For about a month, I’ve been preparing to write a column based on the detailed performance and fee schedule released by State Treasurer Janet Cowell’s office for the North Carolina pension plans. As I’ve previously written, the total fees came to just under $500 million, an 18 percent increase. Like almost every public pension plan in the country, the increases have been driven by the shift to alternative investments. That’s really not news, and the performance and fee data aren’t timely, since they cover a period that ended on June 30, 2014. Regrettably, it takes the Treasurer’s Office more than 10 months to release information that is available internally within 30 days. Suppose your 401(k) program only released performance data on a 10-month delay. The report would be fairly useless.
I had to look at interim performance reports and analysis supplied to the Governmental Operations Committee of the General Assembly and the Treasurer’s Investment Advisory Committee in order to get a better picture of North Carolina’s public pension plans. I discovered that the treasurer has constructed any number of windows into the performance, risks and allocations of the pension plan, but the panes are made of frosted glass, distorting the information. Lest you think North Carolina is alone in creating distorted transparency, I invite you to check out the disclosures at other pension plans or the materials furnished by your broker or adviser.
For starters, North Carolina uses a mélange of asset classes and categories. Although you can find the conventional asset classes such as stocks, bonds, private equity and real estate, the treasurer also reports the pension’s exposure to categories called inflation and credit. Inflation consists of equity, fixed income, private equity and derivative strategies dedicated to energy, commodities, real assets or timber. Credit strategies are made up of hedge funds and private funds invested in anything from distressed debt to high-yield bonds. As pension plans and individual investors have moved into alternative investments, the proper use of asset classes has been distorted by mixing in strategies that hide the true exposures of the investment portfolio.
Sliced and diced
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Not only can’t you get a proper handle on the actual asset allocation, you also can’t tell precisely how much money is managed conventionally (e.g., fee only), using hedge funds, or invested through private-equity vehicles. The way the data is sliced and diced appears to tell you a great deal, when in fact it tells you very little. If I got a brokerage statement with information provided in this manner, I’d look for another broker.
Fortunately, there’s a liquidity report furnished to the Investment Advisory Committee that shows how quickly the treasurer can liquidate assets within each asset class and category, which means you can make some educated guesses about North Carolina’s exposure to hedge funds and private equity. Moreover, by rejiggering the data, it is possible to estimate actual asset allocation of the pension. The good news is that the asset allocation looks like a modestly conservative public pension plan. The bad news is that it is heading deeper and deeper into the world of hedge funds and private equity.
Alternative investments are supposed to represent investment nirvana. Money managers have been promising investors that a mix of private equity and hedge funds will boost returns and reduce risk at the same time. The Cowell’s own risk report shows how badly she is being misled. The pension’s risk report for the three-year period that ended in March states that conventional equities have fluctuated by an average of 10.5 percent, while the private equity has varied by only 3 percent over the same period. This relationship, known as standard deviation, is completely wrong.
Private equity, given its leverage and illiquidity, is 30 percent to 50 percent riskier than public stocks, which is why investors expect higher returns from the asset class. It’s no small wonder that the state treasurer is moving more and more money into alternatives. Her risk reports are telling her that opportunistic real estate, credit and inflation have a risk of 3.2 percent, 2.8 percent and 5.7 percent respectively. I’d be tempted to invest in these asset classes and strategies if the risk was only a fraction of plain old stocks.
But that’s not the full story. The reason that the risk statistics look so attractive is that the treasurer’s consultants and staff are mixing market and accounting data. Actual market movements are being used to measure stock and bond risk, while estimates taken from accounting statements form the basis for measuring the risk of most other investments. Whether you are the fiduciary for one of America’s largest pension plans or a small retail investor, there’s a good rule to invest by. If a particular investment offers a big reward relative to its risk, the data is distorted and/or the risk isn’t being captured by the risk statistic.
The pension plan is also being seduced by the same mistake I made as chief investment officer. I thought I could add significant value by picking the right money managers who could beat their respective benchmarks. In building the pension’s commitment to equity long/short hedge funds, the Public Equity Review presented to the Investment Advisory Committee makes the same error. The report suggests that the treasurer can add an average of 0.50 to 2 percent to performance over the benchmark when she selects conventional equity managers and between 2.5 and 4.0 percent when she picks hedge funds. It can’t be done.
In picking conventional equity you must be correct about 60 percent of the time in selecting managers in order to cover the fees, and then you’ll only begin to achieve a small gain over the benchmark for the entire equity portfolio. The batting average when selecting hedge funds has to be even higher, because the managers earn much larger fees if they are successful but don’t give back any of those bonuses when they fail to perform.
In the past four years, the state treasurer has invested in 135 new alternative funds. What do you think the odds are of adding value, when almost every major investor in the world is making the same bets? My back-of-the-envelope calculation is that about 95 of these investments need to beat their benchmarks for this foray to pay off in the aggregate.
As I’ve said many times, money managers will be the only winners. For example, Blackstone manages 10 portfolios in real estate, credit and inflation categories with a total value of $1.3 billion (market value plus unfunded commitments), representing an increase of 43 percent over the prior fiscal year. Blackstone is on quite a roll, and its fees are going to rise substantially in the next year or so. According to various agendas of the Investment Advisory Committee in the last 12 months, the treasurer approved six new mandates for Blackstone last year, representing another $900 million in commitments. The firm’s fees are more than likely to double from the $21 million the company earned in 2014.
Fund-of-fund managers are also doing well, despite previous claims by the Treasurer’s Office that they would be decreasing their reliance on structures where the pension pays multiple levels of fees. Since the treasurer’s disclosure is translucent, it’s not easy to discern the structure of any particular investment. But as best I can tell, the pension plan added $500 million of commitments to fund-of-fund structures in the first quarter alone.
Over a year ago, the state treasurer received a report from the Investment Fiduciary Governance Commission, a group she appointed to provide guidance on the overall stewardship of pension investments. By a narrow majority, the commission recommended that pension investments be overseen by a board of trustees, rather than by the state treasurer as sole fiduciary. The minority recommended retaining the sole fiduciary model, while significantly strengthening the role of the investment committee. In May 2014, the treasurer deferred a decision on this important step, but promised to submit legislation this year.
The General Assembly did enact some of the consensus reforms, including a periodic audit and greater hiring flexibility. However, any audit comes long after all the investment decisions have been made, and billions of dollars in capital have been committed to alternative investments. I fought very hard, and with limited success, to improve staffing, so I applaud the effort by the legislature and treasurer to provide the flexibility needed attract and retain the requisite expertise.
However, the key reform needed to bring greater accountability before investment decisions has not been enacted. Thetreasurer never submitted a bill. Given the pension’s continued commitment to alternative investments, soaring fees, and frosted glass transparency, pension beneficiaries and taxpayers should demand that the treasurer dust off the commission’s report and submit a reform proposal.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/