Wednesday, April 10, 2013

Don’t Believe Everything Wall Street or Your Professor Tells You

In a previous blog entry, we noted how the Wall Street Journal – the newspaper that is written for stock and bond financiers and investors in New York – recently ran an alarmist but factually empty story that positioned the Teacher Retirement System of Texas as taking inordinate risks with its private equity portfolio. 

We noted how the story’s sky-is-falling “Pensions Bet Big with Private Equity” headline, and some wording in the third paragraph, might lead a reader to believe that “private equity and other non-traditional investments” are aggressive, risky investments when compared to those on Wall Street. In reading the story, it was not hard to infer that there is less risk from traditional stocks and bonds offered by the downtown New York financial companies, you know, the ones that advertise in the Wall Street Journal.

Our worry about the story was its implication that off-Wall Street investments, sometimes referred to as Main Street investments, are inherently more risky and don’t belong in public pension portfolios.

But when we added just a tad of critical thinking, we noticed that the story offered no comparisons of risk factors, or any proof of long-term return superiority of one style of investing. The story only notes how private equity investments play a big part of the TRS portfolio, saying “It now boasts some of the splashiest bets in the industry, having committed about $30 billion to private equity, real estate and other so-called alternatives since early 2008.” (Note the value-laden term “splashiest bets.”)

Even the following paragraph in that WSJ articled noted how the strategy is “averaging returns of 4.8% and 15.6% over the past five-year and three-year periods, respectively.” Not bad, in our view. The story did not include supporting evidence as to how those investments are risky or detrimental to TRS performance. Nor was contrasting evidence presented as to how other pensions’ private equity ‘splashy bets’ played out. Nor was evidence presented as to how “bets” using “traditional” Wall Street investments might have fared over the same time period, or which risk metrics were at play.

Our concerns that this article might negatively influence some people were well-founded, as it turns out.

Professor Elena Farah, senior fellow for public financial sustainability at the University of Houston, began her  recent blog by referencing that WSJ article and posited that the risks taken using private equity are “a perfect example of how misaligned incentives endanger public money. This can only hurt public employees and taxpayers in the long run.” She positioned public pensions as using “risky” private equity to achieve their overly aggressive investment targets.

Professor Farah’s blog article went on to offer one sky-is-falling scenario after the other, all of which supported her premise that private equity offerings are more risky than other types of investments and shouldn’t be used by public pensions.

This just simply isn’t true and her viewpoint is dangerous to taxpayers in many ways.

If anything, private equity components of pension portfolios offer one more element of diversification that help reduce the overall risks of an investment strategy. We’ve previously mentioned how, at one time, the City of Houston’s Treasurer’s strategy for pension investments was limited to U.S. Treasury instruments, which might seem risk-free, except for all the opportunity losses the city’s taxpayers were forced to pay for with higher contributions.

To offer an alternative view of alternative investments, we asked Marcelia Freeman, a director at Invesco Private Capital, to offer their justifications for the use of private equity in pension portfolios. Here’s what she said:

Throughout the Great Recession, we saw that these outsized returns could not be broadly found in public markets, and thus investors were forced to look toward alternative investments like private equity, hedge funds, bank loans, etc. These type of investments not only provide alpha beyond S&P 500 and T-Bill returns, they also provide other benefits like diversification, lower correlation among portfolio investments, etc.

Another major benefit for private equity includes investments in small business around the country, who otherwise were capital starved during the recession. The increase in pension fund investing in the asset class benefits not only pension fund members and beneficiaries, but also communities and economies in which we all must thrive, both in the short and long term. The cost of not investing in ourselves as a nation far outweighs the well-aligned manager fees paid to private capital firms.

“Lack of transparency” in alternative investments and even public securities often indicate inefficiency of markets. Profits are often gathered by skillful managers within inefficient markets, making manager selection paramount in order to produce significant alpha. With the use of consultants, investment committees, and other oversight mechanisms within public pension fund investing, high performing, top quartile managers can be hired, and can thus produce outsized returns for pension fund members and their beneficiaries.

We have more to say about other elements of Ms. Farah’s blog, but that will have to wait for future blog entries.

For now, we hope our readers understand that Texas pension systems seek to balance the risks they take. Wall Street investments are no less risky than Main Street investments, despite what the Wall Street Journal might implicate. And in many cases Main Street investments might be far more less risky, especially if they are more directly under the watch and control of a pension Board. Indeed, the failure to consider ‘alternative investments’ – in Wall Street speak – could actually be a violation of Trustees’ duty as fiduciary.

This subtle shift in orientation that seeks to deem Wall Street investments as “traditional” and alternative investments as “non-traditional” is dangerous to public perceptions about the steady work that pension Boards perform to find the best overall mix of investments for their members and taxpayers.  And this skewing of perception simply isn’t warranted based on performance.

In our view, one of the true shortcomings of the “move all public employees to 401(k) plans” arguments is that they would be limited to stock and bond mutual funds. As an asset class, those have not performed as well as commodities in recent periods, and thus their underperformance risk an entire generation’s opportunity to participate in wealth accumulation for retirement.

We continue to urge readers to view media many news reports and blogs with measured skepticism. Public pension investing is far more complicated, and its practitioners far more sophisticated, than some would have you believe. – Max Patterson