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SKARBECK: State's investment strategy for pensions not paying off

February 18, 2017

Ken SkarbeckPension funds across the country hire financial consulting firms and pay them well to advise their investment strategies.

In my last column, I noted that investment performance for many pension plans has been decidedly poor of late. I suggested that the underperformance is centered on a flawed asset-allocation strategy that most national consulting firms obediently follow.

Years ago, institutions typically invested in two conventional investments—stocks and bonds. However, during the 1990s, the Yale Endowment earned high rates of return investing in non-mainstream, or “alternative,” investments like hedge funds, private equity, real estate and commodities. In time, consultants took notice and eventually adopted the Yale model for their pension fund clients.

By the mid-2000s, most of the big consulting firms were advising institutions—including Indiana’s public pension plan (now known as INPRS)—to allocate into alternative investments. In the summer of 2006, INPRS adopted a new asset allocation plan that took some time to implement. The goal was to change the current portfolio of 75 percent stocks and 25 percent bonds to a new target allocation: 40 percent stocks, 45 percent bonds, and 15 percent alternative investments.

Then the credit crisis hit. In 2009, the INPRS pension lost 20.6 percent—comparable to losses sustained by other pension funds during that period. INPRS’ asset mix at that point was 51 percent stocks, 32 percent bonds and 17 percent alternatives.

The fallout of the 2008-2009 market turmoil did damage to the psyche of many investors, including consultants. Institutions had incurred huge losses and pension clients sought advice to protect and repair their portfolios. The solution was a drumbeat to adjust portfolios to become “uncorrelated” to stocks. Reduce the allocation to stocks and increase alternative investments became the mantra. Here’s where mistakes were made.

In 2012, INPRS’ consultants rolled out a new asset allocation: stocks, 22.5 percent; bonds, 32 percent; private equity, 10 percent; commodities, 8 percent; real estate, 7.5 percent; hedge funds, 10 percent; risk parity (a strategy that attempts to reduce risk and increase returns), 10 percent. I use INPRS as an example, but a recent review of the top 1,000 pension plans in Pensions & Investments shows its asset-allocation strategies are a close match to its peers. In other words, group-think is alive and well.

Note that INPRS’ portfolio during the past decade changed from a simple stock and bond portfolio to a much more complex fund. To wit, at present, INPRS has allocated money to an astounding 129 private equity funds and 23 hedge funds.

Since the 2012 reallocation, INPRS’ performance has struggled, notching a 4.8 percent annual return, weighed down by abysmal annualized results in commodities (-11 percent), hedge funds (3 percent) and risk parity (2.75 percent), together composing nearly 28 percent of the portfolio. It is notable that, last year, INPRS paid $52 million in fees to its hedge fund managers, its largest portfolio cost by far.

In contrast, a low-cost index fund of U.S. stocks, the asset most consulting firms had advised to avoid, has gained 12 percent annually since 2012. Consultants were either unwilling or, worse, untrained to recognize the bargains offered in the stock market.

The result has been complex, high-cost portfolios that have underperformed.•

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Skarbeck is managing partner of Aldebaran Capital LLC, a money-management firm. He can be reached at (317) 818-7827 or ken@aldebarancapital.com.

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