Pa. teachers' pension bets: Better than Vanguard, really?

For all the alternatives to stock and bond investments they've attempted over the past 20 years -- venture capital, hedge funds, real estate, "private equity" buyout funds, commodities -- Pennsylvania's multi-billion-dollar public-worker pension funds have fallen farther behind the target funding levels that would help them keep paying pensions indefinitely; that's why taxpayer "contributions" to the funds are eating up growing chunks of the state budget -- and boosting local real estate taxes, in the case of the Public School Employees' Retirement Fund, which is partly financed by local school districts.

There's a question Pennsylvania pension-board members -- including legislators, Gov. Corbett appointments and retiree reps -- get asked a lot: Why not just fire the hundreds of private-sector firms that manage state money -- firms that collected more than $720 million last year (maybe more, since the State Employees' Retirement System took to hiding some hedge-fund expenses as "administrative" fees and not reporting them) and hire Malvern-based Vanguard Group, which now controls one-fifth of the U.S. mutual-fund industry, or some other low-fee money experts to handle the state's $70 billion in public-worker retirement funds? (That's what Montgomery County did last year.)

PSERS's attempt to answer that obvious question takes up Page 49 of the 116-page annual Senate Appropriations Committee Budget Report that landed in Harrisburg last month. It begins: "Arguments have been made that Private Equity is just an expensive form of investing in public equities and can be replicated by passively managed public equity indexes." PSERS goes on to explain that mere civilians just don't get (and can't hope to buy) this stuff: "Individuals and small institutional investors typically lack the expertise, ability to diversify managers, and, most importantly, access to top quartile managers." For those types, sad but true, private equity might be too rich (it would "most likely not justify the incremental costs associated "). But PSERS, by contrast, "has enjoyed sucess in Private Equity due to having a strong, internal management team, excellent consulting relationships, and most importantly, access to top quartile managers."

PSERS then purports to put the question beyond future challenge with a chart showing "what the returns would have been if, instead of investing in Private Equity, the cash that flows into/out of Private Equity investments were made into/out of a very low cost mutual fund," the Vanguard Total Stock Market Index, for the period December 1998 through September 2013.

The 15-year graph shows the PSERS Private Equity line is higher than the Vanguard fund's line, indicating higher profits. And, next to the chart, PSERS posts a table showing "10 Year, Net of Fee" results for the same instruments, and finds that PSERS Private Equity returned 13.95% a year, better than the S&P fund's 8.38%. This, we're told, shows "PSERS has been able to generate in excess of $5 billion in incremental value versus the passive, low cost approach to index investing."

However, elsewhere in the report, PSERS shows that, even with its "top" hired managers, the system's private equity, venture capital, real estate, and other private-sector investments, in each category, have not yet returned the billions of dollars PSERS has invested in each category.

So how can they claim to be doing better than Vanguard?

When I asked PSERS to explain, spokeswoman Evelyn Tatkovski told me on Tuesday that staff would be too busy for the rest of the week to answer my questions. So I called some expert.

It's a good idea to carefully compare alternative investments to Vanguard funds -- so it's too bad "that's not in the (PSERS) graph," Chris Geczy, academic director of the Wharton School's Jacob Levy Equity Management Center for Quantitative Research, told me.

"On a side-by-side basis, you typically don't compare private-equity reutrns to returns on a public-market index without making further adjustments," Geczy said.

For example, he said: Private equity is typically "much more levered" than traded investments like stocks or bonds, and this leverage must be accounted for. In addition, Private-equity Investors like PSERS may set aside cash that isn't fully invested for years. So comparable returns should include, not just the high profits a successful investment might reap once the money is put to work, but the low or non-returns for the years when cash piles up unused.

"Two, I don't see any adjustment for the illiquidity of the private-equity investment," Geczy added. Measuring risk including volatility in illiquid investments is tricky. In 2008, when Harvard, Yale and Princeton had to raise cash from their endowments, they found they couldn't sell the private-equity, hedge fund and real estate investments they thought had gained value in previous years. So to raise the cash they needed to stay open, they were forced to sell stocks, at the bottom of the market, and take big losses. By ignoring that risk in its data, PSERS was ignoring the real difficulty in cashing in those investments -- a delay that can last more than a decade, reducing returns.

Geczy also noted the private-equity practice of combining actual profits collected with the value of what their remaining investments might be worth some day -- they call this their "Internal Rate of Return." Since these values mix real with self-reported, estimated, possible future returns for as-yet illiquid investments, "Internal Rates of Return don't tell the whole picture," Geczy told me.

Plus, "in private equity you have a very small number of successes driving portfolio performance. So it's inappropriate to say one asset class is 'better' than another, as they do here, even if it's 'won'" for a selected period -- which is unlikely to repeat. In sum, given the academic evidence, and the necessary adjustments "I don't much believe in the ability to beat the market over long periods of time," by private or public managers.

"It's an arbitrary comparison," offers Daniel P. Wiener, editor of the Independent Adviser for Vanguard Investors newsletter and a frequent critic and second-guesser of the fund group's managers, of the PSERS report. "Why would they graph 15 years? That's the lowest (stock market return) number they could come up with." And why compare a Vanguard U.S. stock fund, with a multinational private-equity index? And why only private equity, and not other PSERS private investments?

Ann Headley, a Paoli CPA who recently made a presentation based on PSERS's self-accounting at Stanford University, and who met last week with Senators from both parties to review how SERS and PSERS count and fund their assets, also questioned PSERS's Vanguard comparison: It's "spin, or cherry-picking," she told me. "A more appropriate benchmark would be to break their Private Equity portfolio up into comparable segments, and then make comparison with the appropriate Vanguard funds."

Noting Gov. Corbett and various legislators have proposed ways to extend the problem without resolving it or paying out more cash, Headley predicted nothing will change -- at least until after this fall's gubernatorial election.