Tuesday, July 18, 2017

Lowering management fees is a laudable goal, but it has to be done prudently

Lowering management fees is a laudable goal, but it has to be done prudently

North Carolina’s State Treasurer ran on a pledge to reduce the fees paid by the state pension plan by $100 million.  By terminating thirteen equity managers and renegotiating reductions with several others, he is well on the way to meeting his pledge.[1]  However, he’s only saving the pension plan money if you ignore a variety of expenses and costs that have been incurred as a result of firing the managers and placing the proceeds of $7.4 billion in cash and bonds. According to data furnished to the News & Observer, Treasurer Folwell has saved $61 million as of mid-June.[2]  In my view his decisions have cost the state’s pension plan far more than he has saved.

Retail and institutional investors are well served by keeping a lid on fees.  However, reducing fees should be the by-product of an investment program and not an independent goal for investors.  Moreover, investors need make sure they carefully account for all the expenses that offset fee savings.[3]  In this post I’ll discuss the transactions costs and opportunity costs associated with the terminated managers as well the steps the Treasurer could have taken to substantially reduce these costs.

Transactions costs are the brokerage commissions, bid-ask spreads, and the market impact of selling securities.  When the Treasurer terminated the thirteen managers he probably hired a specialist to liquidate the investment portfolios as efficiently as possible.  As a result, I’d expect that the commissions were extremely low and great effort was made to minimize the impact of liquidating large stock positions.  According to data furnished to the News & Observer, the first ten portfolios incurred transactions costs of $9 million.[4]  By the time all the portfolios are liquidated, transactions costs are likely to be about $10 million, which is a substantial offset to the $36 million in annualized savings from eliminating those managers.[5]

However, the pension incurred additional transactions costs that further offset the reported savings.  The proceeds were temporarily invested in all sorts of investment fixed income securities and money market instruments.[6],[7] I suspect these investments are very liquid so the transactions costs incurred in purchasing the instruments were probably low; perhaps $5 million.  At some point in the future the fixed income and money market securities will be sold incurring another set of transaction fees (perhaps another $5 million), and then those proceeds will be invested in equities.  As you might guess, the purchase of stocks will trigger yet another round of transactions costs.  Since the Treasurer has shown a sensible preference for index funds, I expect those transactions costs will be low (I’m guessing $5-$6 million) and the management fee on the index funds will be around $1 million (about .01%).  When you add it all up, the pension will have incurred $20-$25 million in transactions costs, while saving $36 million in management fees from firing equity managers.  The net savings to the pension plan will be .01%.

Now we need to consider opportunity costs.  Unfortunately the expenses of terminating the thirteen managers didn’t end with transactions costs.  When the Treasurer terminated the thirteen managers and put the proceeds in fixed income and money market instruments, he incurred opportunity costs.  Opportunity costs represent the difference in return between the newly selected investment and one that was passed up or eliminated.  Any time an investor shifts between different asset classes, he should evaluate the opportunity cost of making the shift.

While opportunity costs aren’t recorded as actual gains or losses on a pension’s books, they represent real economic gains or losses to the funds.  A simple example illustrates the impact of opportunity costs.  Suppose you sold $100 in stock and put the proceeds in cash.  If the stock went up 10% after the sale, the opportunity cost would be $10 (ignoring lost dividends on the stock or income on the cash).  You might still choose to make the sale because you need to raise cash, but it’s important to weigh the opportunity costs.

As I mentioned in yesterday’s post on market timing, the stock market has risen since the Treasurer terminated the equity managers.  Thus one short-term measure of opportunity cost is to look at how the pension would have performed the managers hadn’t been terminated.  Undoubtedly neither the Treasurer nor I can make any more than an intelligent estimate of the short-term opportunity cost, but I as I wrote yesterday, I believe the short-term opportunity cost currently stands at about $250 million.[8]   Since the Treasurer terminated the thirteen managers stock indices have risen, while fixed income has only enjoyed small gains.

Opportunity costs can also be approximated on a long-term basis using the State Treasurer’s own data.  The Treasurer’s strategic asset allocation makes long-term estimates for the various asset classes that comprise the pension plan.  These estimates are important because they determine the probability that the pension will be able to meet its investment requirement of 7.2%.  The strategic allocation calls for stocks to increase by 8% per year, while fixed income increases by about 2.5% and cash by 2%.[9]  Thus, by selling $74 billion in stocks and committing the proceeds to cash and bonds, the pension is incurring a long-term opportunity cost of about 5.5% to 6% (the difference between equity and fixed income returns) or about $350 million.   As the Treasurer has repeatedly warned legislators and the public, achieving the targeted 7.2% return will be difficult in today’s investment environment.  When $7.4 billion is removed from the equity portfolio, the prospect of reaching the target is materially diminished.[10]

We don’t know when the State Treasurer will recommit the capital to the stock market, so we can’t determine the precise opportunity cost associated with his decision to terminate the thirteen managers and investment the proceeds in bonds and money market instruments.  However, I am confident that the opportunity cost will be far greater than the fee savings that the Treasurer has been emphasizing.

Was there are an alternative strategy to reduce fees, minimize costs, and maintain the pension’s equity allocation?  Yes.  If Treasurer Folwell felt a great sense of urgency to fire certain managers, he could have had a transition manager turn the terminated portfolios into the appropriate indices at low cost through a combination of index derivatives and transfers in-kind of securities.    Taking this action would have reduced transactions costs since the pension would not have had to incur the cost repeated purchases and sales of securities, thereby virtually eliminated opportunity costs. 

As a result, he would have left the asset allocation largely undisturbed (avoiding the mistake of market timing) while actually saving the pension substantial fees.

When I was CIO, Treasurer Richard Moore faced a similar problem in early 2002.  As I recall the Treasurer terminated ten managers representing $4.5 billion in equities.  While we had completed our asset allocation work, we had not identified the managers to take over management of the assets.  We employed the exact strategy, I’ve just described.  We transferred as many as securities as possible into a transition account and then used stock index options and futures to create index-like exposure.  As we slowly hired new managers, we had the transition manager undo the transition portfolio and create the new active and index portfolios.[11]  Undoubtedly, we incurred some transaction costs and perhaps some opportunity costs, but they were minimized.

I support the Treasurer’s initiative to lower fees and pare back active management of the equity portfolio.  However, the Treasurer’s approach has cost the pension plan dearly.

Tomorrow I will look at some of the inconsistencies imbedded in the decisions to terminate thirteen equity managers and explain why this is a case study for eliminating the sole fiduciary and putting in a board of trustees.

[1] http://www.newsobserver.com/news/business/article161425553.html
[2] DST Investment Cost Efficiency Initiatives Summary of Progress, June 14, 2017
[3] For example, before an individual investor redeems a higher cost mutual fund for a lower cost one, she needs to carefully consider the tax consequences.  Unless the new mutual fund has extraordinarily better prospects, the tax bill will swamp any fee savings. 
[4] Transaction Costs Associated with Terminating Public Equity Investment Managers in 2017, June 14, 2017
[5] NCRS Public Equity Investment Manager Terminations and Projected Annual Fee Savings, June 14, 2017
[6] Disposition of NCRS Public Equity Manager Terminations, June 14, 2017
[7] Since the fixed income and money market instruments are managed internally, the pension did not incur any management fees.
[10] Treasurer Folwell reduced the target from 7.25% to 7.2% in April.  http://www.pionline.com/article/20170424/ONLINE/170429944/north-carolina-lowers-assumed-rate-of-return-by-5-basis-points.  The Treasurer said:

“When interest rates were high, it was relatively easy to make your assumed rate by just investing in low-risk bonds. Since we have been in an essentially zero interest rate environment for the past 15 years, achieving that same rate in the future is unrealistic,”

[11] As I recall, $1.5-$2.0 billion became index mandates, the remainder were split into various active mandates.

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