Monday, March 3, 2014

Not Off to a Good Start: North Carolina Review

Not Off to a Good Start: North Carolina Review

The State Employees Association of North Carolina (SEANC) hired Benchmark Financial Service to conduct an analysis of the North Carolina Public Pension Plan.  The report is supposed to be issued in about 90 days.   However, Edward Siedle, President of Benchmark, has decided to issue interim results on his blog.[1]  In his blog post, he makes the claim that the pension plan’s fees are massively higher than reported.

After reading Mr. Siedle’s blog post, I asked the State Treasurer’s office to furnish me with the data that they’d given to him.  I wanted to see if I could substantiate his claims.  Mr. Siedle gets a couple of things right but jumps to the wrong conclusions.  He’s right that management and incentive fees came to $416 million, which is a lot of money and $121 million more than last year.  Rather than investigate the increase in fees, he simply calls them “staggering.”   The fees including incentives came to 52 BPs (0.52%).
Lead Plaintiff? (2003)
I’m not a forensic accountant like Mr. Siedle, but I decided to investigate the sources of the increase in fees.  It turns out that the management fees increased by about 10%, which is in line with the increase in the value of the portfolio and a slight shift toward higher priced alternative investments.  The lion’s share of the increase in overall fees ($94.5 million) was due to performance fees.   In other words, North Carolina was paying managers under their contracts for performance.  As my readers know, I’m not a proponent of the wide use of alternatives in public pensions, and I’m skeptical about their efficacy at the scale required by pension plans.  However, there’s no evidence that North Carolina paid rates that are above the industry norm.  If the alternative strategy works out, SEANC and Mr. Siedle had better hope that the incentive fees keep rising, because it will mean that the pension’s managers are delivering returns.

Having called the fee increase “staggering,” Mr. Siedle claims that North Carolina is not getting an appropriate level of performance for the fees it is paying.  Mr. Siedle cites a study by the Maryland Public Policy Institute and the Maryland Tax Education Foundation[2] as his evidence. There are three things wrong with Mr. Siedle’s assertion.   First, the Maryland study grossly overstated North Carolina’s fees.  At the time of the study, North Carolina’s fees were about 40 BPs, not 71 BPs.  Second, they misinterpreted their data.  It’s not the high fees that led to the poor relative performance of pension plans with high amounts of alternatives.[3]  Rather, it was their asset allocation that led to the result.  Third, if Mr. Siedle wanted to compare the plan’s fees to its performance, he should have looked at actual data, not a Maryland study.  North Carolina releases detailed data on its performance and asset allocation for all to see.[4]

Mr. Siedle goes on to assert that the pension is incurring “massive hidden fees.”  Once again, he’s making the claim without the benefit of data.  In his blog post, he says that he’s just asked the State Treasurer to give him all the underlying fees from the pension’s fund-of-funds and manager-of-manager programs. Mr. Siedle is right that these funds subject the pension to an additional layer of fees.  For whatever reason, Mr. Siedle selects one fund-of-funds manager, Franklin Street Partners[5], in order to extrapolate to his conclusion that North Carolina’s overall fees are massively understated.

Franklin Street charged the pension $2.6 million on $248 million in 2013.  This is the only correct piece of data in Mr. Siedle’s post about fund-of-funds.  He assumes that the underlying hedge fund managers charge a 2% management fee and a 20% incentive.  Both those figures are too high.  He assumes that all of the managers in the Franklin Street program earned the incentive for a total of $10.4 million.  If all of the underlying manager’s were earning an incentive, Franklin Street’s incentive would have been a lot more than $788,000.    He then suggests that the underlying managers have earned $120 million in the last decade.  This is an even more preposterous claim because it implies all the managers earned incentive each and every year.  If Mr. Siedle consulted all the data furnished to him by the State Treasurer, he’d see that Franklin Street only earned incentive compensation in five of eight year between 2006 and 1013.  Thus, there’s no way Mr. Siedle’s estimate is anywhere close to reality.

He then asserts that Franklin Street is earning $3 million in brokerage commissions by executing trades for the underlying hedge fund managers. Mr. Siedle is right that Franklin Street has a registered broker dealer.  However, there’s no evidence in the firm’s filing with FINRA[6] or the SEC[7] that its brokerage unit executes any trades for any underlying hedge fund managers.  I’m not sure how he derived the $3 million figure, since it would require all kinds of assumptions about turnover and the types of securities traded by the underlying managers.  However, all those guesses are irrelevant if Franklin Street didn’t execute trades for the underlying managers.

Since Franklin Street is, as Mr. Siedle asserts, “just one of the hundreds of funds,” he implies that the hidden fees in the North Carolina pension are huge.  After studying the list furnished to Mr. Siedle, I suspect the number of fund of funds is in the teens. So there are additional fees being indirectly paid by the pension plan, but it is a small fraction of North Carolina’s relationships.  As Chief Investment Officer for North Carolina, I hired a few fund of funds managers.  With a staff of thirteen people and total salaries of well under a million dollars, the only way I could prudently recommend certain investments was through the expensive route of a manager of managers.  Moreover, there were certain areas where we would never have the expertise or access without these programs.

Mr. Siedle is right about one important thing.  Money managers and Wall Street are getting rich from public pension plans.  However, it’s not because there’s something hidden taking place.  We have a pretty good idea of how much money managers charge for their services even if isn’t completely disclosed.  Unless you opt for index funds or ETFs, you’re going to pay market prices or something close to them.  And when you make an investment decision to allocate to alternatives, the fees climb.  North Carolina is just another pension plan that has gone down the alternative road.

If Mr. Siedle’s blog post is a preview of his full report, the debate over investing in alternatives will take a backseat to overwrought rhetoric, incomplete analysis, and faulty assumptions.

[3] See my blog post, “Fees and Investment Performance: Confusing Correlation and Causation [July 5, 2013]” for a discussion of the errors in the Maryland study.
[5] I provided consulting services to Franklin Street Partners.  I’ve acknowledged the dilemma and conflict in earning a living after my stint as Chief Investment Officer.  See for example my blog post, “My Spin Through the Revolving Door”, January 30, 2013.


  1. I read this with a lot of interest too. I have not done the more detailed study behind the numbers that you have done, but a few observations from my own perspective:

    1) If the state wants to really reduce fees it should in-source management and to do that it needs to establish a well funded investment management division that can compete financially with others. There is no doubt in my mind that paying fund-of-fund managers, especially those right next door to Raleigh in Chapel Hill, is crazy when you consider that if organized properly the state could just hire the exact same analysts to perform manager selection. The talent pool obviously exists. The $2.6m paid to one fund of funds manager could pay for a very capable investment team to do that work, and then save all the money paid on other fund of fund managers. Of course then instead of people complaining about paying high fees people will then complain that the state is paying six figure salaries to "Wall Street types". Maybe the way to achieve it would be to establish an independent investment management firm but have the state be the equity holder, so a PE investment in a dedicated manager, so all the profits come back to the state but the salary payment becomes less politically charged as the employees are not direct state employees.

    2) I am noticing an increased scrutiny on fees across the board from public pensions and it's leading to some interesting unintended consequences. Mostly that the genuinely good managers are sticking their middle finger up to the fee crunch and as such the pensions end up with worse managers, or the managers just don't let them in on the best opportunities (see as a great example the very public spat between Apollo and CalPERs) There is a "you will get what you pay for" mentality that is leading pensions into the worst possible investments... mediocre alternatives that are cheaper than the stars but still way more expensive than passive investments

    3) Taking (1) and (2) to it's full logical conclusion the public pensions really have no place investing in these AI's at all because they do not set themselves up in a manner where they cannot perform proper manager selection and they don't want to pay the fees that the best managers can demand, as such they should resign themselves to being absolutely pure beta players and simply invest in the cheapest possible index funds. Perhaps the one single stock they should invest in outside of an index fund is Vanguard. They should simply set up an asset allocation between stocks and bonds and index the former and ladder the latter in line with expected liabilities. In fact I'd argue they should only being doing the latter but obviously there is no way they will close the funding gap doing that so they have to plow into equities with all fingers and toes crossed

  2. Phil -- Well stated. As to your first point, the logic is unassailable. However, the politics are impossible. It's near impossible to pay competitive salaries, let alone create bonus plans that would allow public funds to compete for talent. In state politics, $100,000 is a lot of money if its spent directly, but it's okay to pay money managers millions. I made this point over and over to our legislature and anyone else who would listen. I finally resigned in frustration.

    You are also right about the fee negotiations. Like it or not, there's a powerful market at work here. While we need a discussion about fees, the real issue is the efficacy of alternatives. The fee debate may lead to marginally low fees, but the drive to alternatives will continue.