Dear Ms. Carter,
Thank you for your reply to the letter I sent the Mayor and City Council on May 8, 2013, outlining some of the lessons Seattle can learn from SCERS’ $20,000,000 loss in the Epsilon II debacle. Although I appreciate your enthusiasm in defending recent changes in SCERS’ investment strategy, the time for making small adjustments around the margins has passed. SCERS needs to rethink its investment approach from an entirely new vantage point, one that’s informed by the best theoretical and empirical research in financial economics rather than by the interests and orthodoxies of the money management industry. You repeatedly refer to “best practices” in rationalizing SCERS’ investment strategy. But, the question is, whose “best practices”? You will not find the practice of placing bets on money managers, i.e., “active management,” among the “best practices” recommended by Nobel prize-winning economists, by the cutting edge of financial economists, by Warren Buffett, Peter Lynch, or David Swenson (see below). Nevertheless, let’s take a closer look at your arguments.
1. Long-Term Investment Performance. You write, “After several years of recent restructuring it appears the efforts are paying off in performance returns. Long term, for the period of July 1984 – March 2013 (28 3⁄4 years) the SCERS portfolio has returned 8.73% (gross of fees).”
I agree with your focus on SCERS’ long-term investment performance, but unfortunately you provide no baseline against which to evaluate this performance, and the annualized rate of return you do provide is gross of fees, which ignores one of the main points at issue. Table 1 below displays SCERS’ annualized return net of fees alongside the annualized net return for a risk-equivalent index portfolio.
Long-Term Comparison of Investment Performance
7/1984 – 3/2013
7/1984 – 12/2012
Net of Fees
Notes: SCERS’ annualized net return equals SCERS’ gross return of 8.73% (from your letter) minus (assumed) fees of 0.4%/year; data for the index portfolio can be found at http://www.ifa.com/portfolios/p050/.
The results displayed in Table 1 reveal that SCERS’ bets on investment managers who claimed they could “beat the market” produced an annualized net return 1.37%/year less than the annualized net return of a risk-equivalent index portfolio. This 1.37%/year difference in annualized returns amounts to a 47% difference in cumulative returns over the 28½ year period from July 1984 to December 2012. If SCERS had held an index portfolio rather than betting the Retirement Fund’s resources on “money managers,” the market value of SCERS’ assets would be roughly $900 million greater than it is today.
2. Recent Investment Performance. In defense of SCERS’ investment strategy, you point to the fund’s recent performance. “For the trailing 3-year period ending March 31, 2013, the SCERS portfolio shows an annualized return of 9.61%,” which exceeded “the policy benchmark” by 0.28%.
First of all, it’s very easy to be “fooled by randomness,” especially over a time period as brief as three years. In fact, financial economists are finding it difficult to differentiate between superior returns due to luck vs. superior returns due to skill even over much longer periods of time (see here). For example, although SCERS’ investment portfolio outperformed the index portfolio in Table 1 for three consecutive years, 1997-1999, SCERS then proceeded to underperform the index portfolio in 8 of the next 10 years, 2000-2009.
You indicate that SCERS’ favorable returns were due to 1) “fewer investment managers and lower fees,” 2) a reduction in the proportion of SCERS’ U.S. Equity Portfolio under “active management,” and 3) “security selection in US and non-US Equity, as well as US Fixed Income.”
Although you don’t say anything about the relative contribution of each of these three factors to SCERS’ improved performance, the third factor most likely accounts for SCERS’ “excess return” during this 3-year period. And since this factor includes the fleeting windfalls of “active management,” i.e., “security selection in US and non-US Equity,” it’s hard to conclude that SCERS’ recent success is due to anything other than favorable stock picking the persistence of which will be doubted by anyone familiar with the literature.
3. Active vs. Passive Investment Strategies. In response to my general critique of SCERS’ reliance on money managers who claim they can “beat the market,” you write, “As you know; the question of active versus passive investment management has been ongoing for decades.”
In reply, I can only say that if you insist on characterizing this as an “ongoing debate,” then I must remind you that the advocates of “active management” tend to be money managers whose income depends on “active management,” whereas the advocates of “index investing” (“passive investing” is a misnomer) are mainly academic economists, including Nobel Prize winners Paul Samuelson, William H. Sharpe, Merton Miller, Harry Markovitz, and Daniel Kahneman.
4. SCERS’ Shift from Active to Passive Investment. You point out that SCERS has reduced its actively managed holdings in U.S. Equities from 77% of SCERS’ total investment in this asset class to 52%. This is definitely a step in the right direction, but why not go all the way? Consider some observations from people whose judgment should be accorded more weight than the typical money manager:
“Any pension fund manager who doesn't have the vast majority—and I mean 70% or 80% of his or her portfolio—in passive investments is guilty of malfeasance, nonfeasance or some other kind of bad feasance! There's just no sense for most of them to have anything but a passive investment policy."
Merton Miller, Nobel Laureate in Economics, 1990
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
Warren Buffet, Chairman and CEO, Berkshire Hathaway
“It’s getting worse, the deterioration by professionals is getting worse. The public would be better off in an index fund.”
Peter Lynch, former manager of the Fidelity Magellan Fund
“A miniscule 4% of funds produce market beating results…. The 96% of funds that fail to beat the Vanguard 500 Index fund lose by a wealth destroying 4.8% per annum.”
David Swenson, CIO Yale University Endowment Fund
“Hope springs eternal. We all tend to think either that we're above average or that we can pick other people [to manage our money] who are above average.”
William F. Sharpe, Economics Nobel Laureate, 1990
“People believe they can do what they, in fact, cannot do [beat the market] . . . You have a situation where everybody believes they are above average . . . People have a lot of difficulty figuring out they are just like everybody else.”
Daniel Kahneman, Economic Nobel Laureate, 2002
5. Best Practices. In defense of SCERS’ investment practices, you write, “I think it is important to reaffirm, since 2008 the asset allocation composition of the SCERS portfolio has been designed and instituted using institutional best practices. An example of institutional best practices is manager concentration monitoring. A limit has been set by policy at 15%; meaning it is the Board’s intent to guard against any one manager overseeing more than 15% of the total plan’s portfolio. This is an effort to mitigate any portfolio disruption in the event of a manager breakdown or other investment loss.”
To be perfectly candid, if SCERS wished to “mitigate any portfolio disruption in the event of a manager breakdown or other investment loss,” then shifting all of SCERS’ portfolio to index funds would achieve this objective much more effectively than prohibiting any single investment manager from managing more than 15% of SCERS’ portfolio. In addition, an index portfolio would reduce SCERS’ administrative and legal costs, while also making better use of the Board’s limited time.
6. SCERS vs. WSIP. You write, “SCERS Board and management are very mindful of the performance return comparison discussions between SCERS and the Washington State Investment Board (WSIB). We very much appreciate your analysis and sentiment surrounding the performance comparisons. It is interesting to note, SCERS investment consultant has noted to us the following results for the trailing 4-year period ending March 31, 2013:
4-year trailing for March 31, 2013
Total Portfolio = 13.6 Total Portfolio = 13.4
Policy Benchmark = 13.3 Implementation Benchmark = 15.0”
I’m afraid foregoing paragraph completely misses the point. In my letter to the Mayor and Council, I said the performance of WSIP 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 [to my letter] 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” (emphasis added).
Would it be too disagreeable to point out that “SCERS investment consultant” is not a disinterested party regarding the question of whether SCERS should continue managing the Seattle Retirement System’s assets, nor is the consultant a disinterested party when it comes to deciding whether SCERS should undertake new investments in private equity and real estate?
Recourse to the rhetoric of “best practices” has become an opiate for public officials who, quite understandably, don’t want to stick their necks out on complicated policy questions. Yet, some of the City’s best decisions – investing in energy conservation rather than in WPPSS nuclear plants #4 and #5, launching an ambitious recycling program instead of building a garbage-to-energy plant, “scattering” low-income housing throughout the City – none of these decisions could have been justified by pointing to the “best practices” of the time. By contrast, Epsilon II (the SCERS’ investment whose name must not be spoken) came to SCERS with letters of reference from the heads of major banks and investment firms, industry leaders who were custodians of the period’s “best practices” (BNP Paribas, Prudential Securities, and UBS Financial Services among others).
I’m sorry I can’t share your enthusiasm regarding SCERS’ current approach to investing, but I wish you well.