Dear Mayor McGinn, Council Budget Chair, Tim Burgess, & Council Members
Subject: What Can Seattle Learn From the Epsilon II Calamity?
I’m writing in regard to the May 5, 2013 Seattle Times article entitled “Seattle City Pension Investment Mired in Legal Limbo,” which describes the regrettable misadventure of Seattle’s $20 million investment in the private equity fund, Epsilon II, which is now worthless.
A little more than a year ago I sent you a letter outlining the conflicts of interest that make the City's pension system vulnerable to the sort of investment losses described in the Times article, and I explained why Seattle’s continued practice of betting on investment managers who insist they can “beat the market” has a very low probability of success.
I was gratified to read Councilmember Burgess’s admission that “our private-equity investments have been very problematic, and Epsilon is clearly one of those. We need to get a better handle on this part of our portfolio and better understand the risks as well as the rewards.”
This analytical commitment marks a significant improvement over the rather blasé attitudes expressed by some City officials, elected and unelected alike, regarding the City Pension System's investment practices. The calamity of Epsilon II is, in fact, a symptom of a more general problem, which is the City’s continued reliance on financial consultants who, as a matter of temperament and self-interest, offer advice that is inconsistent with some of the most well established findings of financial economics.
In the Spring 2013 issue of the Journal of Economic Perspectives, there’s an article entitled “Asset Management Fees and The Growth of Finance,” in which Burton Makiel details the underperformance of actively managed investment funds compared to index funds. Moreover, the largest underperformance gap is in small capitalization stocks, where Seattle's financial advisors claim they can exploit market inefficiencies to achieve superior returns. In light of these findings, which have been confirmed by many other studies, Makiel concludes,“Perhaps the greatest inefficiency in the stock market is in ‘the market’ for investment advice.”
Seattle's pension system has been a willing buyer in “the market for investment advice” and has paid dearly for it. Between 1988-2011, Seattle's investments have underperformed a risk-equivalent index portfolio by 0.9%/year, not including fees. This performance gap, which does not depend on hindsight, cost Seattle's pension system more than $500,000,000 (2011 dollars).
According to the Times article, Seattle is considering the possibility of turning its investment decision making over to the Washington State Investment Board because the State’s investment performance has been superior to the City’s results. But this is the wrong standard of comparison. The performance of the Washington State Investment Board has been significantly worse than the performance of a risk-equivalent combination of index funds. The last figure in the attachment displays the performance of 24 state pension funds versus 7 index portfolios for the 10-year period, 7/1/2000 to 6/30/2010. At every risk/return combination, the index portfolios outperformed the state pension funds by at least 2%/year. Washington State underperformed the risk-equivalent index portfolio by more than 2%/year.
The problem facing Seattle is that very few financial advisors would recommend an index portfolio because: 1) there’s more money to be made in active asset management than in the construction of an index portfolio; and 2) virtually all financial advisors believe they can outperform their competitors, but, unless they all live in Lake Wobegone, they can’t all be above average.
It’s time for Seattle to consider a new approach to investing, one that draws on the mountain of academic research showing that active asset management is a losing strategy. Continuation of the current approach will only deliver superior returns if Seattle's pension board can pick those few investment managers who can “beat the market,” a premise that implies a good deal of hubris, especially in light of the Epsilon II catastrophe.