Trying to Understand Connecticut's Public Pension and Other Matters
On any given day quite a few things don’t make sense to me. In the last couple of days three items have puzzled me.
First, the Durham County sent a jury notice to our address in Orange County. It’s easy to make this mistake because we share a zip code. Here’s the part I don’t understand. If you are not a resident of Durham County or North Carolina, you have to furnish proof along with the return form in order to be excused from service. However, if you are felon or still incarcerated, no proof is necessary. Just check the applicable box and your service is excused.
Second, there was no snow on the ground at the Rus Ski Gorki Jump Center for the Nordic Combined event at the 2014 Olympics. They skied on artificial snow with temperatures in the 50’s. Its 25 degrees in Chapel Hill and we will soon have excellent conditions for cross-country skiing.
The third item concerns the Alternative Investments Funds (AIF) for the Connecticut Retirement and Trust Funds, which is where Treasurer Denise Napier invests a portion of the State’ pension plan in hedge funds as well as a few other investments that don’t fit anywhere else. When I started to look at Connecticut’s program, there was only one thing I didn’t understand. Why is a $28 billion pension hiring three fund-of-fund managers to manage a $175 million mandate? A plan the size of Connecticut ought to be able to select its own hedge fund managers without incurring all the extra fees.
Turns out that hedge funds are the only investments where Connecticut uses a fund-of -funds instead of their staff and consultants, with one exception that I’ll discuss in a bit. The state has $950 million in existing hedge fund exposure via three fund-of-fund managers: Permal, Rock Creek, and K2. In other words, Connecticut already incurs an extra level of fees in order to gain hedge fund exposure. I decided to dig into the Treasurer’s Annual Report. On page 31, I discovered that it only costs 0.13% or $1.1 million to operate the AIP. That seemed like a bargain and ample justification for Treasurer Napier’s fund-of-fund approach.
Next I hunted for a fee schedule to document this incredible bargain. To the Treasurer’s credit, there’s a detailed fee schedule in the Annual Report in the appendix at page S-26. Much to my disappointment, none of the hedge fund-of-fund managers were listed. The table only included fees for two real asset managers who have a small allocation in the AIF. There was however a footnote that invited me to read yet another footnote in the Combined Investment Funds Financial Statements. Having gone this far, I decided it was worth wading through footnote 1(J) at page F-24. The footnote cleared up the mystery.
In order to make the AIF’s fees look as small as possible, the Treasurer doesn’t include any fees that are netted out at the fund level and also capitalizes direct fees (spreads them out over time). However, footnote 1(J) revealed the actual management fees without the massaged accounting treatment. The real cost was $6.2 million or seven times the reported amount. This fund of funds program was no bargain. The cost, without carry or accounting for fees of the underlying hedge fund managers, is probably closer to 0.90% than 0.16%.
Having cleared up the fee mystery, I wondered if the extra layer of fees might be justified by AIF’s exemplary performance, so I checked its performance. Although we’re well into February, the Treasurer’s website only reports performance through the end of October 2013. The AIF was up 7% for the trailing one-year period, which looked extremely good against its benchmark. The benchmark only produced a return of 0.09%. I’d come to yet another item that I didn’t understand. The State Treasurer was comparing a collection of hedge fund and real asset exposure to the 3-month US Treasury bill.
How can you possibly compare a smorgasbord of alternative exposure to the safest investment on the planet? Of course, the AIP is going to beat this benchmark. The fund-of-funds managers are investing in all sorts of risks that aren’t at all reflected in a Treasury bill. It’s like a pole-vaulter clearing a speed bump.
Coming back to the State Treasurer’s latest foray into hedge fund of funds, the new mandate has an additional wrinkle. The three managers -- Appomattox Advisory, Grosvenor Capital Management, and Morgan Stanley Alternative Investment Partners --will be looking for Connecticut-based firms (not too hard to find hedge funds in Greenwich) and minority and female-owned firms. The extra layer of fees, which will be netted or capitalized to minimize the apparent expense, will go toward the goal of diversifying Connecticut’s manager base. Connecticut uses all sorts of fund of funds managers in other asset classes to try to achieve the same goal (see, “Public Funds and Emerging Managers [February 18, 2013] for a discussion of the costs and short-comings of these programs).
Those critics who think that loads of disclosure and external auditors will put pension fiduciaries on the proper path should check out Connecticut. Treasurer Napier provides over 288 pages of information and an audited opinion from the State Auditor and Pricewaterhouse Coopers. Nonetheless, it’s extremely difficult to figure out what is really going on. Transparency and auditors don’t necessarily lead to understanding when it comes to investments.
One last thing I don’t understand. Connecticut’s hedge fund-of-funds portfolios are named after Prudence Crandall. During the 19th century, Prudence Crandall educated African American women in Canterbury, Connecticut. Ms. Crandall deserves to be honored and remembered. Putting her names on hedge fund portfolios doesn’t seem like an honor to me.