Thursday, February 26, 2015

The Public Pension Gamble in Kansas and Kentucky: Borrowing

The Public Pension Gamble in Kansas and Kentucky: Borrowing

Rolling the dice is a bi-partisan practice when it comes to pension financing.  In Kansas, Governor Sam Brownback (R) is behind a proposal to issue $1.5 billion in municipal bonds to bolster the state pension plan, which is about 60% funded.[1]  In Kentucky, Governor Steve Bashear (D) is pushing a proposal to issue $3.3 billion in municipal bonds to inject into the Kentucky Teachers’ Pension, which is 54% funded.[2]  In 2012, Kentucky supposedly reformed their public pension system, but the fixes were insufficient.[3] 

Here’s the idea in brief.  The states can borrow at a rate of about 5%, inject the bond proceeds into the pension plan, and hope that the money earns at least 7.5% (Kansas) to 8% Kentucky.  They will narrow their pension deficit over the next two or three decades if their returns exceed their borrowing costs, and they don’t further reduce their contributions or increase their liabilities.

In theory, this is a reasonable bet.  The pensions ought to be able to generate more than the cost of borrowing the money.  But given the political realities and fiscal practices of both states, this is probably a very risky undertaking.  Both states got into this mess by underfunding their pensions.  Like New Jersey and Illinois, which also issued pension obligation bonds, Kansas and Kentucky have kept taxes artificially low and now face a budget and pension crisis.  In researching the fiscal policies of both states, there’s precious little evidence that they have the financial discipline to make this work.

As usual, two groups will be big winners from this undertaking.  The politicians will be okay.  By enacting this proposal, they will push the pension crisis out far enough so they won’t be in office when the problem resurfaces. Wall Street will also do very well.  In addition to underwriting $4.8 billion in bonds, money managers will get the proceeds to invest in stocks, bonds, real estate and private equity.  Here’s the back of the envelope math on issuing a combined total of $4.8 billion in bonds.  The underwriters would make about $24 million selling the bonds.  Over ten years, money managers would take home $280 million in fees, and the pensions would earn about $1.2 billion in extra returns, assuming a 2.5% spread between investment returns and borrowing cost.  The Kansas and Kentucky plans have $23.7 billion in unfunded liabilities (Kansas $9.7 billion, Kentucky Teachers $14 billion).  If the borrowing works, it will put a modest dent in the pensions’ unfunded liabilities.

It’s a win-win, except for the two groups that count most: taxpayers and pension beneficiaries.  Taxpayers have to hope that their politicians suddenly learn financial discipline and that the bond proceeds are invested wisely.  If I were a taxpayer in Kansas or Kentucky, I’d be worried.  Beneficiaries have to hope that the pension deficit shrinks.  Otherwise, they’ll be overwhelming pressure to substantially reduce benefits.

Kansans and Kentuckians need only look northeast toward New Jersey, where pension obligation bonds have done little to reduce the retirement deficit.  Moreover, Governor Chris Christie failed to keep up his end of a retirement reform package passed in 2012, and a New Jersey court has ordered him to make the promised contributions.  New Jersey is being forced to go through another round of reform, which will effectively destroy the pension plan for many public employees.[4]

Democrats and Republicans have different approaches to government.  However, when it comes to solving problems, they both prefer the easy solution: borrowing.

Wednesday, February 25, 2015

The Curious Case of Bowen, Hanes and Tampa Police and Fire Retirement Plan: Part 4

The Curious Case of Bowen, Hanes and Tampa Police and Fire Retirement Plan: Part 4

Bowen, Hanes and Company is the only money manager for the Tampa Police and Fire Retirement Plan.  In other words, the entire $1.9 billion plan is in the hands of a single outside advisor.  As best I can tell, the trustees don’t have any professional expertise in investments, and the pension plan does not have an employee or consultant to review Bowen, Hanes’ investment positions or performance on a regular basis.  According to Leanna Orr, Managing Editor of Chief Investment Officer magazine, Tampa claims to satisfy Florida’s statutory requirement for a consultant review by employing a performance consultant once every three years.  While this might satisfy Florida’s minimum legal requirement, it falls far short of proper oversight.

Admittedly, Bowen, Hanes investment approach doesn’t create many complications.  The firm doesn’t use any derivatives or hard-to-price securities.  Its turnover appears to be modest.   Nonetheless, someone other Bowen, Hanes should be reviewing investment performance on a regular basis.  According to Ms. Orr’s reporting, Bowen’s internal systems aren’t state-of-the-art and have been criticized by Bogdahn Group, a consulting firm that oversees Bowen’s investments at other pensions in Florida.  While Bowen’s portfolio management and trading software may not be up to the standards of a major money management firm or mutual fund, I doubt they pose a substantial risk to Bowen’s clients.  Nonetheless, I think it’s important for clients such as Tampa to understand the operational as well as investment risks of any particular manager.

Having said that Tampa’s investment account should have a consultant or a staff person overseeing Bowen, Hanes, I don’t want to leave the impression that consultants add a great deal of value to clients portfolios (see, “Investment Consultants, October 2, 2013 for my views).  They are no better at manager selection than managers are at security selection.  Many consultants are better at telling clients what they want to hear rather than
what they should hear.  Nonetheless, Tampa lacks appropriate oversight.

A battle between Bowen, Hanes and Bogdahn Group over the $5 million Lady Lake Police Pension encapsulates the rift between Bowen and consultants.  It also suggests why Bowen can’t win the battle with consultants.  Bogdahn criticized Bowen’s recent performance and internal controls.  Bowen didn’t take kindly to the criticism and told Lady Lake’s trustees that if Lady Lake kept Bogdahn Group as a consultant, they would resign.  Although this seems like a very dramatic step (and might indicate that Bowen is trying to avoid scrutiny), I suspect Bowen, Hanes probably figured it wasn’t worth $20,000 in fees to battle the consultant.

Even if Bowen can generate strong returns, it isn’t going to win a lot accounts given its attitude toward consultants.  Moreover, Bowen isn’t just battling the consultants.  Consultants like Bogdahn tend to recommend institutional mutual funds rather than separate accounts for their small pension clients, such as those tiny municipal pensions scattered across Florida.  Mutual funds are a powerful adversary with the resources to produce data and reports to keep consultants happy.

In the end, I don’t think Bowen, Hanes is story about impropriety. I think it’s the last gasp of a bygone era of money management.

Tuesday, February 24, 2015

The Curious Case of Bowen, Hanes and Tampa Police and Fire Retirement Plan: Part 3

The Curious Case of Bowen, Hanes and Tampa Police and Fire Retirement Plan: Part 3

In nearly 40 years Bowen Hanes has generated an annual equity return of 15%, versus 12.4% for the S&P 500, on behalf of the Tampa Police and Fire Retirement Plan.[1]  The firm has beaten the index in 28 out of 40 years.  That’s an outstanding record.  Like many of the portfolio managers I discussed yesterday, Bowen got off to an amazing start by beating the market 12 years in a row (1974-1986).  According to my calculation, during those formative years Bowen beat the S&P 500 by about 5.5% each year.  Thereafter, Bowen has beaten the market by an average of about 2% through November 2014.  In my experience, these results look realistic rather than fraudulent.  A superior firm starts with great performance which ebbs over time.  As I’ll discuss in this post, that doesn’t mean that Bowen’s results versus the S&P 500 are totally accurate.

For starters, successful managers often have a great beginning track record.  If the results hadn’t been great at the outset, they wouldn’t have attracted notice in the first place.  As a result, there is a lot of survivor bias in the universe of money managers.  Only the winners tend to survive.  So Bowen’s great start is actually quite normal, although the 12-year run is extraordinary.

Nonetheless, Bowen’s early results may be overstated, especially against the S&P 500.  Let me emphasize that I haven’t talked to anyone at Bowen.  Thus it is possible that Bowen made all the necessary adjustments to ensure that its track record is precise.  However, in my many decades of experience as a money manager, I’ve found that historic track records are prone to exaggeration due to a variety of factors.  With the advent of computers and more precise performance standards, these errors have become less common.  I’m not suggesting that Bowen committed fraud.  Rather, I’m hypothesizing that Bowen, like many money managers in the 1970s-1980s, made mistakes in calculating performance that exaggerated their margin over the S&P 500.  In seeking to acquire money managers for NationsBank, Legg Mason, and my clients, I found problems in many performance track records.  Here’s my list of possible errors in Bowen’s early record:

1.     Distorting Cash Flows: Bowen calculated the returns on a time-weighted basis (just like a mutual fund).  This is a perfectly acceptable way to measure investment performance.  However, if there are significant client contributions or withdrawals during a reporting period, those cash flows can distort the returns.  Mutual funds get around this problem by calculating the return every day and then chaining (multiplying) the daily results.  In the 1970s and early 1980s this wasn’t easy to accomplish.  Electronic spreadsheets, let alone proper investment performance software, didn’t exist.  In my view, there’s some likelihood that Bowen’s performance record could have been distorted a bit by contributions from the Tampa pension plan, which was expanding.

2.     Allocation of Cash in Balanced Accounts: Since Bowen was managing a balanced account (stocks and bonds) with changing cash balances, the allocation of cash could have distorted Bowen’s returns.  Back in the early days of money management, cash could be moved around to enhance investment returns.  In a rising market available cash might be allocated to fixed income in order to boost reported equity returns, and in bad markets more cash might be shifted to the stock account in order to reduce the reported loss in the equity account.  Again, we don’t know how Bowen treated cash.  However, in my experience cash policy was arbitrary in the early days of money management and tended to exaggerate equity performance.

3.     Somewhat Mismatched Benchmark:  In the 1970s and early 1980s, the S&P 500 was the only benchmark form measuring equity performance, and style (growth and value) and market cap (large and small companies) weren’t measured.  Thus, many of the successful money managers of the early years had great freedom to pick stocks that weren’t representative of the S&P 500.  As I mentioned in my previous post, the consultant community began to rein in this freedom, and over time the managers selected securities that more closely resembled their benchmark.  Bowen, Hanes has resisted this approach over the decades, which is evident in the variation of their correlation and tracking error versus the S&P 500. 

While trying to verify Bowen, Hanes investment track record, Leanna Orr, Managing Editor of Chief Investment Officer magazine, asked Jay Bowen for a copy of the firm’s composite returns.  Although Mr. Bowen claimed that the firm’s composite adheres to industry standards (Global Investment Performance Standards), he refused because the figures hadn’t been properly adjusted for fees.  I think this is a lame excuse.  I suspect that there’s another reason (again, it isn’t fraud). 

Bowen, Hanes manages a lot of money for taxable investors, and probably customizes portfolios.  This was the old school way of managing money before the consultants entered the picture.  In addition, there’s a hint in Part 2 of the firm’s ADV filing with the SEC.  Bowen, Hanes doesn’t block trade.  They tend to buy securities for each of their 171 accounts.  As a result, I’ll bet that Bowen, Hanes has multiple composites and a fair amount of dispersion within those composites.   Ms. Orr reported that a couple of Bowen, Hanes Florida accounts reported differing results.  I suspect they don’t want to air those details.

Bowen’s critics are using modern standards of investment management and disclosure for a firm that is still operating in the 1970s.  By modern standards, Bowen’s performance record, investment practices, and disclosure standards aren’t appropriate, and therefore are suspicious.    Those suspicions don’t, in my view, add up to fraud or a ponzi scheme, as critics imply.

Tomorrow we’ll conclude this series with a discussion of the shortcomings at Tampa’s pension and the role of consultants.


Monday, February 23, 2015

The Curious Case of Bowen, Hanes and Tampa Police and Fire Retirement Plan: Part 2

The Curious Case of Bowen, Hanes and Tampa Police and Fire Retirement Plan: Part 2

In the early days of institutional money management there were few, if any, benchmarks, and no consultants.  Congress’s enactment of the Employee Retirement Income Security Act (ERISA) paved the way for investment advisors to replace bank trust departments, stockbrokers, and corporate treasurers as managers of pension assets.  The pioneers in institutional money management offered balanced portfolios (usually more heavily weighted towards bonds than stocks).  It was the fiduciary standard set forth in ERISA that gave the green light to equity and real estate investments in pension plans.

It is in this environment that Harold J. Bowen, Sr. began managing a $12.1 million account for Tampa Police And Fire Retirement in 1974.  Hundreds of money managers were doing the same thing for state, municipal, and corporate pensions.  I’ve been privileged to work with a number of these firms over the years, such as Batterymarch, Brandywine, Hotchkiss and Wiley, Capital Group, and Wellington.  Each of these firms began just like Bowen, Hanes.  They had one or two individuals (Dean LeBaron, Anthony Hitschler, John Hotchkiss, George Wiley, David Fisher, and Robert Doran), who managed 100% of the assets of a client.  By the early 1980s it was evident that their respective equity products handily beat the S&P 500.

How was a client to know if Batterymarch or Wellington was doing a good job or not? A firm named A.G. Becker established the first return information to allow pensions to compare investment performance to a benchmark, and the consulting business was born. Before long Frank Russell, SEI, and other firms were offering consulting services to measure equity and fixed income performance.

To be sure, the money managers of the 1970s and early 1980s were not big fans of the consultants.  The consultants benchmarks and investment standards began to pigeon-hole managers into specialties like growth and value, large cap and small cap, and challenged the idea of a firm managing a combined portfolio of stocks and bonds.  While almost all of the managers with great track records accepted the consultants and their specialization, Bowen, Hanes did not.  In fact, Bowen, Hanes refused to deal with consultants.  As a result, it was impossible for them to scale up their businesses. Meanwhile Batterymarch, Brandywine, Hotchkiss, Wellington, and many other managers with great historic records accepted the restrictions and specialization imposed by investment consultants.

As a result of its decision, Bowen, Hanes had to trawl for business among small pensions and endowments and high net worth individuals.  It’s no surprise that they found success in Florida, as it is rife with pint-sized municipal pensions.  For many years, these small accounts were happy to have one manager invest all their money and were too small to be attractive to the consultants.  While Bowen, Hanes didn’t build a huge asset management business, Mr. Bowen and then his son were able to build a very profitable business.  Thus, I don’t think it is appropriate to jump to the conclusion that Bowen, Hanes has engaged in some deliberate impropriety because they refused to parlay their track record into a big consultant-driven asset management business.

In the middle to late 1990s almost every one of the pioneering managers ran into performance difficulties.  The ridiculous valuations of technology, telecommunications, and Internet stocks did not fit into the investment parameters of any of these managers.  I had a front row seat as Tony Hitschler, a gifted manager at Brandywine, watched the consultants fire him at virtually every one of his accounts.  Fortunately Brandywine, much like the other pioneering managers, had developed other products which helped the firms through the Internet bubble.

Bowen, Hanes had a similar drop in performance.  According to Tampa’s performance reports, Bowen underperformed the S&P 500 for several years in the late 1990s.  However, there wasn’t a consultant eager to make a change, so Bowen kept the account.  Moreover, there hadn’t been a consultant urging Tampa to hire small cap, international, high yield or other specialists.  Bowen just kept managing Tampa’s money, but was shut out from other institutional opportunities because they wouldn’t dance to the consultants’ tune.  Bowen’s performance improved after the Internet bubble popped.  Tony Hitschler and other pioneering managers didn’t get that chance because the consultants had taken away their accounts.

Critics have charged that Bowen, Hanes must be up to some impropriety because the principals failed to chase the tens of billions of dollars available in the consultant driven market.  What the critics fail to realize is that the Bowens have probably done rather well for themselves financially.  As owners of a firm with only a small number of employees, the Bowens are undoubtedly earning millions of dollars every year.  Today the firm has roughly $2.6 billion in assets, which translates into something like $11 million to $13 million in revenues.  Most of this revenue is profit to the owners.  Over the past forty years, Bowen hasn’t had to invest in additional product teams, extensive marketing, or sophisticated compliance systems.  It seems to me, they probably made a sound business decision.

In the next post, I’ll discuss the question of Bowen’s historic track record and then examine the weaknesses in Tampa’s oversight of Bowen.