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.

Tuesday, August 30, 2016

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.

Are markets efficient?

A must watch discussion between Richard Thaler and Gene Fama - both from the University of Chicago.

Thursday, August 25, 2016

Pension Funds using options.

Two states, Hawaii and South Carolina are using Cash Secured Puts to boost the yield of their pension funds.

So what exactly is a cash secured put?  

A put is a bet that the underlying stock will fall in price.

  • Buying a put results in a payoff when the stock price falls below the strike.   

  • Conversely, selling a put results in a loss when the stock price is below the strike.   

The benefit to writing (selling) a put is that you earn a premium when the stock is trading above the strike.   But when the stock price falls, the writer incurs a loss.  The payoff from this strategy is basically the same as a covered call.

A cash secured put involves keeping cash on hand to cover this loss.   In the case of a pension fund, this cash is probably in the form of Treasuries.   Holding this cash doesn't make the loss go away, it just means that you have the money to cover it.   When the option is exercised, the writer sells the Treasuries to buy the stock, and ends up holding the stock.

If as a portfolio manager, you wanted to move money from Treasuries to, say the S&P 500, but wanted to do so when the price of the index fell below a certain level, then a cash secured put would be one way of doing this.  During the periods when the index was high, you'd keep your money in Treasuries and instead earn the option premium.  It's similar to issuing a limit order.

So is this a risky strategy for a pension fund as implied by the Wall Street Journal?   I don't think so.   The payoffs are pretty clear and the risk is quite quantifiable providing that the strategy is managed
carefully.  That said, essentially what these states are doing is providing market insurance to other market participants.   The insurance business is a great business to be in, except when there is a disaster.   Just ask AIG.

A bigger issue is whether or not the optimal asset allocation of the pension fund is being compromised.  For example, if the pension fund is holding larger allocations to Treasuries instead of stocks, the fund will miss out on stronger performance by stocks in an up market.   The fund will instead be an aggressive buyer of stocks in a declining market which may result in an overweighting of stocks in a bear market.

Wednesday, August 10, 2016

More poor performance from the NC Pension Fund

Ron Elmer crunches the numbers on the recent performance of the NC Pension Fund and yet again finds that the fund has underperformed a simple basket of Vanguard funds.

This isn't just bad luck.   It is exceptionally bad decision making.   Here's to hoping that the next Treasurer will do a better job.