Wednesday, July 19, 2017

A case study on the weakness of the sole fiduciary model

A case study on the weakness of the sole fiduciary model

Treasurer Dale Folwell came to office with a few clearly stated promises, including a commitment to reduce the public pension’s fees by at least $100 million.[1]  As I’ve previously stated, fee reduction is a worthwhile goal.  Regrettably the Treasurer has gone about achieving his goal in a way that has cost the public pension more than the projected savings.  In two previous blog posts I have criticized North Carolina’s Treasurer over the way he went about allocating the proceeds from terminating thirteen equity managers.[2] 

The State Treasurer deserves credit for being transparent with the press and public about his decision-making process.  The Treasurer conducts a monthly conference call with the press[3] called “Ask me anything” where he explains his policy and decisions. He also seems willing to share documents with the press. 

However, his transparency allows us to see the damage that can be caused by a shift from one sole fiduciary to the next.  Without the continuity provided by a board of trustees, the priorities of a new treasurer can too easily create upheaval in an investment program.  As long time readers know, I was a critic of the prior Treasurer’s foray into alternative investments and the soaring fees associated with that initiative.  I have characterized my own involvement in beginning to hire hedge funds in 2002-2003 for the pension plan as a “failed experiment.”  Thus, I recognize that it is productive for the new Treasurer to examine and make improvements to the pension’s investment programs.  However, the series of memos furnished to the News & Observer show that Treasurer Folwell’s fee reduction initiative is running roughshod over policies meant to keep the pension focused on long-term returns and sound risk control. 

In the June edition of “Ask me anything” the Treasurer indicated that the equity managers had been fired because their performance has lagged their peers and benchmarks over extended periods of time.[4]  Among the thirteen managers terminated by the Treasurer, some definitely deserved to lose their mandates based on performance.  Treasurer Cowell had already identified three of the top candidates to be fired before Treasurer Folwell came into office in January.  According to a memo from the CIO to the State Treasurer, $1.1 billion in assets representing $4.7 million in fees had already been slated for termination before the Treasurer launched his fee-cutting initiative.[5],[6]

Other memos reveal managers with strong investment records terminated because they charge relatively high fees.  While the staff was writing memos and relying on consulting data to justify terminating Hotchkis & Wiley’s Large Cap Value and Sand’s Large Cap Growth portfolios, Kevin SigRist was simultaneously recommending that they be retained in the state’s define contribution (DC) plans (401(K) and 457 also known as the Supplemental Retirement Plan).[7]  While the pension plan’s consultant Callan was providing a rationale for firing Hotchkis and Sands, the DC plan’s consultant, Mercer, was singing the praises of the same managers.[8]  Sand’s even offered to cut their fee by 10%.[9]  Both managers have beaten their benchmarks (net of fees) over long periods, so they’ve demonstrated some ability to add value in the nine [Hotchkis] and eleven [Sand] years they managed money for the pension.[10]  Time Square Mid Cap Focus falls into the same category.  It was eliminated in the pension plan, but retained in the DC plan.[11] 

There’s an investment lesson in all of this.  On those rare occasions when a money manager has skill and can deliver performance, higher than average fees may be warranted.  The goal of any investment program is to keep fees low and only reward the limited number of managers who can add value.

As part of the fee cutting initiative, the Treasurer terminated three fund-of-fund programs.  In these programs, the pension hired managers, who in turn, tried to identify small and new money managers.  Thus these programs have two levels of fees and are usually too small to add meaningful value for the pension.  I criticized the state for creating the program in 2013[12] and understand why these mandates were eliminated as part of the fee cutting initiative.

What I see in the memos and analyses that accompanied the manager terminations is a hodgepodge of rationales designed to justify the Treasurer’s promise to cut fees.  In some cases, there are sound reasons for terminating a manager.  In other cases, the termination isn’t well grounded.  I hope this will not be with Treasurer’s modus operandi when he tackles the far more complex issue of restructuring and reforming the pension’s hedge fund, real estate, and private equity exposure, where the real performance, risk and fee issues reside.  While these areas deserve scrutiny, any changes need to be done slowly and carefully.  Moreover, it’s important to recognize that real estate and private equity can play a meaningful if modest role in the pension program.

In defending his decision to terminate managers and raise cash, the Treasurer told the News & Observer that the pension fund’s investments in stocks cost it billions of dollars.  This is not the first time the Treasurer has talked about the losses incurred during the recession.  Admittedly the pension suffered large unrealized losses in the aftermath of the financial crisis.  However, those losses have been completely recouped.   I’m less concerned about the Treasurer’s mischaracterization than what it says about him as an investor.  All of us bring our prior experiences to the market.  Depression era investors of the 1930s shunned stocks.  Inflation era investors of the 1970s shunned bonds and couldn’t get comfortable as the bull market took hold in the 1980s.

I got my start in the wake of rampant inflation and thus was very cautious as stocks began to rise in the early 1980s.  Fortunately, I met Charlie Baehr[13] a veteran broker who got his start in investments in the 1930s.  He taught me how to respect financial history without becoming paralyzed by it.  Without Charlie’s wisdom I don’t think I would have developed the long-term perspective needed to manage portfolios.

In the end the governance of the pension’s investments would benefit from a board of trustees.  Instead of a new treasurer suddenly pulling the pension’s investment program in a new direction and undermining previous programs and work, a board would offer some continuity and balance.  The Treasurer’s voice is important and his views should be given serious consideration.  However, he shouldn’t be the sole decision-maker.  The pension has an Investment Advisory Council, but it has no power.  The professional staff can only make recommendations and serves at the pleasure of the Treasurer.  While a board isn’t a perfect solution, it would be an improvement over North Carolina’s sole fiduciary model.[14]

Treasurer Fowell’s initiative to reduce fees by terminating thirteen equity managers is an excellent case for putting a board of trustees in charge of the investment of North Carolina’s pension assets.

[4] Ibid at 18:15.
[5] Memo from CIO SigRist to Treasurer Folwell, Recommendations to Terminate Public Investment Managers as a component of Enhanced Cost-Efficiency Initiative, March 14, 2017, page 1
[6] Full disclosure: I conducted due diligence and recommended hiring two of the three terminated managers, Piedmont and GMO in 2002.  I also served on the board of Piedmont from 2006-2012.  The third manager, Leading Edge, was hired in 2013.
[7] See, memo from SigRist to Supplement Retirement Board, Discussion/Action: Plan Design & Manager Recommendations, June 2, 2017, page 2.


[9] Memo, Smith to SigRist, “Recommendation to Terminate Active Domestic Large Cap Managers,” May 1, 2017, page 2.  The memo also warns that Hotchkis and Sands might propose increasing their fee in the DC program, since it was based on a broader relationship.
[10] Full disclosure: In 2002 as CIO, I conducted due diligence on Hotchkis for the pension plan and recommended hiring them for a midcap mandate.  Treasurer Moore hired them, but Treasurer Cowell terminated the mandate.  Hotchkis also manages a small cap mandate for the DC plan.
[11] Memo, SigRist to Folwell, “Recommendations to Terminate Public Equity Investment Managers as a Component of Enhanced Cost-Efficiency Program.”
[14] I’ve written extensively about Treasurer Cowell’s aborted effort to examine the board versus sole fiduciary model.  See for example,

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