Monday, February 18, 2013

Public Funds and Emerging Managers

Public Funds and Emerging Managers

Many large public pension plans have programs to hire minority-owned money managers, which is a laudable goal.  In most cases, they retain a firm to assemble and oversee a collection of minority-owned money managers.  For some reason, these initiatives are called emerging manager programs.  In order to implement the strategy, the pension plan has to pay two levels of fees: the arranging manager gets 0.25% to 0.40% and the underlying managers earn another 0.40% to 1.00%, depending on the mandate.   In my opinion, these programs are about two-thirds politics and one-third investments.  Obviously, the managers and trustees don’t discuss the political aspects of these initiatives.

The argument for hiring a firm to retain emerging managers goes something like this.  New and smaller managers perform better than established and larger managers.  As a result, the pension plan will improve its performance, while at the same time diversifying the firms it does business with.  Additionally, the most successful emerging managers can be graduated into a direct relationship with the pension plan after they’ve been incubated for several years.  In short, you can do well by doing good.   The argument concludes with the point that public pension plans are ill equipped to do the labor intensive and difficult task of identifying and monitoring emerging managers.  Sounds like a good argument, doesn’t it? 
PR Bake Off: Part 1 (2009) 
I’ve heard the pitch countless times.  During my tenure at North Carolina I turned it down every time.   That doesn’t mean that we didn’t hire minority managers.  Rather, we hired them directly.  Moreover, we engaged non-minority firms, where minorities played a significant role in managing the pension plan’s money.  Nonetheless, signing up for an emerging manager program allows you to check a lot of political boxes.  Typically, the arranging manager is also minority owned, so the pension plan gets double credit for the initiative.  In addition, the underlying managers tend to do a bunch of business with minority owned brokerage firms, which ticks yet another box.  As an added incentive, the manager and underlying firms will gladly appear at conferences and meetings that help the trustees demonstrate their commitment to diversity.

Here’s why I rejected these programs.  While there’s a bit of truth to the argument that smaller managers perform better than larger ones, there are two flaws in this logic.  First, there’s massive survivor bias in the data.  The small managers who can gather $50-$100 million, typically generate good performance or they disappear.  Second, as these managers grow, their performance tends to deteriorate.  So at the very point, where the manager becomes big enough to add meaningfully to a large pension plan, the performance cools.

Even if the program is successful, the incremental performance won’t make a material difference to the pension plan.  For example, North Carolina has just started one of these programs with an allocation of $500 million to two managers.  Suppose the program consistently beats its benchmark by 2% per year, an impressive feat.  North Carolina’s $78 billion pension plan will be boosted by a tad more than 1/100 of 1%.  This is hardly worth the effort.[i]

In fairness, one of those underlying managers might become highly successful and eventually warrant a direct and meaningful allocation from North Carolina.  On occasion this happens.  However in most instances, there are institutional obstacles.  I was on the board of a minority owned firm, Piedmont Investment Advisors.  We were included in a number of emerging manager programs.  However, when we tried to graduate and develop a direct relationship with the underlying pension plans, our overseer always resisted.  They didn’t want to lose our performance or fees from their emerging manager fund.  And, very often it turned out that the pension plan was more interested in checking the minority box than giving us a full mandate.  When our investment performance hit an inevitable rough patch, our overseer was suddenly willing to let us try to develop a direct relationship.  Obviously, it was too late.

There’s also the problem of fees.  In a low return environment, adding even 0.25% on top of the underlying manager’s fee is a significant drag on performance.  More importantly hiring a firm to manage one of these firms leads to an absurd result.  At North Carolina, when their program is fully implemented, the two managers will earn something like $1.25 million per year for overseeing 1.4% of North Carolina’s equity exposure.  Meanwhile, the staff overseeing the remaining 98.6% of the equity assets earns less money than the two managers.  How does that make sense?

Most of the professionals running emerging manager programs are earnest and well-meaning investors.  I laud their effort to generate business and take advantage of the opportunity.  The big hedge funds, private equity firms, and traditional managers are carting away hundreds of millions of dollars in fees without adding value.  Why shouldn’t the emerging managers get their share of the spoils?  Frankly, the taxpayers and pension beneficiaries would be better off if these ravenous managers were shown the door, whether they’re interested in profiting from alternative investments or emerging managers.

[i] If you’re interested in seeing what one of these programs look like, go to at pages 73 and 74.  It shows the performance of two emerging manager programs for the New York State and Local Retirement System.  The managers operate large and midcap emerging manager programs respectively.  In total they manage $2 billion in assets or 2.4% of New York’s equity assets and earned $4.2 million in fees or 0.22%.  Neither program beat its benchmark over any of the measurement periods.

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