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Best Practices for Investment of State Funds

 

 

By TCCRI Staff.    Feb. 25, 2020

 

As part of our testimony to the Senate Committee on Finance for today's hearing, TCCRI made a series of "best practice" recommendations regarding the investment of state retirement funds. The following summarizes the main recommendations. Click here to read the full testimony.

 

Overall the Endowments have been well-run, with each posting annual returns which generally meet or exceed its benchmark, except for the SLB over five and ten-year periods. However, benchmark data for the SLB is of uncertain quality. The Legislature could seek improvements by requiring each Endowment to adhere to certain best practices. In addition, the Legislature may want to consider providing the SBOE with greater control over the PSF and returning the SLB to its traditional role of managing the land under its stewardship.

 

1.      Require Endowments to Consider Index Funds When Investing in Public Securities

 

To minimize fees, each Endowment should consider investing in public securities through index funds when possible, while still providing managers with the flexibility to exercise discretion over stock investments. Investing through a passive indexing approach eschews “active” management, in which managers attempt to pick stocks they believe will outperform the broader market. Many state pension funds have expanded their investments in index funds in recent years after concluding that the substantial fees charged by active managers did not create enough value. For example, in 2013 the board of trustees for the California Public Employees’ Retirement System (CalPERS), concluded that “Markets aren’t perfectly efficient, but inefficiencies are difficult to exploit after [taking into account] costs” and that “Calpers will use index tracking strategies where we lack conviction or demonstrable evidence that we can add value through active management.”

 

While indexing should be strongly considered for investments in public securities, it should not be mandatory for the Endowments given their need for investment flexibility.

 

2.      For Investments in Public Securities, External Managers’ Compensation Should Require “Beating” Index Funds

 

Because indexing allows investors to obtain the return of the general stock market at extremely low annual costs (as low as 4 basis points in some cases), a third party manager retained by an Endowment to invest in public securities should be compensated only to the extent he or she can “beat” the index fund for the applicable equity class. This compensation arrangement ensures that the manager is compensated only for the value (if any) he or she adds. While TRS has done an outstanding job overall in managing the assets entrusted to it and has routinely exceeded its overall benchmark, even it might benefit from considering indexing; over three, five, and ten-year time frames (measured from August 31, 2019), its investment returns in U.S. public equity significantly lagged its benchmark, indicating that managers of that specific portion of the TRS portfolio were unable to add value over those time periods. Despite this underperformance, TRS paid approximately $78 million in domestic equity management fees for the year ending on June 30, 2019.

 

3.      Review Possibilities for Internal Management Periodically

 

Given the size of the Endowments, in-house management should be considered periodically to minimize fees; this is already done to an extent, with the Endowments using a mix of internal and external investment managers. While in some cases outside expertise will be necessary, the Endowments may be able to attract the necessary expertise in-house as their assets grow over time.

 

4.      List All Fees Paid to Third Parties

 

All fees paid to third parties should be clearly listed by the Endowments in their annual reports. A list of all fees paid should include fees paid out of the invested assets themselves, not just fee payments made by the Endowments to external managers.

 

5.      Negotiate the Lowest Fees

 

Each Endowment should negotiate the lowest possible fees with third party managers. TRS has been an outstanding role model for this negotiation approach in recent years, as evidenced by its successful insistence on a “1 or 30” model rather than the traditional “2 and 20” model. Under the traditional “2 and 20” model, private equity and hedge fund managers often charge a management fee equal to two percent of the invested assets, as well as a performance fee equal to 20 percent of the investment gains. As competition has increased in the hedge fund and private equity industries, sophisticated investors have sometimes been able to negotiate better rates. Each of the Endowments should be able to negotiate reasonable rates with third-party investment managers. TRS, in particular, controls a vast pool of assets, which should give it the leverage to demand better rates. In fact, TRS in recent years began requesting a “1 or 30” model with outside hedge fund managers, under which the manager receives an annual fee equal to only the greater of 1 percent of the invested assets, or 30 percent of the investment gains in excess of an agreed-upon minimum “hurdle” rate.

 

6.      Tie Bonuses for Endowment Employees to Net Results, Not Gross Results

 

As noted in our full testimony, the Houston Chronicle reported that employees in the SBOE and SLB received bonuses based on the gross performance of the PSF portfolio. To ensure that incentives between employees and the state are properly aligned, and that taxpayers are paying only for actual value added, bonuses should be based on the performance of the PSF net of fees.

 

 

 

 

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