How Pa. teachers' pension fund beat the markets in 2016

The $50 billion-plus Pennsylvania Public School Employees Retirement System brought in more money than it paid out last year.

That is news, considering how much it costs: State and local taxpayers paid $4.2 billion last year, including a 30 percent surcharge on public-school payrolls, to keep the plan solvent into the far future.

But for calendar year 2016, PSERS also made more than expected from its investment portfolio, the largest in the state -- $4.8 billion in net investment profits. PSERS scored big on U.S. and foreign stocks, energy and utility-builder funds, gold and other commodities, even bonds.

"All the buckets did well," says James H. Grossman Jr., chief investment officer for the Harrisburg-based system.

Unlike the complex state workers (SERS) and Philadelphia City pension portfolios, with their mixes of public and private investments  -- or the Montgomery County plan, which consists mostly of Vanguard index funds -- PSERS in 2016 significantly beat its long-term annual benchmark, with returns topping 10.7 percent (the PSERS long-term target is 7.25 percent a year.)

Our sharp readers might not think those results so impressive. Didn't the Standard & Poor's 500 return 12 percent last year?

PSERS has its own $3 billion portfolio focused on the S&P 500 stocks. It returned 14 percent in 2016, beating the index, and Vanguard's big 500 fund.

In the past three-, five- and 10-year periods, PSERS's U.S. stock returns have outperformed the S&P 500 by more than 2 percentage points a year after costs. (PSERS also has beaten the state and city systems and Montgomery County over the past three years, since Montgomery switched to Vanguard.)

As Vanguard founder John C. Bogle is fond of noting, a few percentage points add up over the years. Especially if you're investing billions.

How?  PSERS has been indexing since indexes were invented, Grossman said.

Nearly 40 percent of PSERS assets are in funds managed by its 30-member investment staff; it also paid $400 million in direct fees last year to scores of outside managers.

Like other pension funds, SERS also holds a lot of bonds, which are easier to sell when markets go bad. Bonds typically return less than stocks, dragging down total returns.

Grossman says his staff does not believe in bond-index funds, like the ones made popular by Vanguard: Why set up a portfolio robotically focused on "the most indebted companies on the planet?" he asks.

PSERS bonds -- including U.S. and foreign, junk and investment grade -- also beat their investment benchmarks in 2016, returning 10.6 percent.

Some of PSERS' more exotic investments -- Master Limited Partnership energy and pipeline funds, public-infrastructure funds focused on roads and utilities, gold and other commodities -- scored double-digit profits.

This doesn't happen every year. In 2015, a bad year for stocks, PSERS lost 1.8 percent, trailing the state workers' and Montgomery County funds (though still beating Philadelphia), as oil and commodity prices tanked.

PSERS also said it returned 7.4 percent over the five years ended Dec. 31, 2016. That met its long-term 7.25 percent target, which PSERS says it has also exceeded over the past 25 years. The 10-year number is just 4.3 percent. It will look prettier after 2018, when the financial crisis of 2008 drops off the chart.

I remind Grossman how PSERS, SERS and other plans lost big on some of their hedge funds strategies when markets froze in the 2008-09 financial crisis.

"We learned a lot" about hedging against that kind of market collapse, he said.

When markets next turn down -- maybe if the anti-Euro party wins the pending French election, Grossman suggested -- he says PSERS is hedged against risk, diversified, and invested in enough gold and high-rated bonds to keep signing checks for hundreds of thousands of ex-teachers without losing much principal for some time. Maybe long enough for stocks to recover.

Meanwhile, Trump's election has encouraged infrastructure and energy investments, Grossman notes. "If the markets continue to do well, PSERS appears on track to beat its earnings assumption of 7.25 percent for the current fiscal year, which ends June 30," he wrote PSERS members last week.

This broad approach isn't for everyone. Maybe "smaller funds shouldn't be involved in private equity" and other specialized investments, Grossman said. But when you're charged with boosting profits on $50 billion, "we write bigger checks. We get more attention. We get to sit on the advisory committees of the general partners, and see what they are doing."

But on the whole, "Where you show the ability to return above the index," Grossman concluded, "you should keep doing it."