Saturday, May 4, 2013

Expanding North Carolina’s Investment Authority, Again: Part II

Expanding North Carolina’s Investment Authority, Again: Part II

Yesterday I discussed North Carolina’s tortuous investment statute and my concerns about tinkering with it in the existing political environment.  Today, I want to lay out my concerns about the use of alternatives in public pension plans.  I am not an opponent of  the use of private equity, hedge funds, real estate, or commodities under appropriate circumstances.  However, with the exception of a moderate commitment to real estate, I think the other alternative investments cannot possibly add value to public pension plans over the long run.  Moreover, public pension plans have simple techniques for executing these strategies.  Regrettably, the simple techniques are too straightforward and don’t offer money managers big fees, so they will not be implemented.

Back Office (2000)

Proponents of alternatives have three laudable goals.  First, they want to enhance returns.  Second, they hope to diversify the sources of return.  Third, they desire to hedge risk.  Not surprisingly, alternative managers have spent millions of dollars on marketing blitzes, exotic conferences, and political influence to convince pension trustees and staffs that their products can deliver these characteristics.

If you go back to the data from the 1980s and 1990s (before public pensions began to invest in alternatives en masse), there is some evidence that alternatives can achieve these lofty goals.  The problem is that the laudable characteristics disappear when big pension plans star to throw billions of dollars into these strategies.  In other words, when big public pension plans collectively commit vast sums of money at alternative strategies, the opportunities disappear.

Every pension plan, North Carolina included, believes that their staff, consultants, and trustees can pick a group of superior managers that will beat the odds.  The smartest portfolio managers on the planet can’t beat the stock market, so what do think the chances are that any public funds’ professionals can consistently pick enough winners to add value?  They’re nil.

And don’t forget that alternatives investments are expensive.  The management fees, as I’ve repeatedly discussed, typically run at 1% to 2%, and that only represents a fraction of the costs. By the time you added trading expenses, deal costs, and carried interest, 35% or more of any gains disappear from alternative investments. 

In addition, the return-risk profile is totally asymmetrical.  If a fund does well, a portion of the gain goes to the manager.  If a fund does poorly, the pension plan absorbs the entire loss.  If you share the profits with the managers, but not the losses, you’ve got to be amazingly good at selecting managers.  The mantra in the alternative categories is that you have to invest in top quartile managers in order to succeed.  This statement is probably true, but it’s also total nonsense.  First, no one knows in advance which managers will be first quartile.  Second, there’s no way several hundred pension plans can come anywhere close to selecting even above average managers.  And, I am assuming that politics never enter the equation.

Nonetheless, North Carolina and many other pension plans are increasing their commitment to private equity in the hope of enhancing their returns (goal 1).  The data suggests that they will, indeed, do 2% to 3% better than the S&P 500.  However as I’ve argued in other posts, this isn’t nearly good enough for the risks they’re taking and doesn’t come close to meeting their investment targets. 

Moreover, there’s a simple alternative.  Since most private equity in public pensions are leveraged buyouts, the North Carolina would be far better off by borrowing using its impeccable credit rating and accessing the muni markets.  The borrowed funds could be invested in the S&P 500.  It would be much cheaper since PE firms have to borrow at taxable junk bond rates and charge their fees.  In addition, the state would have much more control since their investments wouldn’t be tied up in ten-year investment partnerships.  North Carolina and other pension plans would never take up my suggestion because the risk of leverage would be transparent.  The beauty of private equity is that it buries the risk in an opaque package and allows trustees and politicians to pin the blame on someone else if things go wrong.

Public pension plans would love to find alternative sources of return to domestic stocks (goal 2).  Luckily, real estate can provide a bit of diversification, although real estate can go off the rails if too many pension plans follow the same course.  However, many of the other diversifiers have one of two unfortunate characteristics.  Some strategies start to act more and more like stocks once public pensions enter the strategy (think of foreign stocks in the 1980s and 1990s or emerging market equities).  In other words, they become more synchronized due to the public fund cash flows.[1] 

Other diversifying strategies, such as commodities or currencies are pure speculations.[2]  Sure a pension plan would like to have exposure to commodities for the five years that they are soaring, but they’d want no part of them when they’re spiraling downward.  Somehow pension plans have to find managers who can consistently time these markets.  Good luck finding a collection of consistent market timers.

Finally, the public pension plans are also engaging in all sorts of strategies to hedge risk (goal 3).  The idea is to dampen the volatility of the portfolio, especially when stocks and bonds periodically swoon.   However, these strategies when implemented at scale cost so much performance that when stock markets inevitably rally, pension plans can’t achieve their investment objectives.[3]  As with other strategies, investment professionals claim that they can time hedged strategies.  Public pension plans are behemoths.  They move slowly.  Even if they could be more nimble, hedge funds don’t return money on demand.  Typically it takes six months to a year to redeploy capital between different hedge fund strategies.  Hedging opportunities come and go long before big pension plans can take advantage of attractive opportunities.[4]

Again, there’s a simple alternative to alternatives.  If a pension feels that it needs to hedge, it should hold cash.  It just so happens North Carolina has some of the finest fixed income and cash managers in the country, and it costs the pension plan next to nothing if they were to manage cash.  However, pension plans would never touch this suggestion because it would hold the trustees and internal staff directly accountable.  It’s much better to pay someone 2% and 20% of any profits in order to obfuscate what the pension is really doing.  Moreover, super-sophisticated folks who want that 2 and 20 deal would roundly criticize a hedging strategy using cash.

From my vantage point, South Carolina drove their pension portfolio off the road by loading up on alternative investments, and Rhode Island is in the process of veering onto the shoulder.  North Carolina has been tooling along at about 55 miles per hour for decades, and its pension is in good shape.  There’s nothing wrong with some exposure to alternatives.  I’m all in favor of a few experiments.  However, the continued addition of alternative investments will eventually ruin one of North Carolina’s greatest public assets.  The Kool Aid, it turns out, is habit forming.

[1] When pension plans find a diversifying investment, it always exhibits a low historic correlation with the US stock market.  That’s what makes it attractive.  When the big pension plans invest in that market, the independent characteristics that created the low correlation tend to disappear.
[2] See the blog post, “What About Commodities?” February 2, 2013
[3] We’re seeing this impact in the 3 and 5-year returns of many foundations that utilize some form of the “endowment” model.  It should come as no surprise.  If you hedge a significant portion of a portfolio and then the stock market rallies sharply, the portfolio is going to lag the stock market.
[4] When pension professionals make this argument they always mention the two or three strategies or managers that succeeded, and omit the ones that failed. I’m guilty of this sin.

1 comment: