Monday, July 17, 2017

The danger of market timing: North Carolina’s Treasurer raises cash

The danger of market timing:  North Carolina’s Treasurer raises cash

North Carolina’s Treasurer Dale Folwell is intent on cutting fees in the state’s public pension plan.  He also has a healthy skepticism of active equity money management.  I’m in complete agreement on these two points.    In his eagerness to pursue these goals and fulfill a campaign promise, Treasurer Folwell has committed the biggest mistake in the world of investing.  He has decided to deviate from his long-term asset allocation and try to time the market.   On Friday, the News & Observer published an excellent story outlining these issues.[1]  Today I want to take a close look at the Treasurer’s apparent attempt to time the market and explain why this is a mistake.

Every investor should have a strategic asset allocation, which sets targets for investments in stocks, bonds, real estate, and any other asset classes.    The idea is develop a mix of assets that enables the investor to achieve a certain goal commensurate with an acceptable level of risk.  The North Carolina pension plan has conducted numerous detailed studies in order to determine how best to achieve the pension’s goal of achieving a 7.2% return without taking undue risk.  North Carolina’s strategic allocation sets a target of 42% for public equities and also prescribes procedures for rebalancing the portfolio if equities fall materially above or below the target.  In March 2017, the pension held 43.6% in equities, so as Treasurer Folwell began terminating managers it made sense when he did not reinvest in equities.[2]  However within about a month according to internal memoranda requested by the News & Observer, the equity allocation had fallen to 37%.[3]  As the Treasurer continued to fire equity managers, he put the proceeds into cash and bonds, instead of reinvesting in equities.[4]

Internal memos show that the investment staff recommended that the State Treasurer follow the normal investment procedure and rebuild the pension’s equity allocation using index funds.[5]  Instead the Treasurer invoked an exception, which allows him to temporarily suspend the rebalancing provision.[6]  The various memoranda do not describe the Treasurer’s specific reasons from deviating from the pension’s asset allocation policy, but staff memos imply that the Treasurer had concerns about a potential stock market correction.[7]

With the stock market at record levels, political uncertainty coursing around the world, and the Federal Reserve beginning to raise interest rates, I can sympathize with the Treasurer’s desire to build up cash.  However, as a long-term investor with the responsibility to look out across decades, the State Treasurer has to resist the temptation to succumb to near-term fears.  Short-term threats are a constant worry for any investor.  However, wise investors know that stocks rise over time, and that the beginning and end of any potential bear market is hard to predict.  Moreover, wise investors know that a diverse portfolio with exposure to non-equity asset classes can weather even the harshest stock market setback.

Treasurer Folwell has ignored these lessons and allowed the pension’s cash to rise to
7.8% or $7.4 billion and investment grade fixed income to become $2 billion over target.[8]   He’s decided to time the market.  You cannot quickly shift the course of a large container ship or a pension portfolio without doing damage.  A cargo ship can only turn slowly because any sudden move is liable to dislodge and damage the cargo.  Large investment pools must also be shifted slowly and deliberately.

In order for market timing to work an investor has to be right twice.  In the first instance, he has to sell toward the top of a market.  However, even if he gets this step right, he is still only half right.  If the market falls, he has to know when to put the cash back into the market.  By the time vast majority of market timers have completed the two-step process, their investment portfolio is far worse off than if they’d just relied on the diversification and ridden out the correction.  Many investors learned this lesson during the last recession.  Even if they correctly reduced their equity exposure as the market tumbled in 2008, they failed to get the cash back into the market as stocks recovered.

So far the Treasurer has mistimed the first step as he’s built up the pension’s cash.  Since January when the Treasurer terminated the first managers, the stock market has risen by 10% and on average is up about 5% for each of the 13 terminations.[9]  In other words, the pension, which is valued at about $92 billion, would be worth about $250 million more if the Treasurer had maintained the plan’s equity exposure (that is far more value than he’s saved by cutting fees).  At this point, the Treasurer’s bet will not begin to pay off until the market drops by about 5% (for a rough comparison that is a 1,000 point drop in the DJIA[10]).   At what point will he recommit the capital to equities?  If he’s really wrong, he may be forced to reinvest in equities when the market is even at higher levels because the market doesn’t pull back for a considerable period of time.  If the Treasurer catches a market downturn, how will he know when the market has hit bottom?

I leave you with Warren Buffet’s 2016 investment letter[11]:

American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that.

Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle.  Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics –that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie [Munger], not economists, not the media.

And not the Treasurer of North Carolina.

In the next installment, I will discuss the total cost associated with Treasurer Folwell’s program for cutting fees.

[3] May 31, 2017 Memo from CIO SigRist to Treasurer Folwell, Recommendation to Defund Three Public Equity Strategies, page 2
[4] DST Exhibit, Disposition of NCRS Public Equity Manager Terminations, June 14, 2017
[5] May 1, 2017 Memo from Smith to SigRist, Recommendation to Terminate Active Large Cap Value Managers, page 4.
[6] Investment Policy for NC Retirement Systems, , Sec. V, B,.2.
[7] May 31, 2017 Memo from CIO SigRist to Treasurer Folwell, page 1
[8] May 31, 2017 Memo from CIO SigRist to Treasurer Folwell, page 1
[9] My estimate is based on DST Exhibit, Disposition of NCRS Public Equity Manager Terminations, June 14, 2017 and DST Exhibit, NCRS Public Equity Investment Manager Terminations and Projected Annual Fee Savings.  While the DST did not furnish the exact date of the various portfolio liquidations, I could get some sense of the price movement of stocks and bonds over the general period when these portfolios were liquidated.
[10] DJIA recent value of 21,637.

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