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Thursday, September 17, 2015

The Stuart Smalley world of PSPRS: they're good enough, smart enough, and doggone it, their strategy is working

On September 9, 2015 we were given another of PSPRS' self-serving press releases:
PSPRS fund realizes 4.2 percent gross returns
Stability, $210 million in growth during year of market volatility
PHOENIX – The state’s Public Safety Personnel Retirement System fund realized a 2015 fiscal year investment return of more than 4 percent, placing the $8.3 billion system among top public pension performers during a year marked by high stock market volatility.
The system’s 4.2 percent gross-of-fees returns fell below the assumed earnings rate of 7.5 percent, but still showcased a strong 14.1 percent net return for the PSPRS private equity portfolio. In recent years, PSPRS increased its private equity investments – and decreased holdings in stock market-traded equities – as part of its strategy to minimize risk through a broad diversification across asset classes.
The 4.2 percent gross of fees performance of PSPRS places the system within the top 18 percent of 92 comparable public pension funds, according to Allan Martin, of NEPC, the Fund’s Investment Advisor.
“Our portfolio is designed to deliver earning potential while providing significant protection on the downside,” said PSPRS Chief Investment Officer Ryan Parham. “In a world where treasuries are earning less than 1 percent and stocks are flat or down, our 4.2 percent gross of fee returns shows the true value of diversification.”
When adjusted for measurable levels of investment risk taken, PSPRS outperformed 94 percent of its comparable peer pension funds, while the system has shown dramatic overall peer-to-peer performance ranking improvement over the course of the last 3, 5 and 10-year periods.
“The past year, and especially recent weeks, provide a clear example of the type of rocky environment this portfolio is built to withstand and even perform under,” said Martin. “For five years now, PSPRS has ranked well within the top 5 percent of its peers in terms of risk-adjusted returns, while earning 9.2 percent per year in gross-of-fee returns.”
The gross-of-fees performance of PSPRS exceeded that of peers by roughly 1 percent, according to Martin. PSPRS calculations indicate the additional 1 percent return resulted in producing more than $82 million to the PSPRS trust in fiscal year 2015.
The comparable returns on a net-of-fee basis are 3.7 percent for one year and 8.7 percent per year for the five-year period, respectively. On a net-of-fee basis, the fund increased in value during the 2015 fiscal year by $210 million and is now valued at more than $8.3 billion.
The PSPRS trust along with the Corrections Officers Retirement Plan (CORP) and the Elected Officials Retirement Plan (EORP) provides retirement, disability and survivor benefits to approximately 50,000 retired and active members.
Apparently, PSPRS thinks everything is going great.  Their paid pension consultant, NEPC, seems to agree, so why should any of us trust what we read with our own eyes?  After all, it's just our current and future income, security, and quality of life we're talking about here, right?

Let's start off with the obvious problems.  First, the headline states that PSPRS earned 4.2% gross returns for the fiscal year, which is not particularly great to begin with, but it is better than what PSPRS actually earned, 3.7%.  Of course, this does not appear until the penultimate paragraph, just in case people do not read the release all the way through.  Earning less than half your assumed rate of return (ARR) might make people think that you do not really know what you are doing.

This brings us to the glaring misrepresentation about PSPRS' ARR.  PSPRS' ARR was 7.85% last fiscal year.  PSPRS just lowered its ARR to 7.50% this fiscal year, so actually PSPRS fell even further below its ARR last year than the press release indicates.  But once again, why trouble PSPRS members with such details since it would reflect even more badly on its investment performance.

Now we get to the numbers, PSPRS' favorite embellishment tool.  Shouldn't we all see that PSPRS is doing quite well versus its "comparable peer pension funds?"  I do not know what qualifies as a peer pension fund.  Are the 92 peers based on assets, membership, investment strategy, or some other criteria?  In the last post, we saw that PSPRS surpassed the 3.2% average return of 265 public plans with more than $1 billion in assets by about a half-percent, but the referenced Pension & Investments article does not give enough information to rank PSPRS or place it in a percentile.  Is PSPRS still in the top 18% among the 265 funds?  Who knows, maybe PSPRS is better, maybe worse, but there are 173 other public plans not included in NEPC's calculations.  Ultimately, it means nothing to compare one's returns to a particular subset of public plans and highlight your performance against them, unless they are the well-funded, ARR-besting plans worthy of emulation.  It is like a perennially 8-8 NFL team comparing itself against all the teams with losing records, instead of the teams that regularly have double-digit wins and make the playoffs every year.  In this press release, PSPRS' comparative numbers are essentially worthless.

The press release also highlights PSPRS' five-year returns of 8.7%, net of fees.  This is fine until we look at last year when it was 10.68%, net of fees.  This two percent decrease, year-to-year, is conspicuously omitted, and this decrease was during the best five-year market PSPRS is likely to ever see.  It really can only get worse from here on out, as August 2015 showed.  PSPRS' ten-year returns are only about 5%, well below the ARR ,regardless of which ARR PSPRS chooses to use.

Lastly, we have to discuss the puffery from PSPRS Chief Investment Officer (CIO) Ryan "9%" Parham.  Yes, your diversification strategy seems to be minimizing risk on the downside, but PSPRS still needs, at the very least, to earn its ARR over the long run, even if you are claiming that PSPRS' disappointing earnings are caused by the incentive to lowball returns so as not to pay out COLA's to retirees.  Your strategy seems only to be halfway working.  This past fiscal year was not a flat or down year.  The Russell 3000 earned about 7.3% and even an equal dollar weighting of foreign (down 5.26%) and domestic stocks would have still earned about 2%, just 1.7% below your actively managed PSPRS portfolio.  If this past year is Mr. Parham's definition of success, we are all doomed.

If PSPRS dryly stated the facts of what happened last fiscal year, there would be no problem with this press release.  PSPRS did do a little better than average and did better than the Arizona State Retirement System, both good things that should be known in order to put PSPRS' performance in perspective.  However, this is all that needs to be said, not a bunch of misleading, happy talk about how a substandard year is some great success, if you just look at it the right way.  I am happy that PSPRS replaced the dangerous stock-picking strategy of past years, but that was not a justification to swing completely in the other direction to the point where you are so conservative that you can only earn your ARR in years when the markets are producing returns of 14% or more.  The danger in the past was that people were blinded by good PSPRS returns to the point that they did not see that those returns were unnecessarily risky and could have just as easily been produced by a much safer passive investment strategy.  The good returns were a factor of an extended bull market and had nothing to do with what individual stocks were chosen or who was making the choices.  Anyone can be a genius in a bull market.  However, the danger to PSPRS' portfolio was not an illusion and became very apparent when the dot.com market crashed and took a lot of PSPRS' individual stock picks down with it.  A mirror version of the same problem could just as easily happen if the only metric you look at is managing downside risk, and you cannot see that you have made it virtually impossible for PSPRS to ever earn an adequate return.  You are only supposed to play prevent defense when you are protecting a lead at the end of a game.  PSPRS is about five touchdowns behind late in the fourth quarter.

PSPRS is fond of presenting stress test models of how their current strategy would have lessened the losses of past financial crises, but they do not throw in a third comparison using a passive index fund strategy as a neutral baseline.  Also, they do not show how much lower the returns under the current strategy would have been in the years when PSPRS was doing well, such as during the bull market years of the 80's and 90's.  Lower returns in those good years, especially the 80's and 90's when the ratio of workers to retirees was much higher, would have had a negative compound effect over time that should be factored into any fair comparison of strategies.  Does PSPRS really know if their "nationally recognized" strategy is working, or are some people so personally invested in it that they can not objectively assess it?

In the end, applying the strategy is not the goal, consistently earning at or above your ARR over the long run is.  I am sure there was a "successful" strategy in place in 1999 when PSPRS was investing heavily in technology stocks and a "successful" strategy in place in the mid-2000's when PSPRS was investing heavily in real estate with Desert Troon.  We know how those turned out for all of us, but we can all take solace in the fact that PSPRS feels good about how they are doing now.

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