Question

Carl Karl, a portfolio manager for the Alpine Trust Company, has been responsible since2015 for the City of Alpine’s Employee Retirement Plan, a municipal pension fund.

Alpine is a growing community, and city services and employee payrolls have expanded ineach of the past 10 years. Contributions to the plan in fiscal 2020 exceeded benefit paymentsby a three-to-one ratio.

The plan’s board of trustees directed Karl five years ago to invest for total return over thelong term. However, as trustees of this highly visible public fund, they cautioned him thatvolatile or erratic results could cause them embarrassment. They also noted a state statute thatmandated that not more than 25% of the plan’s assets (at cost) be invested in common stocks.

At the annual meeting of the trustees in November 2020, Karl presented the followingportfolio and performance report to the board.

Karl was proud of his performance and was chagrined when a trustee made the followingcritical observations:

a. “Our one-year results were terrible, and it’s what you’ve done for us lately thatcounts most.”

b. “Our total fund performance was clearly inferior compared to the large sample of otherpension funds for the last five years. What else could this reflect except poor managementjudgment?”

c. “Our common stock performance was especially poor for the five-year period.”

d. “Why bother to compare your returns to the return from Treasury bills and the actuarialassumption rate? What your competition could have earned for us or how we wouldhave fared if invested in a passive index (which doesn’t charge a fee) are the only relevantmeasures of performance.”

e. “Who cares about time-weighted return? If it can’t pay pensions, what good is it!”

Appraise the merits of each of these statements and give counterarguments that Karlcan use.

Short answer

a. Extended time frame is essential to draw a conclusion

b. Large proportion of pension funds has caused a decreased returns.

c. Alphine’s stock was positive.

d. Heavy weightage in bonds was determined upon by the Board and not the fund management.

e. Manager’s ability is revealed in the time-weighted return.

Step-by-step solution

Explanation of statement ‘a’

Though the one-year return was terrible, but this small duration of one year cannot be used as a base to draw inferences. Moreover, the mandate was to give priority to long-term investments.

Explanation of statement ‘b’

The pension funds held a much larger share in equities whose returns significantly exceeded bond returns. Moreover, the Alpine fund manager was also instructed to hold down risk, investing at most 25% of fund assets in common stocks.

Explanation of statement ‘c’

c. On the contrary, over the five years, Alpine’s alpha was positive:

α = .133 – [ .075 + 0.9 x ( .138 – .075)] = .13%

Explanation of statement‘d’

d. Over the last five years, especially the last year, bond performance has been poor because Alpine was encouraged to hold this asset class.

Still, however, the Alpine fund fared much better than the index. Moreover, despite the underperformance of the bond index, it outperformed both for the five years. Its performance was also superior on a risk-adjusted basis. The major source of disappointment was the heavy asset allocation weighting towards bonds, which was the Board’s choice, not the fund manager’s.

Explanation of statement‘e’

e. A trustee may care little about the time-weighted return, but this would reflect more about manager’s performance.