Friday, March 1, 2013

South Carolina Investment Commission Airs Some Dirty Laundry

South Carolina Investment Commission Airs Some Dirty Laundry

A couple of days ago, the South Carolina Retirement System Investment Commission censured State Treasurer Curtis Loftis.[1] After reading the Commission’s 2012 Annual Report[2], I think the State Treasurer deserves some credit rather than a rebuke.  The censure resolution lists four pages of comment attributed to the Treasurer that criticizes the management, structure, performance, and fees of the investment portfolio.  I’m sure the Commission members and staff don’t like the Treasurer’s critique, and they won’t like mine.  While some of the words are tough, the substance of his concern appears to be legitimate.  I suppose in another era, the Commission chairman, having had his honor questioned, would have challenged the Treasurer to a duel.  In this day in age, we tend to fight through press releases and board resolutions.

Wilmington Review (1999)

Over the last five years, Columbia Municipal Airport has to have been the favorite destination of hedge fund, private equity, and real estate managers.  The South Carolina Plan has gorged on alternative managers and driven up their fees in the process.    The plan incurred $296 million in fees in 2012 on only $25.3 billion in assets.  If the pension were three times larger, this fee level would start to make sense.   Unfortunately, the overall fees are even higher than reported by the Commission.  For example, South Carolina has at least $3.3 billion in exposure to fund of funds, which means that the fees charged by the underlying managers are not included in the annual report.   I’m guessing that this represents another $50 million paid out to money managers.

I suppose the fees might be justifiable if the asset allocation and managers were capable of driving outstanding investment performance.   While there are some reputable managers in South Carolina’s portfolio, there is also a lot of exposure to the Wall Street banks and big brand name asset gatherers.  South Carolina’s long-term objective is to reach a 7.5% return.  In recent years, like most public pension plans, they’ve failed to reach this goal.  It is not out of the question that they might one day sustain a 7.5% return, but the odds do not favor them.  The transactions costs and fees alone make this a daunting task.

Frankly, the portfolio is hard to analyze.   Its exposure to the various asset classes is unclear, and the portfolio is subject to a fair degree of idiosyncratic risk (risks specific to the managers), which means it is really difficult to translate the portfolio’s asset allocation into an expectation about its future performance and overall risk.  Moreover, South Carolina has added a lot of this exposure in a very short period of time (known as vintage year risk).  In reading the Annual Report, I imagined rushing into a Piccadilly Cafeteria, grabbing a plate, and taking a heaping spoonful of every item on the menu.  The South Carolina portfolio has sampled a bit of everything that money management has to offer, and unfortunately it has created a bit of a mess and case of political indigestion.

Repairing the damage will take many years, as much of the South Carolina portfolio is relatively illiquid.  The Commission would be well served to answer the State Treasurer’s questions, if it hasn’t done so already, and directly confront their problems.  Unfortunately, several of the Commission members were present as the portfolio was constructed.  Thus, there’s a natural reluctance to admit mistakes and a tendency to attack critics.

To make matters worse, there’s an ongoing inquiry into the business relationship between the Chairman’s law firm and the pension fund.  I have no idea if there’s any merit to this charge.  However, I know that this type of controversy is a huge distraction when you’re trying to untangle and restructure a complex portfolio. Dealing with this in a nonpartisan way is important because the South Carolina Retirement System faces significant challenges, even without the investment controversy.  As the chart taken from the financial section of the Retirement System’s Annual Report[3] shows, South Carolina’s pension plans aren’t particularly well funded.  Their funding ratios are by no means the worst in the country, but they’ve got some work to do in meeting their obligations to their civil servants.

Investing isn’t a partisan activity.  Financial markets don’t much care if you’re a Republican or Democrat, liberal or conservative.  I’ve found it’s best to check all this baggage at the door.  Moreover, Wall Street and money managers are adept at exploiting weaknesses, and the squabble between the State Treasurer and the Commission is a perfect opening.  With a good bit of patience and a whole lot of nonpartisanship, South Carolina can fix this problem.

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