Thursday, July 20, 2017

Why 8.5% is delusional

I am quoted today in an article on about the Connecticut pension fund return assumptions.  The article is here:

So why is an 8.5% return assumption delusional?

It's pretty simply really.  Assume that your fund is 50% bonds, 50% stocks.  Currently 10-year Treasuries are yielding about 2.3%.  Let's round that up to say 3% to be generous.  Assume an equity risk premium of 5%, and equities will return about 8%.  So our hypothetical pension fund is going to earn:

             50% bonds + 50% equities = 0.5*3 + 0.5*8 = 5.5%

Even with a tweaking the bonds to 4%, and using a risk premium of say 6%, you are looking at:

            0.5*4 + 0.5*10 = 7%

I think 7% is still pretty optimistic, but if we use today's numbers, 8.5% implies stock returns of:

            8.5 = 0.5*3 + 0.5*X

Solve for X, ... go ahead, I'll wait.

           X = 14%.

So stocks would need to return 14% on average, implying an 11% equity risk premium.  That's why it's easy to say that 8.5% or even 8% is delusional.

But just labelling something delusional doesn't really help anyone, and I appreciate this.   Unfortunately to ensure a pension fund is fully funded, and meets a realistic return goal, either contributions have to increase, or payouts have to decrease.  Both are hard choices and there's no easy fix.  Just setting a high return merely kicks the can down the road.

Saturday, July 15, 2017

Will fee cutting hurt the pension fund?

In an article yesterday in the News and Observer (, 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.

Wednesday, June 14, 2017

Folwell reduces fees by $50m

Some good news from the Treasurer's office.  Apparently our new Treasurer has reduced fees by $50 million so far.  He reports that he's on track to hit $200 million by the end of his first term.

This is great news.   I am sure we will be digging into the numbers when the annual report comes out, but for now, this is a great start.

Wednesday, January 25, 2017

Dow hits 20,000

What does this mean?

Ummm. Not much.

Some will say that you need to get out once a milestone is met.   Trouble is - when do you get back in?   Oh - that's right - before the market goes back up.

Of course, 20,000 is no 36,000.  We're still waiting for that one.

Wednesday, October 26, 2016

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.
(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.

Monday, October 3, 2016

You can't consistently beat the market. Just ask Harvard.

Harvard University has been lamenting a substantial loss in the value of their endowment.  Apparently about $2 Billion.   See:

Harvard has chased all sorts of exotic strategies, including private equity and hedge funds and yet - to quote the above article:

"...if Harvard had passively invested in a standard mix of 60 percent stocks and 40 percent bonds, it would have gotten a higher rate of return — 8.9 percent over the past five years, versus 5.9 percent with its active in-house management, according to The Boston Globe."

What's worse, is that Harvard was paying its money managers millions to come up with these strategies.   While Harvard is clearly one of the premier academic institutions in the world, this status does not give it the ability to beat the market.  Other institutions (I'm looking at you NC Pension Fund) would do well to learn from this.

Monday, September 12, 2016

Money Monster - a review

I just watched "Money Monster".   It's a thriller staring George Clooney and Julia Roberts that's basically a mashup of Jim Cramer meets the flash crash meets (fill in your evil corporation here).

The movie is OK, if you don't know much about finance.   However, if you do happen to know a little bit about how markets actually work, you'll be cringing all the way through.

The basic plot:  Clooney is a TV star (a la Cramer) who runs a stock picking show.  Roberts is his producer.  At some point Clooney had recommended a stock (in an evil corporation called IBIS) and said it was as safe as a savings account (sound familiar?).  Some guy looses his savings in this stock and comes to the studio and takes Clooney hostage.   Drama ensues until there is a showdown with the evil corp CEO who admits defrauding the stockholders.   The hapless investor gets shot by the the police, and Clooney suffers a bad bout of Stockholm Syndrome.

Here's what drove me crazy.

Apparently the evil CEO had manipulated his stock price (no explanation of how) so that it crashed and lost $800 million of investors money.   He then took this money and bribed a South African union to strike at a mine in South Africa.  With the strike underway, he ploughed his $800 million into this mining stock.  His brilliant plan was to call off the strike and cash in when the stock went up in price.

What is so stupid about this, is how on earth the CEO was able to extract the $800 million due to the decline of IBIS corp's stock?  All I can think of was that he must have shorted the stock and then announced some very bad news.  But such an action would have been such a blatant case of insider trading that the Feds would have been all over it.  And anyway, there was no mention of the CEO saying anything.  In the movie the price crash is a mystery to the media and to folks at IBIS.

In reality, the writers of the movie clearly don't understand what happens when a stock price falls.  They seem to think that the reduction in value must have wound up in someone's pocket.  And of course, who else but an evil CEO.  To make a movie about finance and not understand the basic premise of the stock market really boggles the mind.

What's even more confusing was that IBIS corp apparently hires its own "quants" to run HFT trading strategies on its own stock.   Why?   Are they buying on IBIS corp's account?   Is this some sort of repurchase program?   I just don't get it.   But the kicker is that the HFT guys hardly trade at all on the day of the IBIS corp stock crash.   To quote the movie: "it has someones fingers all over it".

One more stupid thing:
They send a producer to the SEC to find out what is going on.   He comes back with a piece of paper that says that the volume was down 80% on the crash day.   Umm, you don't need to go to the SEC to find that stuff out.   Try yahoo finance instead.

So unless you really like Clooney and Roberts, give this one a miss.   Watch "the big short" instead.

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.

Wednesday, August 31, 2016

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:

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:  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.