Author Archives: James A. Bacon

Stick It to the Hedge Fund Managers!

by James A. Bacon

One of the voices urging reform of the Virginia Retirement System (VRS) is a semi-retired University of Virginia economics professor, Edwin T. Burton III, who served 18 years on the board. He argues that the VRS pays too much in management fees to outside investment firms that pursue labor-intensive strategies and should rely on low-overhead funds that index stock and bond markets.

In fiscal 2016, the VRS generated a 1.9% return but lagged the 3.99% return on the S&P 500. The year before, the VRS generated a 4.7% return compared to a 7.4% return for the S&P. “We haven’t come close” to the 7% rate of return assumed by the VRS in reaching its calculation of $22.6 billion in unfunded liabilities, he told Michael Martz with the Richmond Times-Dispatch.

Getting a higher rate of return is the best way to boost the financial health of the state retirement fund. Of course, that’s easier said than done. Everyone would like to boost returns on their financial investments, but very few investment managers have outperformed the market consistently. While pension funds can tinker with their portfolios, shifting funds between stocks, bonds, real estate, private equity and hedge funds, often chasing yesterday’s hot categories, they can’t control their returns. But they can control how much they pay outsiders to generate those returns.

As it happens, the VRS paid $362 million in management fees in 2015, according to its 2015 Comprehensive Annual Financial Report. (The 2016 report is not yet online.) That sum is divvied up between ten major investment categories such as U.S. and foreign equities, fixed-income, real estate, hedge funds and other alternative investments.

Hedge fund managers stick out like a sore thumb — they collected $87 million in management fees. Hedge funds delivered outstanding returns for many years, which justified their sky-high management fees, but they have stubbed their toes in recent years. With some 10,000 funds playing in the sandbox, typically betting on movements of currencies and commodities, competition has squeezed industry profit margins to nothing. After years of sub-par returns, there is no justification for the overly generous fee structure.

VRS also paid exceptionally high fees to “alternative investment” managers and for its “strategic opportunities portfolio.” Taxpayers might wonder if those fees are worth the returns they generate.

Remarkably, the VRS staff, which manages one third of the portfolio, cost one-tenth that of the hedge-fund and alternative-investment managers.  If the entire portfolio were managed that efficiently, management fees would have cost only $81 million in 2015 — a savings of about $280 million! Over the years, that could amount to billions of dollars.

So, why don’t we fire the hedge fund managers?

It gets complicated. First of all, you don’t mind paying higher fees to managers who outperform the market averages. Unfortunately, the VRS annual report doesn’t tell us the performance of its individual funds, and even its discussion of investment categories (stocks, fixed-income, hedge funds) doesn’t match up with the categories listed in its table of management fees. So, there’s no way the public can tell if the management-fee differentials are worth it or not.

Second, you shouldn’t judge a fund manager based on one year’s performance. Even the best can have a bad  year. What most interests me is the internal VRS performance. Does its track record over the years equal that of other fund managers? If so, why we paying the other fund managers?

Third, there is a benefit to diversifying a portfolio. The idea is to limit exposure to wide swings in any single investment category. Strong performance in one category offsets weak performance in another. A pension portfolio that invested only in stocks and bonds would be distressingly volatile.

Still, Professor Burton has a point. The VRS may be paying way more than it needs to. Saving $280 million a year won’t bail out a pension fund with $22.6 billion in unfunded liabilities (probably an optimistic assessment), but it sure would help, creating less pain for Virginia’s public-employee pensioners and taxpayers. The idea is definitely worth a closer look.

Digging into Rate-of-Return Assumptions


by James A. Bacon

House Speaker William J. Howell is rightfully concerned about the long-term health of the Virginia Retirement System. The pension system’s own actuary estimated a year ago that the $68 billion retirement system has unfunded liabilities of $22.6 billion.

On Sunday, the Richmond Times-Dispatch’s Michael Martz described the debate over restructuring the VRS from a defined-benefits system to a defined-contribution system. Today, Martz reports how Howell is questioning the outsized fees paid to outside fund managers, who handle two-thirds of the system’s assets.

“My biggest concern is the unfunded liability and the fact that it’s just going to grow,” Howell said.

Howell has every reason to be concerned. Unfunded liabilities might turn out to be far bigger than the actuary’s estimate. As I have observed many times, the liability is based upon an assumed 7% annual rate of return on the $68 billion portfolio. If the system under-performs expectations, as the VRS has done the past two years, the unfunded liability can grow by tens of billions of dollars. Writes Martz:

For Howell and other lawmakers on the [Virginia Commission on Retirement Security & Pension Reform], however, the retirement system’s recent investment performance has raised questions about whether the 7% assumed rate of return is too optimistic for the longer term, especially with interest rates keeping bond yields low for the foreseeable future. …

The 7 percent return, lowered by the VRS board from 7.5 percent in 2010 is among the lowest in the country for public pension funds, said Katie Selenski, state policy director for the Pew retirement initiative. “At 7 percent, you’re in a good, prudent position.”

Prudent? Not really. The pie chart above shows VRS’s portfolio allocation. Some 17.6% consists of fixed income assets. Barring some bizarre experiment with negative interest rates in the U.S., there is no way in a zero interest-rate environment that these assets can generate a 7% return. Another 39.8% of the portfolio consists of equities. Insofar as the bull market in stocks over the past 30 years has been driven by lower interest rates and an expansion of earnings multiples, there is no way to replicate the stock gains of the past ten years. Indeed, earnings and earnings quality of stocks are deteriorating, not a good sign for near-term price performance. Meanwhile, the performance of hedge funds nationally has been dismal of late. There is no rabbit to pull out of the magic hat of alternative investments.

For another view on the outlook for long-term portfolio performance, it is instructive to turn to the University of Virginia, which, whatever one might say about the Board of Visitors’ strategic priorities, one must credit with doing an excellent job of managing its endowment. The 10-year return of the University of Virginia Investment Management Company (UVIMCO) has been 10.1 %, according to its 2014-2015 annual report. That compares to 5.8% ten-year performance calculated by the VRS in 2014-2105.

How much do UVa’s masters of the universe think they can earn on their portfolio looking forward? As best as I can tell from perusing UVIMCO’s annual report, they don’t say. UVIMCO doesn’t report that assumption because it isn’t relevant:  Although UVIMCO does have unfunded commitments, it is not a pension fund in which shortfalls must be made up by taxpayers.

Still, it is possible to get a sense of UVa’s expectations from comments made by university officials that they expect the controversial $2.2 billion Strategic Investment Fund to throw off $100 million a year to pay for programs to advance the university’s strategic goals. University officials have not explained what rate-of-return assumptions they are using. But a simple calculation reveals that $100 million is only 4.5% of $2.2 billion.

From that, one can draw one of two conclusions. Either UVa’s investment mavens are assuming a much lower rate of return than the VRS, or they expect a higher-than-4.5% rate of return but plan to retain a substantial fraction of the earnings, presumably in order to grow the size of the portfolio.

It appears that the second conclusion is true. Here’s what the UVIMCO annual report says: “Each year a portion of the endowment value is paid out to support the fund’s purpose, and any earnings in excess of this distribution help build the fund’s market value over time. In this way, an endowment fund grows and provides support for its designated purpose in perpetuity.”

For legislators digging into UVa’s controversial Strategic Investment Fund, which is managed by UVIMCO, it would be interesting to know what rate-of-return the university is assuming for its endowment and what percentage it figures on spending and what percentage it figures on retaining. The numbers should be equally interesting to Speaker Howell. It would send out a flashing yellow caution signal if the UVIMCO’s assumption about of future performance was more conservative than that of the VRS.

Another Example of Good Intentions Gone Wrong

Jennifer Doleac

Jennifer Doleac

by James A. Bacon

Last year Governor Terry McAuliffe signed an executive order to “ban the box” prohibiting employers from asking job seekers about their criminal history at the initial job stage. The goal was to “remove unnecessary obstacles” to felons seeking employment after incarceration. How could one object? Once felons have paid their debt to society, we should ease their transition back into the workforce, right?

It turns out that things don’t always work the way we expect them to. From the Daily Progress:

Research published recently by Jennifer Doleac, an assistant professor of public policy and economics at the University of Virginia, found that ban the box policies actually lowered the probability of employment by 5.1 percent for young, low-skilled black men and 2.9 percent for young, low-skilled Hispanic men.

According to Doleac, who conducted the study with the University of Oregon’s Benjamin Hansen, the lowered chance for employment comes from the unwillingness by employers to take chances on hiring someone without knowledge of their potential criminal history.

“Simply taking away information about whether someone has a record doesn’t stop employers from caring about someone’s criminal background,” Doleac said. “It just leaves them to guess based on the remaining information they do have.”

All too often, that “remaining information” is age, race, ethnicity and socioeconomic background. (Hat tip: John Butcher)

Bacon’s bottom line: Society is extraordinarily complex. Political ideologies (both on the left and the right) provide simplified models for how society works. Often those simplified models overlook important linkages and feedback loops that lead to very different results than anticipated. Individuals and private entities can quickly alter their behavior to adjust to reality; government adjusts much more slowly, if at all.

Will McAuliffe rescind his “ban the box” order? I’m not betting on it. The social engineer’s response to problems created by a law or regulation is to “fix” the emergent problem by enacting more laws and regulations… thus creating new problems. 

It’s fine to try new ideas, but we have to pay attention to whether they work or not. If they don’t, we need to reconsider them. Good intentions are not enough.

Yeah, It’s Probably a Good Idea to Update Your Zoning Code Every Half Century or So

Pouring whale oil. At long last, Henrico zoning code will leave the 19th century behind.

Pouring whale oil. At long last, Henrico’s zoning code will leave the 19th century behind.

News flash: Henrico County officials see the need to bring the county zoning code into the 21st century.  Although the zoning code has been amended 240 times, it was adopted in 1960 and has never seen a systematic overhaul since.

The code, Randy Silber, deputy county manager for community development, tells the Richmond Times-Dispatch, is “over 55 years old. It’s antiquated. … There’s disconnect in the uses in the zoning ordinance and the economic development that is being put before us.”

Regulations governing sperm whale oil and poison manufacturing remain on the books, notes Silber. The code also refers to bone distilleries. “I don’t even know what that is,” he says.

The 1960 zoning code shaped the “suburban sprawl” model that propelled Henrico County growth in the 56 years since. But the model has run its course, having saddled the county with vast expanses of low-density land use patterns that are costly to maintain and are beset by intractable road congestion issues. Moreover, businesses are reversing a decades-long migration from the central city to the suburbs as Millennials and Empty Nesters seek walkable, mixed-use communities found in the urban core, along with easy access to the city’s museums, festivals and cultural events. To avoid the same kind of hollowing out that central cities experienced a half century ago, Henrico must create walkable, urban places as well.

While Henrico has permitted a few such places, growth continues to be dominated by old-fashioned sprawl. An outdated zoning code is, in effect, mandating the county’s premature obsolescence.

The fact that county professionals see the need for change is encouraging — although the examples cited in the Times-Dispatch article suggest that they may be in more of a mind to tinker with the code than to embrace an alternative paradigm for development and re-development. It’s also unclear whether the citizenry, which is terrified of any change that might affect their homes’ property values, sees the need for change. But at least it’s a start.

Fed Official Still Optimistic about Offshore Wind

Wind turbines off the Danish coast.

Wind turbines off the Danish coast.

by James A. Bacon

As the cost of offshore wind energy in Europe continues to decline, Abigail Ross Hopper, director of the federal Bureau of Ocean Energy Management, believes that offshore wind will come to the United States eventually.

Responding to a question by Dave Mayfield with the Virginian-Pilot what prospect she sees for ocean wind energy by 2050, she said:

I think there will be turbines running up and down the coast, the Eat Coast and the West Coast, and I don’t think it will be a big deal. Just like I’m looking out the window right now and there’s power lines along the side of the road that I ordinarily don’t see because I’m used to them.

Recently, the Dutch government auctioned rights for two large wind farms in the North Sea. The winning bid came in at the equivalent of about $95 per megawatt hour generated — $40 per megawatt hour below the previous low set by a Danish project just last year. That’s still higher than the cost of other energy sources, but the trend-line is moving in a positive direction.

The U.S. has a lot of catching up to do, Mayfield notes. Compared to the 500 wind turbines off the coast of tiny Denmark, there are five turbines off the East Coast of the U.S. — off Block Island, R.I.

Bacon’s bottom line: Europe is driving down costs now because national governments used massive subsidies to build a large and competitive wind industry, with all the supporting infrastructure and expertise required to install wind turbines in the open sea. That scale and expertise does not exist in the U.S. yet, and given the fact that offshore energy policy is driven mainly by uncoordinated state initiatives, there is no sign that it will develop any time soon.

If all East Coast states could coordinate their policies, they conceivably could generate a critical mass sufficient to entice European major players to set up shop in the U.S. For whatever reason, no one has undertaken the task of getting all the states working together.

Here in Virginia, Dominion Virginia Power investigated the cost of building two experimental turbines off the Virginia Beach Coast. That project would have tested, among other things, innovations designed to help the turbines stand up to hurricane-force winds, thus laying the groundwork for the large-scale deployment of offshore wind power. But the cost of the two experimental turbines was so high that the power company did not think it could get State Corporation Commission approval to build. Progress has stalled since the feds pulled a $40 million research grant.

Virginia has the most to gain of any U.S. state from building a vital offshore wind energy industry because Hampton Roads, centrally located along the East Coast and home to a large ship repair industry, is the most logical location for companies to operate. But the McAuliffe administration has done little — at least nothing visible — to build the interstate cooperation needed to achieve European-style economies of scale. Perhaps that’s because the McAuliffe team has chosen to focus on solar energy, for which the economics are considerably more favorable and the development lead times are much shorter. Given the string of recent solar project announcement, the administration arguably made the right decision.

Mo’ Money Is Not the Answer

by John Butcher

It’s been a while since I sent Jim a bang per buck analysis of school performance. Now that the 2016 SOL data are out, I’ll try to get back in the groove.

In the past I have plotted the raw division SOL pass rates vs. the annual disbursements per student. But comparing bang-for-the-buck between different school systems is a tricky business. We know, for example, that poverty impacts academic performance. As shown in the scatter graph below, economic disadvantage explains about 39% of the variation in 2016 reading test scores.


To level the playing field this year, I’ve adjusted each division’s pass rate to eliminate the effect of economic disadvantage. (I can offer an explanation in the comments, if you’d like to know the details.)


You might notice that six divisions show corrected pass rates exceed 100%. That is because their pass rates were high in the first instance and considerably higher than their average ED would predict.

That rising tide floats all boats: The adjustment also raises the City of Richmond from an actual 60% pass rate to an adjusted 79%.

As to cost, VDOE will not post the 2016 data until sometime this spring so we’ll have to make do with 2015 data for disbursements per student (using end-of-year enrollment).

On that basis, here are the 2016 division average reading pass rates, corrected for the economic disadvantage of the division’s studentbody, plotted vs. the 2015 division disbursements per student.


The fitted line suggests a slight increase in score with disbursement but there is no correlation. That is, spending more per student is not correlated with better pass rates. Continue reading

A Bright Line between Research and Academic Funding at UVa?

Gerald Warburg, professor of public policy at U.Va.’s Frank Batten School of Leadership and Public Policy.

Gerald Warburg, professor of public policy at U.Va.’s Frank Batten School of Leadership and Public Policy.

by James A. Bacon

Gerald Warburg, a professor of public policy at the University of Virginia, provides important context for the university’s controversial, $2.2 billion Strategic Investment Fund. In an op-ed published a week ago in the Virginian-Pilot, he describes the fund as a tool to boost the university’s research mission without relying upon state funds or tuition dollars. The fund should serve as a national model for public universities, he says. He writes:

A decade ago, cuts from Richmond made clear legislators’ conclusion we could no longer afford to bear the financial cost of maintaining world class, state-subsidized research universities.

During the subsequent recession and recovery, U.Va. administrators struggled to reinvent a model public research university. …

Today in Virginia, the funding responsibilities are clear. Tuition, endowment and modest state support will fund access to education and training. The university and external sponsors of academic research are responsible for funding research. No other university in America has addressed this challenge as successfully as the University of Virginia.

Read the whole thing. It’s the most coherent justification I’ve yet seen for the Strategic Investment Fund.

Bacon’s bottom line: If I understand him correctly, Warburg is saying that UVa is drawing a bright line between its academic mission and its research mission, and that the academic mission is funded by tuition and state support, while the research mission is (or will be) funded by the Strategic Investment Fund and external sponsors. Politically, this is an astute way to frame the issue because it alleviates fears that students and parents are helping pay for UVa’s research ambitions.

Creating that bright line is a worthwhile goal, if it can be achieved. I laud Warburg for articulating it. Research universities really do cobble together two distinct missions — academics and research — each of which really should have their own dedicated sources of funding. Students should not be asked to subsidize corporate and federally funded research.

But I have two questions: (1) Are the academic and research functions so intertwined and the funding so inter-mingled that it is even possible to separate research from academics, and (2) where did the money come from to seed the Strategic Investment Fund in the first place?

UVa has not even tried to answer the first question (in fairness, no one has yet asked it), and it has yet to give a clear and comprehensive explanation of the second. University officials have said that some of the funding came from university reserves and some from squirreling away savings from “efficiencies.” One might speculate that other funds have come from budgeted monies unspent at the end of the fiscal year, or budgeted monies not spent on construction projects, or monies accumulated from hospital operations in the same way that the Inova and Carilion health systems have used surplus revenues (what normal people would call profits) to fund their own research initiatives. One could make the argument that any of these sources, known and speculated, were extracted from students or patients and, from an ethical perspective, should be used to reduce tuition and hospital charges.

Hopefully, we’ll be learning the details Aug. 26 when the House Appropriations Subcommittee on Higher Education and the Senate Finance Subcommittee on Education hold hearings on the Strategic Investment Fund.