Money management, according to billionaire hedge-fund managers and other high-paid practitioners, is a complex science and art. But does it really have to be?
Big state pension funds in such states as Pennsylvania or California spend many hundreds of millions of dollars a year hiring many sophisticated advisers to bet on arcane strategies — multiple classes of hedge funds and private equity, real estate and debt funds — in hopes of boosting long-term profit and protecting from market downturns. Over time, returns have lagged.
A couple of Pennsylvania counties have found a simpler, better way, says Jack McMillin, elected controller of Butler County from 1994 to 2014 and an architect of that county’s pension investment strategy, which relies mostly on low-fee investments based on stock and bond indexes, from Malvern-based Vanguard Group.
Butler was “the first county in Pennsylvania to go fully indexed,” McMillin recalls. “We cut our fees by over $1 million annually, lowered our fund’s overall risk, and routinely outperformed the great majority of actively managed funds.”
Montgomery County made a similar switch starting in 2013, a break so decisive that the county doesn’t report its profits from before that date.
McMillin points out that the largest Pennsylvania pension fund, PSERS, which currently invests $73 billion for half a million working and retired public school employees, would have raised an extra $4 billion plus over the last 10 years if it had invested like Butler County (and that’s based on a conservative average of $50 billion for PSERS assets in those years).
Butler’s financial reports show that it averaged 8.8% annual returns in that decade while PSERS — the Public School Employees’ Retirement System — averaged 8.0%, a small difference that adds up mightily over time.
McMillin suspects that the disparity is actually greater. Count him among the skeptics who think that returns are inflated for “esoteric” alternative investments that are privately held and can’t be readily sold. “I don’t know how you get a fair-market value on hedge funds and limited partnerships,” he said. “If that instrument is not trading on the market, the valuation is subjective.”
Last year, as stocks rebounded from pandemic lows, PSERS returned 24.6%, breaking its own record. But Butler posted 26.8%, more than two percentage points higher.
Montgomery County, which shifted to low-fee index funds starting in 2013, returned 26.5%, according to data from Montgomery’s chief financial officer, Dean J. Dortone.
After the stock market briefly lost nearly half its value in late 2008, PSERS responded by cutting its U.S. stock holdings and investing more in private funds, arguing this would protect the fund from volatile stock prices while building more value over time.
That’s when McMillin and his pension board — the county’s treasurer and elected commissioners — took a different approach. They asked its hired money managers to disclose more clearly their investment results, after deducting their fees, for every quarter.
They didn’t comply cheerfully. “It was a tough battle,” he said, laughing at the thought that a public contractor would resist presenting its performance in an easy-to-read format.
But, he said, investment managers led by C.S. McKee, a well-connected Pittsburgh firm that specialized in investments for county plans, eventually laid out its returns clearly, as requested.
The pension trustees compared those results to broad stock and bond indexes such as the S&P 500, basic benchmarks in the investment business.
“It was a real eye-opener” when they realized the private managers were falling far short of the indexes, McMillin recounts.
That led to much debate since the managers had “cultivated strong ties to Butler County” politicians, McMillin said, including in some cases direct campaign contributions in local races, or picking up dinner and golf tabs at investment events, before such contributions were effectively banned by the Securities and Exchange Commission in 2010.
Ultimately, the board ordered what he now calls “a tectonic shift in our investment policy: Virtually all the fund’s $200 million in assets were moved to Vanguard index funds — large cap, mid cap, small cap, international, and fixed income.”
Measuring the difference “was not a Herculean task,” he adds. “That’s how we migrated to indexing. It became apparent we were getting beat up with fees, and paying for active management that was underperforming.” So they bought stock index funds, instead, tracking specific baskets of investments.
It was the opposite of a major strategy pursued by PSERS, with what are now called “private” investments — private equity, private real estate, private debt, and a bewildering variety of hedge funds.
PSERS was an outlier among its peers for its low percentage of U.S. stocks. PSERS leaders feared that stocks might fall again, as they had in 2001 and 2008. It couldn’t afford the risk of such big losses. So managers bet that other investments would both earn more over time and fall less when markets were weak.
But, instead, U.S. stocks rose rapidly through the Obama and Trump administrations, while hedge funds, in particular, failed to perform as predicted. So the strategy pushed PSERS returns far below the U.S. stock indexes such as the S&P 500.
The Butler reform wasn’t quite complete. The board majority insisted on keeping about 10% of its money in one last, local stock-picking firm, McMillin said. That firm’s returns consistently underperformed stock indexes, and was terminated last year, he said.
But the broad results of Butler’s experiment have been clear, said McMillin. Since switching to index funds, Montgomery and Butler Counties have outperformed the biggest state fund, at far lower percentage cost.
In the comparison he assembled for The Inquirer, McMillin also included Westmoreland County, in Western Pennsylvania, whose plan, like those of most of the state’s 67 counties, is still invested over a wider range of “active” investments. Not surprisingly, its returns more closely tracked those of PSERS.
Can state funds learn from counties? New investment targets the PSERS board adopted in its December meeting dropped the plan’s hedge-fund target down to zero, while nearly doubling the dollars invested in stocks.
Some trustees questioned whether it’s really a good time to buy more stocks after so many years of record performance and with inflation squeezing returns. The current and former state treasurers, Stacy Garrity and Joe Torsella, who both sit on the PSERS board, have long advocated for a simpler investment strategy. They say it could take years to finish the switch from hedge funds to stocks. Maybe the stock market will look more attractive then.
This debate is not new. McMillin recalls how then-PSERS board chair Melva Vogler “would cringe when I appeared” at state investment conferences in the early 2010s, “knowing full well the uncomfortable questions I frequently posed to PSERS representatives.”
PSERS won’t change overnight. After chief investment officer James H. Grossman Jr. and executive director Glen Grell announced their departure late last year, trustees in 2022 will be reviewing a series of critical reports that may affect how PSERS buys future investments. And that’s in addition to ongoing federal grand jury and Securities and Exchange Commission probes of PSERS practices, including how it exaggerated its investment returns and was forced to recant them.
McMillin also notes the plans have different needs. Besides the much larger scale of the statewide plans, the county plans are better funded — they did not face the gap between state funding and ballooning pension costs that opened for the statewide funds in the 2000s. With extra cash, the county plans might better endure a short-term downturn in investment values, he said.
And McMillin said the counties can certainly learn from some things the state plans do. For example, Treasury Inflation-Protected Securities (TIPS), whose principal increases with inflation, are one of the largest investments PSERS holds.
The Butler County pension board “dumped the Vanguard TIPS component” after he left office, as if inflation were no longer something to worry about, McMillin said. “They could probably use more of that about now.”