being made available to other similar investors) in the agreement.
• Leveraging the consultant's knowledge of the marketplace to minimize fees for contracted
services, keeping in mind that fees are a key component of the competitive procurement
process.
2. Give a specific individual or group of employees explicit responsibility for negotiating fees, and
require that they report on the status of negotiations before the management agreement is executed.
Consult with retirement system trustees to determine their interest in alternate fee structures (e.g., a
fixed fee versus a performance fee that may have a higher or lower expected cost, based on
performance).
3. Identify where the importance of competitive fees ranks among the multiple factors analyzed when
selecting investment managers:
http://www.gfoa.org/print/3053
11/20/2017 Investment Fee Policies for Retirement Systems
• The primary factors to consider are demonstrated track records, proven investment talent,
repeatable investment processes, competitive and strategic investment advantages, and
other qualitative factors.¹
When screening investment managers, make sure fees are reasonable. Future returns are
uncertain, while fees can be determined in advance. When one manager's fees are higher
than another's, analyze the track record to determine whether the additional cost is necessary
and appropriate.
Because fees for active management can be dramatically higher than fees for passive
management, examine the fees, the investment process, and historical performance of active
managers to determine the likelihood that their performance will be better than the index
return, after fees.2
4. When investing in traditional investments, ensure that the pension system is paying a reasonable,
competitive fee by implementing the following strategies:
When using a separate account structure (whereby professional investors manage a portfolio
solely for the system), establish fee break points as the manager's mandate grows.3
Explore the possibility of excluding uninvested cash from management fees, where possible.
If exclusions aren't possible, consider a refunding arrangement.
When investing in commingled and mutual funds (investment vehicles that pool assets of
multiple investors), ask the manager to identify and quantify all levels of fees.
• Any fees that aren't directly related to the management of the portfolio should be
considered for elimination.
• Seek access to the lowest-cost share class and require that any fees related to
services provided to retail investors be refunded to the retirement system.
• Ask the investment manager to consider all the accounts it handles for your
organization when determining fees.
5. When investing in alternatives, ensure that the retirement system is not paying excessive fees by
implementing the following additional strategies:
Identify all fees. Paying a base fee is usually appropriate, but the fee policy should specify a
preference for performance-based fees, where applicable. Focus on aligning the interests of
the retirement system and the investment manager through the performance fee structure,
potentially including fulcrum fees, hurdle rates, fee caps, and clawback provisions.4
The fee policy should state a preference for performance fees that compensate the manager
for alpha rather than beta, and it should include a hard hurdle. Alternative investment
managers commonly use "carried interest," or participation fees, which are expressed as a
percentage of net returns over a specified minimum return.
Rather than entering into direct partnerships with alternative investment managers,
investigate the possibility of group purchasing arrangements such as an alternative
investment fund of a P-share class. These options allow retirement systems to realize pricing
concessions based on their meaningful economies of scale and their long-term investment
horizon.
Look for ways to "piggyback" on other institutional investors to maximize economies of scale
and increase negotiating leverage. One way of piggybacking is through a cooperative pool,
in which an investment manager makes available a separate pool that provides lower pricing,
based on the combined assets in the pool. Such "break points" are employed by mutual funds
and commingled investment trusts and can be replicated through investment pools
established for public pension funds.
• Hire an attorney to oversee alternative investment contracts.
http://www.gfoa.org/print/3053
11/20/2017 Investment Fee Policies for Retirement Systems
Notes:
1A repeatable investment processes is one that is disciplined and consistent in strategy. Competitive
and strategic investment advantages refer to an advantage that a firm has over its competitors,
allowing it to generate greater sales or margins and/or retain more customers than its competition;
this can include the firm's cost structure, product offerings, distribution network, and customer
support. Qualitative factors refer to aspects of a firm's business such as its business model,
competitive advantages, management, and corporate governance.
2 In active management, an investment manager attempts to earn more than the average market
return. In passive management, the manager simply attempts to replicate the average market return
before fees.
3Break point refers to the investment amount that qualifies the investor for a reduced sales charge.
4Performance fees are paid when an investment manager achieves an investment return that beats
a specified benchmark. Fulcrum fees are fees that are centered on a target, or "fulcrum,"
performance level, which are increased or decreased, depending on performance. Hurdle rates are
minimum rate of return required for payment of performance fees. Clawbacks are payments the
retirement system has made that the investment manager needs to return because of special
circumstances that are included in the contract, such as failure to meet a minimum investment
the
return.
Alpha refers to the portion of investment returns that is attributable to the manager's performance
and skill, while beta is a measure of an investment's volatility, or systematic risk, when compared to
the market as a whole. A soft hurdle calculates the manager's performance fee on all the fund's
investment returns, if the hurdle rate is cleared. A hard hurdle is calculated only on returns above the
hurdle rate. A hurdle is intended to ensure that a manager is rewarded only upon generating
investment returns that are greater than what the investor would have earned elsewhere in the
market.
6 A P-share class is a special pricing structure established by some investment fund companies; it
gives retirement systems access to lower fees than those paid by retail investors.
7 Pension funds can also pursue collaborative procurement strategies and other methods of lawfully
increasing the pension plan's bargaining and purchasing power. Each of the 50 states has enacted
statutes permitting intergovernmental service and procurement arrangements.
References:
Orange County Employees Retirement System Fee Policy.
• Girard Miller, "Managing Against Escalating Pension Investment Fees," Government Finance
Review, February 2014.
Applicable to Canadian Governments:
203 N. LaSalle Street - Suite 2700 | Chicago, IL 60601-1210 | Phone: (312) 977-9700- Fax: (312) 977-4806
http://www.gfo w.gfoa.org/print/3053 3/3
PERAC
COMMONWEALTH OF MASSACHUSETTS | PUBLIC EMPLOYEE RETIREMENT ADMINIS
PERACAC MEMО #10/2025
STRATICION COMMISSION
PHILIP Y. BROWN, ESQ., Chair WILLIAM T. KEEFE, Execut cuive Director
Auditor DIANA DIZOGLIO | KATHLEEN M. FALLON | KATE FITZPATRICK | JAMES J. GUIDO | RICHARD MACKINNON, JR. | JENNIFER F. SULLIVAN, ESQ
МЕМORANDUM
TO: All Retirement Boards
FROM: John P. Galvin, Compliance Manager
RE: Tobacco Company List
DATE: March 12, 2025
On October 22, 1997 PERAC Memo #37/1997 informed you of the adoption of Chapter 119 of
the Acts of 1997. That statute prohibits retirement systems from making any new investments in
stocks, securities, or other obligations of any company which derives more than 15% of its
revenue from the sale of tobacco products. On December 18, 1997 PERAC sent Memo #48
regarding the implementation of Chapter 119 and the first Tobacco Company List.
Enclosed please find a Tobacco Company List dated April 2025. This list replaces any other
Tobacco Company List previously sent to your board and is effective upon receipt by the
retirement boards. Most of these companies appeared on previous lists and such investments
were prohibited from the time the companies first appeared on the list. Please forward a copy to
your investment advisors or inform them that this list is available on the PERAC website. In
communicating with your investment advisors, please inform them that the Tobacco Company
List is only for their Massachusetts public fund clients and that any other use of the list is strictly
prohibited.
As part of its audit process, PERAC will assess the portfolio of each board to determine
compliance. That review will determine if the board, after January 13, 1998, has purchased
stock, securities, or other obligations of any company which derives more than 15% of its
revenue from the sale of tobacco products. In the event a portfolio is not in compliance, the
board must bring the portfolio into compliance by divesting in a prudent manner. Prior to taking
any action, the board shall consult with PERAC.
In applying the statute to pooled funds, PERAC will assess the 15% rule against the entire pool
as the board is purchasing shares in the pool not the individual holdings of the pool. Thus a
pooled fund, if in violation of this standard, will be included on the list.
If you have any questions, please contact this office.
/ram
Enclosure
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
IC EMPLOYRE PERAC
ТОВАСCO COMPANY LIST
APRIL 2025
COMPANY COUNTRY
22nd Century Group, Inc. United States
Altria Group, Inc.
AMCON Distributing Company
United States
United States
В.А.Т. Саpital Corporation
Charlie's Holdings, Inc.
United States
United States
Fyolo Technology Corp United States
Performance Food Group Company United States
Philip Morris International Inc. United States
Pyxus International, Inc. United States
Reynolds American Inc. United States
Starfleet Innotec Inc United States
Turning Point Brands, Inc. United States
Universal Corporation
Vapor Group Inc
Vapor Hub International Inc.
Vector Group Ltd.
VPR Brands LP
United States
United States
United States
United States
United States
British American Tobacco Bangladesh Co. Ltd.
Badeco Adria d.d. Sarajevo
Bangladesh
Bosnia & Herzegovina
Bulgartabac Holding AD
Gotse Delchev Tabac AD
Nicotiana BT Holding AD
Sila Holding Plc
Yuri Gagarin AD
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Bulgaria
Mercer International Inc. Canada
Anhui Genuine New Materials Co Ltd
Chengdu Hongqi Chain Co Ltd
Huabao Flavours & Fragrances Co Ltd
Mudanjiang Hengfeng Paper Co., Ltd.
RLX Technology Inc
China
China
China
China
China
Shenzhen Jinjia Group Co., Ltd.
Smoore International Holdings Ltd
WElli Holdings Ltd
China
China
China
COMPANY COUNTRY
Cyprus Trading Corporation Plc Cyprus
Philip Morris CR as Czech Republic
Scandinavian Tobacco Group A/S
STG Global Finance B.V.
Denmark
Denmark
Eastern Company SAE Egypt
Kumulus Vape SA France
Karelia Tobacco Company Inc Greece
China Boton Group Company Limited
China Tobacco International HK Co Ltd
Ecogreen International Group Limited
Huabao International Holdings Ltd.
Litu Holdings Limited
Hong Kong
Hong Kong
Hong Kong
Hong Kong
Hong Kong
Godfrey Phillips India Limited India
ITC Limited
NTC Industries Ltd.
Sinnar Bidi Udyog Ltd.
India
India
India
VST Industries Limited India
Indonesian Tobacco Tbk PT Indonesia
PT Bentoel International Investama Tbk
PT Gudang Garam Tbk
Indonesia
Indonesia
PT Hanjaya Mandala Sampoerna Tbk
PT Wicaksana Overseas International Tbk
Wismilak Inti Makmur Tbk PТ
Indonesia
Indonesia
Indonesia
Globrands Group Ltd. Israel
Societe Ivoirienne des Tabacs SA Ivory Coast
Carreras Ltd. Jamaica
Japan Tobacco Inc. Japan
Al-Eqbal Investment Company PLC
Jordanian Duty Free Shops PSC
Union Investment Corporation P.L.C.
Union Tobacco & Cigarette Industries Co PSC
Jordan
Jordan
Jordan
Jordan
COMPANY COUNTRY
British American Tobacco Kenya PLC Kenya
KT&G Corporation
Kuk-Il Paper Mfg Co., Ltd.
Korea
Korea
Tutunski Kombinat AD Prilep Macedonia
7-Eleven Malaysia Holdings Berhad
Bright Packaging Industry Bhd
British American Tobacco (Malaysia) Berhad
Malaysia
Malaysia
Malaysia
B.A.T. Netherlands Finance B.V. Netherlands
Khyber Tobacco Company Ltd.
Pakistan Tobacco Company Ltd.
Philip Morris (Pakistan) Limited
Tri Pack Films Ltd.
Jerusalem Cigarette Co Ltd.
Pakistan
Pakistan
Pakistan
Pakistan
Palestinian Territory
Poland Eurocash Spolka Akcyjna
Duvanska Industrija Coka ad Coka
Philip Morris Operations a.d. Nis
Serbia
Serbia
New Toyo International Holdings Ltd. Singapore
Logista Integral S.A. Spain
Miquel y Costas & Miquel, S.A. Spain
Ceylon Tobacco Company Plc Sri Lanka
Swedish Match AB
Taiwan FamilyMart Co., Ltd.
Tanzania Cigarette Company Ltd.
The West Indian Tobacco Company Ltd.
Bizim Toptan Satis Magazalari AS
British American Tobacco Uganda
Sweden
Taiwan
Tanzania
Trinidad and Tobago
Turkey
Uganda
COMPANY COUNTRY
B.A.T. International Finance P.L.C. United Kingdom
British American Tobacco Plc United Kingdom
Imperial Brands Finance Plc United Kingdom
Imperial Brands Plc United Kingdom
McColl's Retail Group Plc United Kingdom
Cat Loi JSC
Cong ty Co phan Ngan Son
British American Tobacco (Zambia) Plc
British American Tobacco Zimbabwe (Holdings) Ltd.
Vietnam
Vietnam
Zambia
Zimbabwe
COMMONWEALTH OF MASSACHUSETTS |PUBLIC EMPLOYEE RETIREMENT ADMINISTRATION COMMISSION
DOMENIC J. F. RUSSO, Chairman JOSEPH E. CONNARTON, Executive Director
Auditor SUZANNE M. BUMP | ALAN MACDONALD | JAMES M. MACHADO | DONALD R. MARQUIS | ROBERT B. McCARTHY | GREGORY R. MENNIS
МЕМORANDUM
TO:
FROM:
All Retirement Boards
Gorish Joseph E. & Connarton, Commeton Executive Director
RE: Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
DATE: December 2, 2011
As you know, Governor Deval Patrick has signed into law Chapter 176 of the Acts of
2011, "An Act Providing for Pension Reform and Benefit Modernization”. There are
many aspects to this new law some ofwhich impact the pension benefit structure and
others which impact retirement board operations. The Public Employee Retirement
Administration Commission (PERAC) is taking a two pronged approach to implementing
the statute. Under separate cover we will provide you with a Memorandum outlining
those provisions of Chapter 176 that bear primarily on benefit structure. This
Memorandum will focus on those provisions dealing with retirement board operations or
Governance. Please note that these Memos are introductory in nature. The Commission
urges you to review the new law in detail.
Governance
A number of sections in Chapter 176 focused on the operations of retirement boards.
These sections are an outgrowth of the Commission's efforts in working with retirement
boards and their representatives, legislators and governance experts over several years.
Fundamentally, this approach can be broken down into several categories – Investment
Regulation, Board Member Eligibility/Education/Reporting, Procurement Reform and
Enforcement. This Memorandum will briefly review each section bearing on these
general categories. During the course ofthe next several months PERAC, through the
issuance of other Memos and Forms, will provide retirement boards with further
direction.
FIVE MIDDLESEX AVENUE, SUITE 304 | SOMERVILLE, MA 02145
PH 617 666 4446 | FAX 617 628 4002 | TTY 617 591 8917 | WWW.MASS.GOV/PERAC
MISTRATION
CRA
MEMORANDU M - Page Two
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
December 2, 2011
Although a number of the sections of Chapter 176 take effect pursuant to dates
specifically set forth in the new law, the Governance sections, with one exception noted
below, become effective on February 16, 2012.
Investment Regulation
Section 2 and Section 40 of Chapter 176 dramatically alter the investment oversight
function of PERAC. This is in keeping with the evolution of board practice in this area
and with an added focus on Procurement reflected elsewhere in the new law.
PERAC will no longer be providing "Exemptions" or "Waivers" focused on individual
investment managers. Under Chapter 176 boards will be required to submit
documentation primarily dealing with certifying that the Procurement Process has been
followed, various disclosures from the vendor, certifications from the vendor and each
board member that the process was not compromised, a certification that the investment
is not prohibited by regulations and any consultant reports regarding the investment and
the selected vendor.
Similar submissions are required when retaining an investment consultant.
Following review of this material, the Commission will, in instances where no issues of
concern arise, issue an acknowledgement and the board may go forward. Such
acknowledgement may be withheld if the Commission determines that such action is in
the best interest of the retirement system.
Board Member
Several provisions of the new law relate to retirement board members. As noted,
include matters regarding eligibility to serve, education and financial disclosure.
these
MEMORAND U M - Page Three
Joseph E. Connarton, Executive Director
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
TO: All Retirement Boards
FROM:
RE:
DATE: December 2, 2011
Eligibility
Although there are several areas in which an individual is prohibited from serving on a
board for failing to meet education requirements or file financial information, Sections 33
and 53 provide that, "No employee, contractor, vendor or person receiving remuneration,
financial benefit or consideration of any kind, other than a retirement allowance or the
statutory stipend for serving in the retirement board shall be eligible to serve on a
retirement board; provided, however, that an employee of a retirement board may serve
on a retirement board other than the retirement board by which the person is employed;
and provided, further, that this paragraph shall apply only to individuals who first become
members of a retirement board on or after April 2, 2012".
Education
This requirement is contained in the new Subdivision 7 of Section 20 of Chapter 32
added by Section 35 of Chapter 176. Although this section of Chapter 176 takes effect
on April 2, 2012 the Commission will commence educational activities prior to that date
in order to assist retirement board members in meeting these education requirements for
calendar year 2012.
The law requires that during each term a retirement board member complete 18 hours of
training. In each year a member must take a minimum of 3 hours of training. However,
no more than 9 hours may be credited in any one year. There is no prohibition on a
member completing more than 18 hours of training in the course of a term.
PERAC will provide board members with appropriate forms to file as statements of
completion of education.
Failure to meet this mandatory requirement will prohibit the member from serving
beyond the conclusion of the term for which the training requirement was not met.
PERAC is required to sponsor at least 9 hours of training which include, at a minimum,
the topics of fiduciary responsibility, ethical conduct and conflict of interest. An
additional 9 hours is to be related to topics prescribed by the Commission and provided
by local, state, regional or national entities as it may determine.
A more detailed outline ofthe 2012 program will be available shortly.
MEMORANDU M - Page Four
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
December 2, 2011
Financial Disclosure
Sections 1 and 36 of Chapter 176 require that each board member file an annual
"Retirement Board Member Statement of Financial Interest" with PERAC. Section 1
provides that these statements will be exempt from the Public Records Law and thereby
not subject to public release. Section 36 provides that "...every member of a retirement
board shall file a statement of financial interests for the preceding calendar year with the
commission: (i) within 30 days of becoming a member of a retirement board; (ii) by May
1 of each year thereafter that the person is a member of a retirement board; and (iii) by
May 1 of the year after the person ceases to be a member of a retirement board".
Under these provisions individuals who are members of a retirement board must, by
May 1, 2012, submit a Statement of Financial Interests for 2011. Also, individuals
who leave a retirement board after February 16, 2012 will be required to submit a
Statement of Financial Interests by May 1, 2013 for 2012. Finally, individuals who
served on a retirement board in 2011 but are not serving in 2012 must, by May 1,
2012 file a Statement of Financial Interest for 2011.
Those items that must be disclosed closely parallel several of the provisions of Chapter
268B with certain exceptions. Other employment, investments, loans, reimbursements,
gifts, honoraria, and other items must be disclosed.
Failure to file a Statement or the filing of an inaccurate or incomplete Statement will
result in removal of the person from the board and a prohibition on that person
serving on any board.
A more detailed outline of these requirements will be available shortly.
Chapter 268A Compliance Pledge
from
Section 41 of Chapter 176 requires each retirement board member upon the
commencement of his/her term to file with the Commission "...a statement
acknowledging the member is aware of and will comply with the standards set forth in
Chapter 268A, this chapter (Chapter 32) and rules and regulations promulgated under this
chapter." This form must be filed by any retirement board member beginning a term
after February 16, 2012.
MEMORAND U M - Page Five
TO: All Retirement Boards
FROM:
RE:
DATE:
Joseph E. Connarton, Executive Director
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
December 2, 2011
Procurement Reform
Sections 4 and 42 of Chapter 176 set forth a specific statutory process to be followed by
retirement boards when procuring and contracting for certain services. It is important to
note that, although this law requires the retirement board to adhere to that specific
process, under Chapter 32, Section 23(3) board members, as fiduciaries, must meet the
standard ofa prudent expert in taking all actions related to procurement and contracting.
Due to the fact that these provisions come into effect on February 16, 2012,
retirement boards must conclude any ongoing procurement (including the execution
of a valid contract) prior to that date. Consequently, all procurements that have not
resulted in an executed contract as of that date will be void and retirement boards
must commence a new procurement process in compliance with the new law.
Although these provisions are not law until February 16, 2012, please be advised
that, in order to meet the requirements of 840 CMR 19.01(1),(2),(3),(7) and (11),
retirement boards must comply with the new statute regarding all regulatory
submissions made after December 31, 2011. PERAC will not process any such
submissions in relation to investment services unless the provisions of Chapter 176
have been followed. Such an action is permissible under the provisions of Chapter
32, Section 23 (g) and PERAC Investment Regulations.
Many of the requirements contained in the statute are clear and this memo is not intended
to be an exhaustive treatise on implementation. Retirement boards and their advisers
should be able to conduct procurements under the new law with little additional effort
beyond what has been required for years under the fiduciary duty noted above.
Applicability
The specific provisions of Section 23B of Chapter 32 apply to all contracts and
procurements for investment, actuarial, legal and accounting services. Under paragraph
(k) of that Section there are additional provisions relative to the procurement of services
from an "investment service provider". These would include, but not be limited to,
managers, partnerships, trusts, custodians, consultants, proxy services, securities
litigation services and services related to the financial information (cash books, pooled
fund statements, Annual Statements) the retirement boards must file with PERAC.
MEMORAND UM - Page Six
Joseph E. Connarton, Executive Director
TO: All Retirement Boards
FROM:
RE:
DATE:
Chapter 176 ofthe Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
December 2, 2011
Paragraph (c) of Section 23B mandates that a contract for procurement of legal,
investment, actuarial and accounting services must take place utilizing "...competitive
sealed proposals, in accordance with this section."
Procurement File
Under paragraph (d) a retirement board that must "maintain a file on each contract"
which retains "all written documents required by this section." In addition, this
paragraph addresses the issue of records retention by requiring that these documents
"...be retained by the retirement board for at least 6 years from the date of final payment
under the contract."
Request for Proposals (RFP)
For all procurements covered by the statute the retirement board must "solicit proposals
through a request for proposals". That RFP must include, among other items set forth in
paragraph (g) of Section 23B, the following:
(1) The time and date for receipt of proposals, the address of the office to which
the proposals are to be delivered and the maximum time for proposal acceptance
by the retirement board;
(2) The purchase description and all evaluation criteria that may be utilized;
(3) All contractual terms and conditions.
Evaluation
The initial evaluation of the responses to the RFP is the responsibility of the retirement
board. However, with respect to investment management services, the investment
consultant may conduct the initial evaluation. That evaluation must be in writing and
based solely on the criteria set forth in the RFP.
Each proposal is to be rated as highly advantageous, advantageous, not advantageous or
unacceptable based on the evaluation criteria. The retirement board or investment
consultant, if applicable, must state the reasons for the rating.
Each proposal is to be assigned a composite rating and the retirement board or investment
consultant, if applicable, must state the reasons for the rating.
MEMORANDUM - Page Seven
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
December 2, 2011
Any revisions to a proposed plan for providing services should be obtained by
negotiation prior to awarding the contract. It should be noted that any such revision that
is agreed to by the retirement board that diminishes the rights of the retirement board as
originally proposed may result in a violation of fiduciary duty.
In the event that the initial evaluation is conducted by the investment consultant the
consultant must review evaluations of all the proposals with the retirement board and
provide each member with the initial evaluation of each proposal.
Decision
The retirement board shall determine the most advantageous proposal from a responsible
and responsive offeror taking into consideration price and the evaluation criteria. An
award may be conditioned on "... successful negotiation ofthe revisions specified in the
evaluation..." Any omission of a revision so specified must be explained in writing.
Negotiation
As noted, the retirement board or its duly designated agent, subject to the approval of the
retirement board, may negotiate all terms of the contract not deemed mandatory or nonnegotiable. If, after negotiation, the retirement board determines that it is in the best
interest of the retirement system not to award the contract to that vendor, it may
determine the proposal which is next most advantageous from a responsible and
responsive vendor and may negotiate terms of the contract with that vendor.
Disclosures
On or before January 1 of each year and as part of the RFP process all contractors or
prospective contractors must file annual disclosures with the retirement board and
PERAC. These include disclosure of arrangements for compensation paid or to be paid
to a contractor or a related person in connection with the services the contractor provides
to the retirement board or any other client; disclosure of compensation in whatever form
paid or expected to be paid by the contractor or a related person to others in relation to
the services provided to the retirement board or any other client; and disclosure of any
conflict of interest that the contractor may have that may interfere with the ability of the
contractor to provide unbiased and objective services to the retirement board.
MEMORANDU M - Page Eight
Joseph E. Connarton, Executive Director
TO: All Retirement Boards
FROM:
RE:
DATE:
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
December 2, 2011
Cancellation/Rejection
The retirement board may cancel an RFP or reject in whole or in part any and all
proposals if it determines that cancellation or rejection serves the best interests of the
retirement system. The reason (s) for the cancellation must be stated by the retirement
board in writing.
Vendor/Board Forms
In accordance with the new law, proposals submitted to a retirement board must include a
Vendor Certification Form by which vendors certify under the pains and penalties of
perjury that the proposal "has been made and submitted in good faith and without
collusion or fraud with any other person."
In addition, each retirement board member must certify to PERAC under the pains and
penalties of perjury "that, to the best ofthe members knowledge and belief, this proposal
has been made and submitted in good faith and without collusion or fraud with any
person."
Term
No contract may be awarded for a term exceeding 5 years, however, a retirement board
may participate in a limited partnership, trust or other entity with a term for a longer
period "...as part of an investment of system assets." As a result, all contracts entered
into by a retirement board must explicitly state a term consistent with the new law.
Written Contracts
All contracts must be in writing and no payment may be made for a service rendered
prior to execution of a contract.
Penalties
A contract made in violation of these provisions is not valid and the retirement board may
not make any payments under such a contract.
MEMORAND U M - Page Nine
TO: All Retirement Boards
FROM: Connarton, Executive Director
RE:
Joseph E.
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
DATE: December 2, 2011
Any person conspiring to cause a contract to be solicited or awarded in violation of these
provisions will pay to the retirement board not more than $2,000 for each violation. In
addition, such a person will pay the retirement board double the amount of damages
sustained by the retirement board as a result of the violation.
As noted above, the provisions of the new law pertaining to procurement are clear,
concise and easily understood. During the course of its educational efforts the
Commission will review various aspects of procurement best practices, however,
retirement boards in concert with their attorneys and consultants should be able to
implement the law as written.
Enforcement
Section 38 of Chapter 176 authorizes PERAC to debar contractors and vendors thereby
excluding such contractors and vendors from "contracting or subcontracting with a
retirement board".
Debarment may be imposed for a number of reasons including:
(1) Conviction or final adjudication by a court or administrative agency of the
following:
(a) a criminal offense related to obtaining or attempting to obtain a contract or
subcontract or the performance of such a contract or subcontract;
(b) a criminal offense involving embezzlement, theft, forgery, bribery,
falsification or destruction of records, receiving stolen property or other
offenses indicating a lack of business integrity or honesty;
(c) a violation of state or federal antitrust laws;
(d) a violation of Chapter 268A (the State Ethics Law);
(e) a violation of Chapter 32.
(2) Substantial evidence of any of the following:
(a) providing false information in connection with obtaining or trying to obtain
a contract;
D
MЕМОRANDUM - Page Ten
TO:
FROM:
RE:
DATE:
All Retirement Boards
Joseph E. Connarton, Executive Director
Chapter 176 of the Acts of 2011: An Act Providing for Pension Reform and
Benefit Modernization (Governance Provisions)
December 2, 2011
(b) failure to comply with record keeping and accounting requirements of law
or regulation;
(c) failure to perform or unsatisfactory performance;
(d) submission of an inaccurate disclosure statement;
(e) failure to disclose certain compensation;
(f) any cause affecting the responsibility of a vendor which the Commission
determines to be serious and compelling enough to warrant debarment.
As noted within, additional guidance will be provided on the "non-governance" aspectof
Chapter 176 of the Acts of 2011.
Thank you for your cooperation in this matter.
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