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Easy investments beat state's expert pension planners

An ordinary investor who put $100 into an easy investment fund portfolio 10 years ago could have had $184 by the end of the decade — without combing through the stock listings, making lots of trades or hiring high-priced experts.

And what about somebody who put his retirement in the hands of Florida's pension fund, which employs hundreds of experts and spent hundreds of millions of taxpayer dollars making investing decisions?

That person would have realized much less from that $100 bet — $157.

That's the result of a St. Petersburg Times analysis of how effectively the State Board of Administration invests the retirement savings of state, county and city employees.

The idea was straightforward: We asked financial professionals to create portfolios of index funds that required no Wall Street wizards to oversee them. Index funds are simple investments that are content to do precisely as well as the markets do, and no better. Some are riskier than others, depending on the market they track.

We didn't set a lot of rules for our experiment. We merely asked our contributors to build funds that were inexpensive and easy for people to understand. We also looked at model index-fund portfolios developed by two Ivy League finance professors. Then we compared how all of those funds would have performed with the returns the investment gurus at the SBA actually got.

The result? The professionally managed SBA performed worse — by more than a percentage point — than seven index-fund portfolios for the decade ending Dec. 31, 2010.

On average, a $100 investment grew to $184, with results ranging from $162 to $207.

We were also curious about how the pension fund performed over a working lifetime. We looked at the time period from 1984 through June 2011. One of our contributors found that an unambitious, plain-vanilla index portfolio with just U.S. stocks and bonds out-earned the state by more than $1 billion.

The State Board of Administration manages Florida's retirement system, the nation's fourth-largest with 1 million participants. The $130 billion defined benefit pension fund relies heavily on investment gains to pay the benefits of schoolteachers, police officers and other state and local employees.

What's left over is paid by taxpayers in more than 900 cities, counties, school districts and state and local government agencies. So, in theory anyway, we'll all have to pay less if the pension fund performs well.

It could do better.

"There is no getting around it,'' said Richard "Rick'' A. Ferri, a Michigan financial adviser who has written six books on investing. His analysis: "Unimpressive investment decisions made by the Florida pension fund have cost Florida taxpayers at least $5 billion dollars in the past 10 years.''

Told of the Times' findings, Gov. Rick Scott, who oversees the SBA, asked for details so he can study the issue.

"We should be looking at how we're spending the money and what's the return on that money,'' Scott said.

Ash Williams, executive director and chief investment officer of the SBA, declined to comment for this story or answer written questions. But the SBA made it plain that it didn't think much of the Times' exercise.

''The SBA has no comment on the contrived 'experiment,' the naive conclusions, or the use of obscure retail 'experts' advocating their services,'' spokesman Dennis MacKee wrote in an e-mail.

He said Florida's cadre of experts "has resulted in the SBA recognized by the industry as consistently producing excellent returns."

As recently as last week, Williams touted Florida's pension fund as one of the least expensive and best performing plans in the country. Florida regularly exceeds its investment objectives, he has said, and is a ''very positive exception'' to the mistakes that have troubled many pension funds.

"We've got tremendous, tremendous talent here,'' Williams said last year.

But when it comes to investing, talent can be overrated.

• • •

Index fund managers buy baskets of securities that mimic various financial markets. Index funds track broad swaths of the markets including big-company stocks, emerging-markets stocks, bonds, real estate investment trusts and so on.

These investments are sometimes called lazy portfolios or no-brainer funds. An investor just settles on the right mix of publicly traded index funds and holds on. This is a form of passive investing.

Active investing means trying to beat the markets by buying and selling securities. The argument for active investing is that it gives you a chance for much higher returns than the indexes will give you. Even if you have some spectacular failures, the thinking goes, you can generate greater returns in the long run.

Florida invests about half its money passively in index strategies. It actively manages the other half. SBA's stock pickers, hedge funds and private equity managers try to pick the winners on Wall Street and divine where the market is headed.

Florida, by the way, is not unusual in trying to maximize returns through active investing. Lots of states do the same thing.

On its website, the SBA says it uses the active managers when the returns are likely to be high enough to justify the risk and the cost. SBA uses passive investing when it's unlikely to beat the market.

To examine the pension fund's performance, the Times asked several financial professionals how they would invest $100 in a portfolio of index funds.

The funds they chose earned 17 percent more on average than Florida's pension fund over the first decade of the 2000s.

Ferri, who writes for Forbes, built a portfolio with four basic Vanguard index funds where the $100 grew to nearly $164. Average yearly return: 5.06 percent, almost a half-percent better than Florida's.

Ferri calls his fund a "robot blend" because it doesn't take any effort to manage it.

• • •

Williams of the SBA has said that prudent investing by his staff and private partners has kept costs low and helped save taxpayers billions. But while Florida's money managers sometimes beat the markets, the Times' experiment suggests that the profits may not be enough to overcome the drag of expenses.

Investment management consultant Steven Pomerantz of Princeton, N.J., did an analysis for the Times showing how costs eat away chunks of retirees' savings.

Pomerantz, who consults with investment firms and the federal government on tax and economic issues, compared Florida's fund to a blend of two simple indexes with 69 percent in U.S. stocks and 31 percent in U.S. bonds.

From 1984 through 2011, Pomerantz found, the SBA underperformed the indexes by about $1.2 billion. SBA's investments made money, but not enough to make up for the cost of active management.

"Time and again investment management fees pose a serious and meaningful barrier to investors' wealth,'' Pomerantz said. "Beyond the mathematical certainty of this burden is the true cost it bears upon the public in good times and bad.''

Burton Malkiel, an economics professor at Princeton, put it this way: "The one investment principle I'm sure about is that the less I pay the purveyor of an investment service, the more there will be for me.''

Malkiel is the author of the bestselling book A Random Walk Down Wall Street. In it, he cites a lot of evidence that the odds of investing success with active money managers are no better than a coin toss.

Only one in three active managers outperforms market averages, but often not for long. Fund managers lauded as geniuses in the '90s, Malkiel found, did worse than the markets in the first decade of the 2000s.

The professor documented how well-paid investment professionals make mistakes, hype the investment bet du jour and use "a gaggle of other technical theories to help you lose money.'' But telling investors that an expert can't help them is like telling a 6-year-old that Santa doesn't exist.

"Some academicians have gone so far as to suggest that a blindfolded monkey throwing darts at the stock listings can select stocks with as much success as professional money managers,'' Malkiel wrote in A Random Walk.

Malkiel suggested a well-diversified mix of low-cost index funds, with a relatively high level of risk. How did it fare against Florida?

One hundred dollars on Jan. 1, 2001, grew to $205 at the end of the decade. That's almost a third better than Florida's performance.

• • •

The passive index portfolios created by the Times' contributors need just a handful of managers to run. They likely would cost a fraction of the more than $300 million the state paid for managing pension money last year.

So what do Florida taxpayers get for the money? They get 148 employees at the SBA who supervise about 190 private money managers and dozens of consultants, researchers, auditors and lawyers, including a senior partner who earns $765 an hour to review hedge fund contracts.

They travel the world looking for the best managers and the best deals.

They produce audits, glossy performance reports and hundreds of studies. Since 2007, the SBA paid $68,000 for three studies suggesting Florida's investment staff is underpaid. The agency plans another pay study this year.

"Americans think the harder you work, the more success you're going to have,'' said Jared Faltys, a Nebraska-based financial consultant who assists firms in Florida and other states.

"That works with most things except when it comes to investing. The harder you work, the more disasters you're going to have — more trading, more commissions, and you can't get over the expense hurdles.''

Those expenses can be difficult to track.

The SBA, like many pension funds, does not report performance fees — the bonuses managers get for beating return expectations — levied by hedge funds, private equity and real estate funds.

There are also trading costs for going in and out of investments.

That's a passion of John Bogle, founder of Vanguard Group, who introduced the first index fund (the Vanguard 500) in 1975. Now, many firms offer index and exchange-traded funds, including Fidelity, Schwab and BlackRock.

The problem with trading costs is not just that investors don't get what they pay for, Bogle says in The Little Book of Common Sense Investing, they often get what they don't pay for: financial middlemen like brokers.

If beating the market is a "zero-sum game,'' Bogle said, the cost of investing with active money managers pretty much ensures that you'll lose.

• • •

Florida's performance is typical of a lot of state pension funds, according to Mark Hebner, president of Index Funds Advisors in Irvine, Calif. He recently analyzed many state pension funds after an inquiry from the Times. He found "room for improvement'' in most of them.

Pension managers who try to outdo the market are "gambling with taxpayers' hard-earned money,'' Hebner said. He calls the underperformance of actively managed pensions ''Pension-gate.''

One reason for the risk: Florida is betting on big returns from hedge funds and other complex private partnerships that are hard to value. Taxpayers don't know what they're really worth until they're sold.

Their management and performance fees often run at least 20 times the 0.1 percent an investor pays for a basic index fund portfolio.

• • •

So if active management is often a losing strategy, why do public pension funds keep using it?

Because the idea of making a killing is exciting. And because people's careers depend on it.

If Florida invested only passively in index strategies, experts say, the SBA would have much less work to do and would require far fewer employees to do it.

Sydney P. Freedberg can be reached at Times researcher Shirl Kennedy contributed to this report.

This article has been revised to reflect the following correction: The State Board of Administration has a $32 million budget. A box accompanying a story Sunday gave an incorrect figure.

About the SBA

The State Board of Administration manages more than $159 billion in public money. It protects retirement funds for 1 million current and retired teachers, public employees and their families. It manages money for more than 800 cities, counties, school districts and state government agencies. Its largest fund is the defined benefit pension plan, valued at $130 billion as of May 30, 2011. Almost three-quarters of its members are from school districts and counties.

The agency has a $32 million budget and 170 staff. A board of trustees — Gov. Rick Scott, Chief Financial Officer Jeff Atwater and Attorney General Pam Bondi — oversees the SBA.

The contributors

Here are the people whose portfolios the Times used in its index fund-vs.-Florida experiment.

David F. Swensen pioneered the use of hedge funds for Yale University's endowment. But for most individuals and institutions, Swensen recommends low-cost index funds. He is the author of Unconventional Success: A Fundamental Approach to Personal Investment.

Burton Malkiel is an economist, Princeton professor and author of the bestselling finance book A Random Walk Down Wall Street. Malkiel is famous for his remark that monkeys can pick stocks better than experts.

Charles H. Fisher Jr. and Martin B. Solomon are founding shareholders of Reilly, Fisher & Solomon, a Tampa accounting firm. They specialize in tax and investment advice for high net-worth individuals and private companies.

Richard "Rick" A. Ferri founded Portfolio Solutions, a Troy, Mich.-based investment company. Ferri is the author of six books on investing. He specializes in low-cost index funds and writes for Forbes.

Steven Pomerantz is an investment management consultant based in Princeton, N.J. With a Ph.D. in math from University of California at Berkeley, Pomerantz consults with banks, investment firms and government agencies. He specializes in risk management and financial modeling and has testified as an expert witness on a variety of topics, including mutual fund fees.

Carolyn Hill is a specialist in exchange traded funds at IndexUniverse, an independent authority on index-based investing and trading. She graduated from Claremont McKenna College with a dual degree in economics and government.

Mark Hebner is president of Index Funds Advisors Inc. of Irvine, Calif., and author of Index Funds: The 12-Step Program for Active Investors.

Jared Faltys and Nathan Raabe are wealth planners at Wealth Management based in Norfolk, Neb. They specialize in managing money for certified public accountants and other fee-only advisers in Florida and across the country. At the Times' request, they created their portfolio for one of their Florida clients, Capital Accounting Company, of Naples.

On the web: More information about the funds in our contributors' portfolios is available at You'll find an article describing each portfolio, with links to a Morningstar report on every fund.

Easy investments beat state's expert pension planners 07/30/11 [Last modified: Sunday, July 31, 2011 4:27pm]
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