Will fee cutting hurt the pension fund?

In an article yesterday in the News and Observer (http://www.newsobserver.com/news/business/article161425553.html), David Ranii explores whether fee cutting by the pension fund might hurt future returns.

It's a good article, I was interviewed for it, and I recommend that you read it.  I would, however, like to add a small comment/clarification with regard to my comments within the article.

While I strongly support attempts by the pension fund to reduce fees, this has to be done in a sensible manner.  When high cost equity managers are liquidated, the proceeds should be put into an equivalent low cost index fund.  What the pension fund has been doing is to put these proceeds into cash and fixed income.  In the article, I am quoted as noting that this action will likely result in lower returns for the pension fund going forward.  

The article incorrectly portrays me as in conflict with critics of the pension fund's strategy.  This is inaccurate.  I fully agree that cutting fees by firing equity managers and then putting the proceeds into cash is a bad idea.  This will hurt future returns.

Nevada only pays $13 Million to run its $35 Billion pension fund!

A recent article in the Wall Street Journal is getting some attention - as it reports that Nevada only pays $13 million to run its $35 billion Pension Fund.  To put this in perspective; North Carolina pays 12 times as much, even after you take account of the size differences in the plan.

So how does Nevada keep costs so low?   The answer is simple: the plan is indexed.

Not only are the costs super low, the performance is pretty good.   Ron Elmer runs the numbers and finds that over 10 years, Nevada's plan earned 6.2% while NC earned 5.5%.   A difference of 0.7%.

Together with a few others (Ron Elmer, Andy Silton and SEANC), I've been advocating indexing for the NC Pension Fund for quite a while now and we've struggled to see any meaningful change.  But now we're now in a position to elect a new state Treasurer.

Recently - WRAL's "On the record" interviewed both candidates - you can see the video here.
http://www.wral.com/candidates-for-state-treasurer-go-on-the-record-/16005623/
(start at the 18 minute point).

Of the two candidates, I think that Dale Follwell understands the problems and has a realistic approach, so I'll be voting for him.

Just as a point of clarification (this came up in the video) - there is a huge difference between the funding of the plan and the performance of the plan.

• A plan's funding level is based on how much money is put into the plan - basically - has the state honored its obligation to fund the plan?
• A plan's performance is based on the investment choices that the plan makes.   Poor investment choices (and high fees) result in lower performance and can negative impact the funding level.  These choices are largely controlled by the Treasurer.

NC SPIN talks about Pension Fund Fees.

On a recent episode of NC SPIN, the topic was pension fund fees.   I was quoted at the start of the segment.  The video is here:  The bit about the pension fund starts at 17:37.

While the discussion was pretty good and I am glad to see that the fees are getting more and more attention, there were a few comments that I think need addressing.

1. John Hood talks about the idea that if everyone indexed, markets wouldn't be efficiently priced anymore.   While in theory, this is correct as no one would trade on actual information, in reality it would never happen, simply because, as prices got out of whack, investors would have the incentive to pile back in to active investing.  But Hood does emphasize that we need to reduce costs.

2. I think that this focus on getting higher returns is a fool's errand.   This notion that there are good returns out there and that all we need to do is find them is pretty silly.   This might seem counter-intuitive, but in reality an $85 Billion pension fund is going to be broadly invested across stock and bond markets.  Because of this, the fund is really just a price taker - it will earn whatever these broad market segments earn.  The two key decisions that the fund has to make are 1) what is the mix of stocks and bonds and 2) how do we get this mix and at the same time pay as little in fees as possible.

3. Cash Michaels says that "a lot of other states are not experiencing the same kind of luck" when talking about the returns of the fund.  The facts don't support this statement.   NC is lagging other states in performance.   Ron Elmer estimated the returns of NC vs other states and tweeted the results.  Here's the graph:

4.  Mr Michaels also talks about investing in infrastructure projects as a way to boost returns.   I think that this would be a terrible idea - risky and expensive.   Stick to stocks and bonds.

5.  There was some discussion of broadening the control of the fund to a board structure.   I support this idea, providing that we have good people on the board!   

6. The idea of defined contribution plans was also raised.  While a DC plan gets the state out from its pension obligations, it is not a solution to high fees.   So I think that this is red herring.

Bottom line, I appreciate that the panel of NC SPIN took the time to discuss this issue and keep it in the attention of the electorate.  I hope both candidates for Treasurer put fees at the forefront of their campaigns and more importantly, the candidate who is ultimately elected enacts meaningful change.

Pension Fund Fees keep on growing.

Last Friday, Cullen Browder reported on the level of fees now being paid by the NC Pension Fund.   In the process, he interviewed yours truly.   The video is here:

http://www.wral.com/fees-grow-faster-than-nest-egg-in-nc-employees-pension-fund/15963461/

A big thank you goes to Ron Elmer who blogged about the fees on his investorcookbooks blog.

Ron compared the fund today vs. what it would have looked like had the asset allocation in 2000 been maintained using Vanguard index funds.  His analysis is here.

The results are shocking.   Fees as a percentage of the assets have increased by a factor 7 from 0.1% to 0.7% and the fund has gone from being overfunded to underfunded.

But it's not just fees - Ron also takes a look at the lost performance of the fund.   Again, the results are shocking.  The fund has underperformed by 1.8% per year over the past 10 years.

But it gets worse.  If you look at the annual report for 2014 - 2015 - here: https://www.nctreasurer.com/inside-the-department/Reports/NCDST_Annual_Report_FY2014-2015.pdf  you can start to add up all the fees that are being paid (for fiscal 2015).

Page 32:  Total Fees: $538 Million.
Page 33:  Fund of Funds Management Fees:  $38 Million
Page 33:  Fund of Funds Incentive Fees: $36 Million.
and in the Government Ops Report for June 2015, there are additional costs of $53 Million (presumably mostly attorney and consultant fees).  (Again thanks go to Ron for spotting this).

Add all these together and you've got a total cost of $665 Million which on an $85 Billion fund is about 0.78%.   So amazingly the total fees are approaching 0.8%!   And given that this data is from last year, I'd fully expect the total to be higher now.

So what's going on?

Well - it's really hard to say, but a look at page 31 of the annual report can shed a little light.

Let's look at Global Equity - the second row.   Global equity is benchmarked against the MSCI All World Index (AWI) Long Only - pretty reasonable, but also in the benchmark is a beta adjusted version to reflect hedged portfolios.  My guess is that some of the Global Equities allocation is in long-short hedge funds - a very expensive strategy.

Or take a look at Opportunistic Fixed Income.   Here 50% of the benchmark is in the HFRX Distressed Securities Index (the HFRX site doesn't seem to have the exact index that is described).  The remaining parts of the benchmark cover stuff like leveraged loans and high yields.   Bottom line, these are, in part, hedge funds buying junk and distressed debt.

So the takeaway is that the Pension Fund asset allocations are highly complex and as we've seen, very expensive.   And yet, as we've seen from Ron's post above, this strategy is not paying off.

But what about risk?   A frequent defense of the heavy use of hedge funds and private equity is that these assets provide risk reduction benefits to the fund.  But the evidence doesn't support these claims.   For example, in a recent Journal of Finance article Francesco Franzoni, Eric Nowak and Ludovic Phalippou find that private equity doesn't earn a positive alpha when you include liquidity risk.  In a 2013 Review of Financial Studies paper, Adam Aiken, Chris Clifford and Jesse Ellis find that hedge fund index returns have a significant bias because only "winning" funds tend to report returns to the index creator.

The real question though, is even if these alternative investments are generating positive alpha (which I strongly doubt), are they generating enough to offset the 1.8% annual performance drag over the past 10 years?

I am pretty sure that they aren't even coming close.

Indexing Pension Funds

This is a bit of a repost - but is relevant as we talk about fees.

Back in February I wrote a white paper that was a back of the envelope analysis of the fees paid buy the pension fund, including some hidden fees such as trading costs.  

You can read the paper here.    It was referenced in this article on Forbes that talks about indexing pension funds.

Gawker on Pension Fund Fees.

Gawker media on pension fund fees (and NC in particular).

http://gawker.com/retirees-are-handing-wall-street-billions-for-no-good-r-1767496764

What level of fees should an investor (including a pension fund) pay?

I got an update about my retirement account yesterday from TIAA-CREF.   It was good news - apparently the fees are going down on an equity index fund and also on a bond fund.

Here's a snapshot of the statement.  My fees are now 0.06% and 0.07% for two index products.   Now that is what I call cheap!

It got me wondering, how much would the NC Pension Fund pay at these rates?

Assuming that the NC Pension Fund is about $90 Billion in assets, a 0.07% expense ratio would be about $63 million in fees.

Which raises the question: Why does the NC Pension Fund pay $500 million in fees?  It appears that the fund is overpaying by about $437 Million annually.

Reform needed at the NC Pension Fund.

Andy Silton has a nice piece in today's N&O in which he criticizes the management of the state pension fund.  First - the information provided by the Treasurer's office is awful.   It is almost impossible to figure out where the money is invested and what the fees are and the information is always out of date.

Second, the Treasurer seems to be pursuing a "pick winners" strategy.   This is a fool's errand.   You can't reliably pick winners in today's financial markets.  All you will end up doing is paying high fees to so-called "experts" and getting average performance in exchange.   A mountain of evidence shows this to be true.

What is worse is that the pension fund continues to move into Private Equity and Hedge Funds - both of which are incredibly expensive and do not provide the return for the risk and costs.  As Andy correctly points out, the risk of these assets is understated because they don't trade daily in the markets.

I've been making these arguments for a few years now and during that time the fees paid by the pension fund have gone up from about $300 million/year to about $500 million/year.  

This isn't small change.   The state of North Carolina pays half a billion dollars a year to Wall Street firms who provide worse performance than if the State just indexed the money.  At some point you have to question whether the Treasurer actually understands basic finance.

NC Pension Fund Fees Approach $500 Million

Andy Silton does the math and reports that fees for the pension fund are approaching $500 Million.

Just so we are clear here, that's $500,000,000.

So what are we getting for all these fees?   Apparently not a whole lot of extra performance - which is no surprise to anyone who believes that markets are pretty efficient (they are).

Silton points out that otherwise the fund is in good health - which is good, but that doesn't make wasting hundreds of millions of dollars a year any less bad.


The question we should ask then is "how much should these fees be?"

I'd answer that for such a huge portfolio, 0.1% of assets is a good start, as I can pay only 0.18% for $3000 with Vanguard and it seems reasonable to assume that $90 billion would get some sort of discount.

So assuming $90 billion in the fund, 0.1% fee would yield $90 million in fees.  But even if you go with the Vanguard fee of 0.18%, we're still only looking at $162 million.   That's $338 million less that what we are paying.

A tepid defense of hedge funds by Cliff Asness

Cliff Asness of AQR capital has an excellent blog - well worth reading.  A recent posting is called a tepid defense of hedge funds.  

This is a nice article and from it we can draw a few interesting conclusions...

1. Hedge funds look a lot like boring stocks (they have betas between 0 and 1).

2. Based on 1), hedge funds are not hedged.  If they were, they would have zero betas.

3. The positive alpha earned by hedge funds is probably not enough to cover the 2/20 fees that they charge.

4. Hedge funds didn't really provide much protection in 2008.

Fantastic investigative report into alternatives in the pension fund.

Investigative reporting at its best, done by Tom Bullock of WFAE 90.7 - public radio in Charlotte.

It's in two parts.  Well worth listening to.

http://wfae.org/post/cowell-s-alternative-part-1-high-fees-secrecy-surround-pension-investments

http://wfae.org/post/cowell-s-alternative-part-2-conflicts-interest-claims-and-campaign-donations

Charlotte Observer on NC Pension Fund Fees

Today, the Charlotte Observer tried to sort out the debate on the level of fees paid by the NC Pension Fund to hedge fund managers.

The debate has evolved into what fees do Fund of Fund managers pay the managers of the hedge funds that they hire?   Ted Siedle, the consultant hired by SEANC argues that these fees are massive and greatly underreported by the pension fund.   The pension fund (and Andy Silton) argue that Siedle's estimates are overblown.

I think we're missing the point here.  So let me recap.  Until a couple of years ago, nobody cared about the fees being paid by the Pension Fund.   Then, during the Treasurer's reelection campaign, one of her opponents starting raising the issue.   Since then a few vocal critics have continued to argue that the pension fund pays too much in fees and doesn't disclose the fees adequately.  SEANC realized that this was an issue of importance to its members and hired Ted Siedle to look into the matter.

Here are the key issues:

1. The fees are too high.
The article quotes a spokesperson for the pension fund who says that the fees are only  0.52% in total.   0.52% may not seem much, but on $86 billion it is well over $400 million per year.   As a contrast, my personal retirement portfolio with TIAA-CREF has an average fee of 0.1%.   I find it hard to believe that I have better buying power than the State of North Carolina.  My portfolio also outperforms the State's.

2. The fees being paid by the State are not unusual.  
They are the industry standard fees.  The problem is simply that the Pension Fund is allocating too much money to high fee investment products such as hedge fund funds of funds.   This is a debate about poor asset allocation.

3. The Pension Fund does not adequately disclose all the fees paid.
We don't know whether Mr. Siedle's estimates are too high or too low, because these layers of fees are not disclosed.  But my guess is that if they were disclosed - if we saw all of the trading costs and fees incurred by the pension fund - the total fee bill would be well over half a billion dollars.

Let me repeat that: a reasonable guess of total fees must be over $500 million.

This is what SEANC is upset about, and it is what all tax payers and citizens of NC should be upset about.   The State Pension fund is handing over around half a billion dollars annually to Wall Street and in exchange is getting mediocre performance.

How much does the NC Pension Fund pay hedge fund advisors?

The answer is hard to figure out.  While the pension fund will disclose (reluctantly) the fees paid directly to managers - in many cases those managers hire other managers who in turn charge another layer of fees.   This practice is common and indeed the norm in the hedge fund industry where investors contract with "fund of funds" managers.

So how much are these hidden fees?   According to the Treasurer's office fees paid to Franklin Street Partners (an alternative investments manager) by the pension fund were around $2.6 million.  But an ongoing SEANC audit reveals that when fees to the funds managed by Franklin Street partners are accounted for, this total fee bill is $16 million.   And this is just one manager.

A more detailed discussion appeared on Forbes.   And a brief summary of the problem was discussed on WRAL news.

Apparently Franklin Street states they aren't doing anything wrong and this is normal industry practice.  I am sure they are correct.  But that's the problem.  Normal industry practice is all about making Hedge Fund managers rich.

NC Pension Fund Returns - what is the benchmark?

Ron Elmer has an excellent blog posting showing that although the NC pension fund outperforms its own "custom" benchmark, it has lagged the median return for all public pension funds over 1,2, 5, and 10 years.  

In the past year, the fund underperformed by over 2%.

A couple of observations:

1. The NC Pension Fund benchmark is largely worthless because it changes from year to year and is created by the office that is running the money.   As Ron points out, a simple median of all state pension funds makes a lot more sense unless you believe that NC's pension fund is somehow special.

2. The 10 year underperformance is about -0.38%.   That gap could be eliminated by just reducing fees.  As I've pointed out before, the NC Pension Fund pays way too much in management fees, and lowering those fees by about 1/3 of a percent wouldn't be too hard.   

And in case you're wondering, a very back of the envelope computation of 1/3 of a percent over 10 years is about $2 Billion in fees (assuming $60Bn fund value as a rough average over 10 years).

We are bleeding money to Wall Street.

Refuting an attack on indexation

Probably the best money management blog out there is Andy Silton's "Meditations on Money Management".  Andy is a retired professional, who although in his earlier days was an active manager, now fully subscribes to the notion that you can't beat the market.

Andy's latest post [ here ] - is a rebuttal to a piece in the New York Times profiling Robert Olstein who is an active manager.  Olstein lives in a world where anecdotes and stories carry more weight than hard facts and data.  This is the world that most active managers live in.   They'll claim that of course, most people can't beat the market, but a few can - and they are part of the chosen few.   They'll point to a few good years of returns and say "see how I beat the market?"

All active manager's have stories and anecdotes about how they can beat the market, and if you believe them, then you'll hand over your cash and pay the 1% management fee.   But if you're smart, you'll index.   In the long run you'll be richer - because of the hard facts of the mathematics of finance.  No anecdotes needed.

Mutual Fund trading costs.

An interesting post from Josh Brown.  What really caught my eye was this:

Trading costs are too high, too. What comes along with lots of trading is lots of trading costs. Scherrer puts the annual cost at around 1.4% (average) to 2.59% for small cap managers, which really takes a chunk out returns.

Remember that when you buy an actively managed fund you are already paying the fund expense ratio which can run 0.5% - 2% depending on the fund.  Add to that 2% trading costs and it is amazing that any of these funds ever beat the market.

Josh Brown doesn't understand why people invest in Hedge Funds.

And neither do I.   Here's Josh's rant - in his classic style he doesn't hold back.  

But I fully agree with him, and I even spent time this summer trying to prevent the State of NC from increasing its allocation to Hedge Funds in the State Pension Fund.   I testified in front of the House Finance Committee and also met with the Democractic Caucus and Phil Berger (the Senate Leader), but alas to no avail.  Ultimately the bill was signed in to law by Governor McCrory.   Wall Street Investment managers will be $200 Million per YEAR better off from this bill.

Andy Silton on Money Management Fees.

Great article in the Sunday paper.  

As an exercise - take the dollar amount of your 401-K and managed retirement assets and try to figure out what fees you are paying.  If, and that's a big if, you can figure this out, think about whether you are getting value for your money.

If you think you are then you are either drinking the Wall Street kool aid, or you are indexing.

State Pension Fund and my experience with the legislative process.

Today the house finance committee met to discuss the SB 558 which would increase the possible allocation to alternatives for the pension fund.   I blogged on this yesterday.  A friend and I decided to go downtown to see the action.   The bill had been voted on in the senate and had passed almost unanimously.  Next it was heading to the house via some potential revisions at the house finance committee.   (All this is new to me - but I had a lesson in NC civics this morning!).

I decided to speak up and voice my concern (as a concerned tax payer) that moving to more alternatives will not generate higher returns, but will lead to much higher fees.   The vote was close - 14-13 in favor of the bill - and was reported (and tweeted by) Pensions and Investing Magazine.

#PensionPlans North Carolina takes step closer to higher alternative investment limits http://t.co/yupAk4CKL3
— Pensions&Investments (@pensionsnews) July 17, 2013

But all is not lost - I also got to meet some of the Democratic Caucus and (separately) the leader of the Senate - Phil Berger - to express the concerns about these very high fee investments.  These products are not a guarantee of higher returns - in fact quite the opposite.  Hopefully these folks will be able to stop the passage of this bill.

Anyhow, the legislature session is winding up, so we'll see what happens.

NC Pension wants to increase allocation to alternatives - and why this is a bad idea.

In todays News and Observer it was reported that the State Treasurer, Janet Cowell, is formally requesting that the $80bn state pension fund be allowed to increase its allocation to alternative investments to 40%.   (Alternatives are a broad category that includes commodities, private equity and hedge funds).

Ms. Cowell correctly points out that the current return objective of the fund of 7.25% is going to be hard to meet in the current or even foreseeable future given market conditions.  A cut of this return objective to 7% would cause the pension fund to be underfunded by $280 Million per year.   

The hope is that by increasing the alternatives allocation, the fund can boost returns to cover this shortfall.   This is a very risky strategy.   First, alternatives are risky - this is the first rule of finance - if you want a higher return, you better be prepared to take more risk.   Therefore, this proposal is to increase the risk profile of the fund.   Alternatives are good at artificially masking this risk because they are not traded on public exchanges and so we don't get to observe daily price gyrations.  

Alternatives are are risky in another way because we don't know what their expected returns should be.   Stocks and bonds, for example, while risky, have provided us with a long history of data.  Furthermore, their returns can be linked to fundamental measures (such as corporate profits).  As a result we can make a reasonable guess at the expected returns on these assets.   Figuring out the expected return on alternatives, on the other hand, is a complete shot in the dark.   We have no real idea what a hedge fund or private equity fund should return.   So making a big bet on alternatives is just that - a big bet.

An alternative to alternatives, is to cut the return assumption of the fund to 7% and then try to come up with the $280 million.   This may be actually easier than you'd think.   Based on recent numbers, the pension fund incurs over $350 million of fees to outside managers each year.   By moving all of the fund into low cost passive investments, the fund could save a large portion of these fees which would then offset the lower return projections.   This idea is not quite as crazy as it seems - in fact one municipality in Pennsylvania has done just that.