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Sunday, September 24, 2017

The continuing tragedy of PSPRS' investment returns

The following table shows PSPRS' investment returns, gross of fees*, versus the Russell 3000 through June 2017, the final month of the current fiscal year (FY), with the FY end 2014, 2015, and 2016 returns included for comparison:

Report PSPRS PSPRS Russell 3000 Russell 3000
Date Month End Fiscal YTD Month End Fiscal YTD
6/30/2014 0.78% 13.82% 2.51% 25.22%
6/30/2015 -0.73% 4.21% -1.67% 7.29%
6/30/2016 -0.32% 1.06% 0.21% 2.14%

7/31/2016 1.62% 1.62% 3.97% 3.97%
8/30/2016 1.76% 3.40% 0.26% 4.23%
9/30/2016 0.71% 4.14% 0.16% 4.40%
10/31/2016 -0.27% 3.86% -2.16% 2.14%
11/30/2016 1.17% 5.07% 4.48% 6.71%
12/31/2016 1.30% 6.43% 1.95% 8.79%
1/31/2017 1.03% 7.52% 1.88% 10.84%
2/28/2017 1.17% 8.78% 3.72% 14.96%
3/31/2017 1.06% 9.93% 0.07% 15.04%
4/30/2017 0.75% 10.76% 1.06% 16.26%
5/31/2017 1.33% 12.24% 1.02% 17.45%
6/30/2017 0.22% 12.48% 0.90% 18.51%

There is usually about a two-month lag in PSPRS reporting its investment returns.  PSPRS' August 2017 Board of Trustees meeting included returns from both May and June 2017 because PSPRS did not have a meeting in July 2017.

PSPRS' FY 2017 return, net of fees, was 11.85%.  For comparison, PSPRS' own Cancer Insurance Plan (CIP) earned 10.12%, net of fees.  The CIP is a simple mix of approximately 25% US equity, 25% non-US equity, 30% fixed income, 10% inflation-linked bonds, 5% commodities, and 5% short-term investments.  The Arizona State Retirement System (ASRS) has not given its FY 2017 returns yet, but an Arizona Republic article from July 19, 2017 stated that it will be around 13.6%, net of fees.  We should keep in mind, though, that this same article also said that PSPRS' FY 2017 returns, net of fees, were going to be 12.5%, so the ASRS estimate might be inaccurate as well.

PSPRS is already crowing about the FY 2017 return and are again using their own particular data set to make their returns look like something special.  However, if we go here to ASRS' page on its rates of return, we can see PSPRS' true mediocrity in comparison to ASRS.  The numbers presented by ASRS do not even do ASRS justice as they do not include the most recent FY return of 13.6%, and yet ASRS still beats PSPRS by 2% (6% to 4%) in the 10-year annualized rate.  On a $9 billion fund, the additional 2% annualized returns over 10 years would generate nearly $2 billion in additional earnings.  PSPRS also lags the CIP by 1.40% in the 10-year annualized rate.

Even more telling is ASRS' historic rates of return, which go back over 35 years.  This is data, by the way, that PSPRS conspicuously does not provide on their webpage.  I suspect that this is because similar PSPRS data would make past PSPRS Administrator Jim Cross look too good in comparison to the succession of mediocrities that have run PSPRS since his departure.  Mr. Cross is the favorite scapegoat of PSPRS' current administration and Board of Trustees, as well as state union leaders, because of some bad investment choices he made during the dot.com bust, but these same people conveniently fail to mention the years of stellar returns he produced prior to those last couple of years of his career as PSPRS Administrator.  I believe that his good years were just in line with the overall markets at the time and not the sign of any particular investing acumen, but it is unfair to look at only his last couple of bad years and give him credit for his prosperous years.

ASRS' historic rates of return show that in 37 years, dating back to FY 1981, ASRS had only five years of negative returns.  One negative year was way back in FY 1984 (-5.2%).  The other four were in FY 2001 (-6.7%), FY 2002 (-8.2%), FY 2008 (-7.6%), and FY 2009 (-18.1%), and we all know what happened during those years.  During that same period, PSPRS had negative returns in eight years in FY's 1984 (-2.45%), 1988 (-1.10%), 1994 (-0.71%), 2001 (-16.86%), 2002 (-15.07%), 2008 (-7.27%), 2009 (-17.72%), and 2012 (-0.79%).  This PSPRS data had to be gleaned from annual reports and is not openly available like it is on ASRS' webpage.

We can see that PSPRS had losses that were nearly double what ASRS had during the dot.com bust.  This makes sense because of the individual stock investment strategy that was being followed at that time by Mr. Cross.  An index-based approach would not have produced such large losses, though some type of market crash was unavoidable when the internet bubble finally popped.  During the Great Recession ASRS' and PSPRS' losses are not much different with ASRS' losses only about 33 basis points greater than PSPRS' losses.  This is because that crisis was systemic and took down everything.  It would not have mattered where one was invested, except strictly in cash or in Big Short-type bets on the housing crash.  You were going to suffer some type of loss.  There was virtually no way to avoid that. 

The point here is that we now have the brain trust at PSPRS trying to develop a strategy for two recent past events that were either caused and/or exacerbated by bad policy (i.e. stock picking during a bubble) or major market downturns (i.e. an investment bubble popping and/or a global liquidity crisis).  This is why they continually highlight data about how the current portfolio would have done in the past during specific crises, but, of course, anyone could retroactively design a better strategy when they know what the markets actually did.  Bad investment policies are easy to deal with by simply getting rid of them, but what about market crashes?

PSPRS is selling the idea that they have found a strategy for mitigating market crashes with its Modern Pension Diversification, but the strategy has yet to be put to the test in an actual market downturn.  Even if we buy into PSPRS' theory, there is the other side of the coin: how much would PSPRS have foregone in higher returns during the past had it utilized this investment strategy? PSPRS, of course, do not provide this information, and we are left with an incomplete picture, as if PSPRS' only goal was to mitigate the effects of market downturns.

The goal for PSPRS should be to produce steady gains over the long term.  ASRS has done this over the past 37 years, absorbing losses during the inevitable market downturns but more than making the losses during the subsequent bull markets.  This has been a success for ASRS, and if PSPRS wants to implement an effective investment strategy all they need to do is study and mimic what ASRS has done.  Or better yet, place PSPRS' investment portfolio in the hands of ASRS.

What is even more unsettling is that PSPRS does not see the policy pitfalls in its own strategy.  By my count, PSPRS has 74 private equity investments, 53 real asset investments, and 39 real estate investments listed its 2016 Consolidated Annual Financial Report (CAFR).  This compares to only a total of 22 US and non-US equity investments listed.  At what point does their strategy become just another form of individual asset picking, especially with private equity (PE), which makes up about 14% of  PSPRS' total portfolio?  While I do not know exactly how PSPRS may be invested with each PE firm, we can see that the PE firms themselves have a multitude of investments.  Just looking at the first three PE firms listed in the CAFR, Abry Partners, Avalon Ventures, Baring PE Asia, we can see each has numerous companies in their PE portfolios.  So you have PSPRS picking dozens of PE firms which each have dozens of companies in their portfolios.  What will happen to all these companies, and PSPRS's stake in them, if there is another market crash?

It has never made sense for PSPRS to invest separately from ASRS, just based on economies of scale alone, and when PSPRS decided last decade to move away from one-man rule over its investment portfolio, its Board should have looked to the established, proven team that had already been successfully running ASRS to take over its investments, or at the very least, for guidance in getting PSPRS back on track.  Instead of PSPRS turning things around after 15 years, we still have second-raters like Jared Smout, Ryan Parham, and Brian Tobin whining and making excuses about PSPRS' failings in both its management and investment performance.  What a tragedy it is that PSPRS, which is not even five miles distant from ASRS, was so incompetently led down such a different and broken financial road, a road from which there seems no exit.

* Returns, gross of fees, are used because PSPRS usually does not report returns, net of fees paid to outside agencies, except on the final report of the fiscal year.  Returns, gross of fees, are used in the table for consistency.  The past two years fees have reduced the final annual reported return by about a half percent.  Returns, net of fees, were 13.28% in FY 2014, 3.68% in FY 2015, 0.63% in FY 2016, and 11.85% in FY 2017.


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