Forget FOREX, VRS’ problem is with active management

by Norm Leahy

The headline news is that Virginia and Florida are suing Bank of New York Mellon for “…cheat[ing] pension funds in those states by choosing improper prices for currency trades the bank processed for the funds.

But the real headline story that, so far, I’ve only seen posted here, is how Virginia’s public employee retirement system is paying handsomely — with retirees’ money — for investing in actively managed funds:

The Virginia Retirement System, or VRS, pays millions to Wall Street, as well as highly-paid internal managers, to oversee its $55 billion fund. The state paid $125 million more to fund managers in 2010 than it did in 2005, when the system first embraced a “more active” investment strategy. The strategy yielded results in 2011, as the fund grew nearly 20 percent, still $3.4 billion short of its pre-recession high.

The fund needs a 49 percent gain to make up for recession losses.

“The reason the fees are so high is because 89 to 90 percent of our investments are under active management,” VRS Director Bob Schultze said. “We have to go to outside firms that put out all of these results.”

This feeds into an old debate: whether actively-managed funds perform better over the long term than index funds:

The VRS could achieve similar long-term investment gains with an index fund, a computer generated investment scheme designed to react to market trends, according to Andrew Biggs, a retirement scholar at the conservative American Enterprise Institute.

“The whole point of active management is to try and outsmart the market,” he said. “But 75 percent of the time, active managers don’t beat the index funds. You can’t outsmart the market.”

Some large index funds have been able to churn out results similar to the system’s performance.

I remember having a long-running argument argument with the retirement fund managers at a former employer. They weren’t keen on index funds, preferring to stick with actively-managed funds that carried higher fees.

So I asked for information on the active funds’ holdings. When that data was provided, it was not surprising to find that funds which, by their names alone, would seem to have vastly different investment goals also tended to own shares in the same companies. But we could only see what the top ten holdings were — in the past. A complete list of current holdings was unavailable, nevermind how long those holdings had been in the portfolio. And tax considerations? Fuggedaboutit.

So what did active management provide? The promise of greater returns, but rarely greater than the index used as a benchmark. And at a far higher price, with less diversity, than those same benchmark index funds. But the idea that smart people were watching the market like a hawk every day, as opposed to a dumb index that just sat there, gave some of my colleagues great comfort.

It’s the same with the VRS. The state’s retirement plan took a huge hit coming out of the 2008-2009 market swoon. They turned to active management to try to cover the losses because they believed the smartest guys in the room would give them an edge. But that move has cost them a great deal — arguably, far more than the monies in question in the suit pending against Bank of New York Mellon.

So why does the VRS stick with active managers that cost a heckuva lot more? Sen. Roscoe Reynolds offers the classic response:

“If something went wrong, could you imagine the response from the public if we were relying on a computer? I can tell you it wouldn’t be good.”

Is SkyNet running the Russell 2000? Or the Wilshire 5000? Not yet. But there’s also no indication that the bright minds behind active investment strategies — and the costs they bring — do any better than the far cheaper, and in many ways far smarter, index approach.

17 Responses to Forget FOREX, VRS’ problem is with active management

  1. Bottom line: VRS is paying big bucks to employ people who pay big bucks to third parties to actually manage the money. Wow. How can I get a gig like that?

  2. fascinating subject! How about people’s own 401(k)s?

    how much of VRS in planted in US treasuries?

    how about investing Social Security money the way that VRS does it instead of investing in treasury securities?

    Can you imagine the SS fund getting behind the way VRS has and then hiring smart guns to engage in riskier investment practices in an effort gain back their losses?

  3. “Bottom line: VRS is paying big bucks to employ people who pay big bucks to third parties to actually manage the money. Wow. How can I get a gig like that?”.

    Become a general contractor and build houses? You’ll never swing a hammer or fit a pipe. You’ll make lots of money (in an up market) and you’ll pay out a lot to your plumbing contractor, electrician, etc. Of course, you’d have to work with unions so that’s probably out for you.

    Run a software company? You get to make lots of money (if your software ends up selling well). You pay twenty-something software engineers princely sums.

    You get the point. Lots of people get paid big bucks to manage other smart people who also get paid big bucks.

    The only question worth considering is how the VRS pension did against other pensions like it.

    There are 50 states. Doesn’t that give us 49 comps?

  4. ” The only question worth considering is how the VRS pension did against other pensions like it.”

    agree and I think you’ll find that different states have different strategies but one thing to observe is this – Is it smart to have an investment strategy that depends on the market not having problems .. and then when the market does have problems.. your response is to hire “experts” to try to go out and beat the market by engaging in even riskier investment strategies than before?

    Bonus Question: If VRS is invested in U.S. Govt securities – would they get downgraded also?

    McDonnell says no… why am I not convinced?

    You know all along – they told us that 401Ks should not be viewed as retirement plans… but then they turn around and tell you to configure them so that they are riskier in the years far in advance of your retirement and more conservative as you approach retirement.

    Well.. over the last 5-10 years.. the “investment” least likely to “damage” your 401K is what? that’s right.. good old U.S. Govt Treasuries – right?

    and when the rest of the world gets into trouble what do they do? Why heckfire they ALSO buy U.S. Treasuries.

    In fact so many people buy US treasuries that the pay almost nothing in interest which is really good for the US debt, eh?

    Norm… I much appreciate your perspective added to BR – which often did not delve very deeply into the issues behind the budget and finances.

  5. Look into Foliotrade. You can buy a subscription that allows unlimited trades, own dozens of stocks in fractional shares, and basically create your own mutual fund.

    Over the past five years, stocks I own have outperformed the market by 15%. But, i don;t own very much, with big holdings it would be harder to do.

    Even if you don’t have a lot of money, this is so cheap it is worth it for the entertainment value and the learning experience. Create play money portfolios to test out your theories, etc.

    Paying high expense fees for VRS is nuts. With that much invested, it is much harder to beat the market.

  6. “actively managed” appears to be murk-speak for the pension funds to try to gain back their losses from an under-performing market by hiring “experts” to basically engage in riskier investment strategies.

    This shows the folly of “investing” SS funds in the stock market and especially letting people pick the stocks.

    right now – by far – the safest perceived investment is US Treasury Securities.

    Those who hold those securities, including other countries have been held harmless in the recent market problems.

    So… Social Security has been invested correctly all along, eh?

    When I see people dumping U.S. Securities en mass and buying non-govt stocks and bonds – I’ll believe the “downgrade”.

    Over the last couple of decades – we’ve moved from a nation of savers that put aside money and are content with modest dividends to a country with people are … in essence… “going for broke” .. pushing their savings into much more risky investments in an attempt to grow their wealth faster.

    Even the pension plans seem to have moved that way.

    it’s a bad strategy for money set aside for retirement and it’s a hard lesson that both individuals and pensions are now learning.

  7. Is SkyNet running the Russell 2000?

    Obviously you have never heard of a flash crash. Or 500 points down only to finish 400 in the green. Or the fact that regular people are setting all time records in the bailing out of mutual funds and the trusty 401k. Or the bond bubble. Or that the major buyers of gold and other hard assets has been Central Banks. All the pension experts in the world can’t match a supercomputer with a microsecond algorithm.

    The age of sitting around making deals from a ticker are over. The big profit is displayed as mere noise in even a 1 second chart. Like a scattered random collection of pixels on the screen you are viewing right now, but worth billions.

  8. so… Darrell.. I agree with you …so why is Va hiring human ‘experts’?

    and if they were using those microsecond computers to start with does that mean the algorithms need tweaking to put the focus on preserving the equity of the funds …or trying to get back what they lost using riskier strategies?

    A computer by the way is only as good as what the program running on it says…. and there are many, many “buy/sell” algorithms “out there”.

    the question is which one is Va and it’s human “experts” using.

  9. Well Larry that’s been the subject of some debate. The pension fund depends on experts to maximize their return. So they go out and hire these experts for large sums from the companies who own the computers. The experts give advice to the pensions and then their own company makes bets against the pension advice, using their little electronic friend. The pension is left hanging but the experts make out huge in what is now a casino game with loaded dice.

  10. Larry, don’t know where you have been the last five rears, but despite recent events my stocks are still up 60%. And I’m an amateur working without expert help or microsecond trading.

    All I do is look around me at what is happening.

    Not what my politics tells me I’d like to happen. Not what I wish would happen. Not what my philosophy tells me ought to happen.

    It is not rocket science, but I don’t have to trade millions of shares, either. And it is my money. The VRS has a fiduciary responsibility, so the probably have to hire people to give them advice.

  11. Darrell is correct that there is additional money to be made from algorithms that can react quickly to small changes. But there is another ones out there triggered to short that change get. I is unlikeley that those incremental changes can be micromanaged to create huge swings.

    Despite darrell’s analogy, it is not a casino, because a casino manufactures nothing. If a coke costs the same tomorrow as today, and the company is selling coke, and paying dividends, then that has a value. I might make a few cents on a day trade by shifting to Pepsi and back. If I do it with thousands of shares I might do it in seconds, but I still have to pay for the trade, plus pay capital gains and wash sale taxes. At the end of the day I made money, maybe, but I did not change the value of coke.

    If Darrel is right, no one will make money and all will get out. Those super geniuses with their super computers will then be competing and preying on each other.

  12. Those super geniuses with their super computers will then be competing and preying on each other.

    They already are. 75 percent of the trade volume is made by the computers. They don’t care about dividends or what Coke is selling, only the point spread at a given microsecond. A casino. They don’t get charged a fee for trading either. And now the computers are actively manipulating the spread by ramping trades with volume to create an illusion in pricing, similar to what used to happen in the low budget stocks. I used to buy $5 stocks and wait for the pump and dump traders to show up. Then I’d close out before they blew up the stock. Computers are too fast to play that game now.

  13. Here read this, especially the part about Low Frequency Traders like pension funds or retail investors.

    http://www.bis.org/review/r110720a.pdf

  14. If they are preying on each other, one drives the price up, the other down. Net net, the price is the same.
    If you think they have a sure thing, why not buy shares in the , that do this?
    Why do I care if they are buying and selling for factions of pennies and how does it cause wild swings when they run on a hair trigger?

    Your conspiracy theory seems to have some major internal conflicts. Besides, it depends on a predilection to dislike anyone who is making money by trading. Not me, I’m happy for them. If the hardware store buys a load of snowshovels and takes delivery just as the snow falls, they may sell out in minutes. Why do I care? So what if the store hired a weather expert, and hedged their purchase with insurance?

  15. If I buy and sell all day long for fractions of a penny gain, at the end of the day don’t I own shares at the average daily price?

  16. Under my brokers rules I can trade all the stocks I want, twice a day, at no cost.

    Suppose I have $1000 worth of coke and , and I’m indifferent between them.

    I can easily set up my computer to sell part of whatever goes up more and buy whichever goes down more. Over time I will accumulate more shares, a few pennies at a time, without changing my initial investment.

    The geniuses have no way of knowing when my trade will execute or for how many pennies it will be. How do they outsmart me on this? They do the same thing every few seconds, so what? They cannot know which pairs I am cross trading, and in fact, I might do fifty at a time.

    How do they hurt me? All they can do is reduce the relative change between coke and Pepsi, maybe. I make less because the market noise I depend on is less, because they made the price more stable.

    Your link did not work. Adobe wont read the file.

  17. Not a $1000 worth of coke: $1000 each of Coke and Pepsi.

    Anyway, your example depends in someone else doing something, which you cannot know. So does my example, but I don’t care who does what as long as the relative price of coke and Pepsi change.

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