New York Discovers Wall Street Charges Fees
How much should you pay for investment management? I feel like a good benchmark is the expense ratio of the Vanguard 500 Index Fund's small-investor shares, which is 0.17 percent. If you're a big investor and you're mostly trying to match the market, you should be charged a bit less than that. (Vanguard's class of shares for bigger investors charges 0.05 percent.) If you're doing fancy things to try to beat the market, you will be charged more; the average actively managed equity mutual fund charges something like 0.89 percent. Whether those fancy things provide any extra value is, of course, a hotly debated topic.
How much do New York City pension funds pay for investment management? Here is a very weird press release from New York City Comptroller Scott M. Stringer, and an accompanying New York Times story, both of which carefully avoid saying how much those funds pay, though they're quite sure it's too much. The Times headline is "Wall Street Fees Wipe Out $2.5 Billion in New York City Pension Gains," and Stringer's is "Billions in Pension Fund Fees Paid to Wall Street Have Failed to Provide Value to Taxpayers," so that sounds bad. From the Times:
The analysis concluded that, over the past 10 years, the five pension funds have paid more than $2 billion in fees to money managers and have received virtually nothing in return, Comptroller Scott M. Stringer said in an interview on Wednesday.
“We asked a simple question: Are we getting value for the fees we’re paying to Wall Street?” Mr. Stringer said. “The answer, based on this 10-year analysis, is no.”
Until now, Mr. Stringer said, the pension funds have reported the performance of many of their investments before taking the fees paid to money managers into account. After factoring in those fees, his staff found that they had dragged the overall returns $2.5 billion below expectations over the last 10 years.
There are two big, more or less unrelated, conclusions in the comptroller's analysis, by Chief Investment Officer Scott Evans and the Bureau of Asset Management. The first is that, apparently, the pension funds never noticed that they were being charged fees on their public-market investments. The funds report the performance of their public investments (stocks, bonds) gross of fees, but their private investments (private equity, real estate) net of fees. When they went and looked, they noticed that the fees on their public investments totaled more than $2 billion over the last 10 years. And that was too much:
Managers of public asset classes exceeded the benchmark slightly. However, those managers gobbled up more than 95 percent of the value added -- over $2 billion -- leaving almost no extra return for the Funds, which provide retirement benefits for 715,000 City workers, retirees and their beneficiaries.
But is $2 billion in fees a lot or a little? Well, the funds have $159.6 billion in invested assets as of January 2015, up from $88.7 billion 10 years ago; about $140 billion of the current assets are in public markets. Figure average public-market assets over the last 10 years were, I don't know, $100 billion? So $2 billion in fees is 2 percent over 10 years, or about 0.20 percent a year. It's not quite as cheap as a Vanguard index fund, but it's pretty cheap.
That calculation is of course a vague hand-wave, but it seems to get pretty close to the real number. The annual report for the New York City Employees' Retirement System, one of the biggest of the funds, shows $140.6 million in fees for investment managers, consultants and lawyers (page 142), and another $5.9 million in brokerage commissions (page 154), in fiscal 2014. That's on total assets of $60.8 billion as of the end of the year (page 129), for total fees of about 0.24 percent a year on all assets, including private assets. Still cheap!
You can break those fees down further. The fees that NYCERS pays for U.S. domestic public equities are about 0.08 percent a year, more or less Vanguard levels. For international equities, which are a bit harder to just index and forget about, the fees are 0.28 percent. For bonds, they're 0.14 percent. The big fees are for private equity, which ran about 1.3 percent last year; real-estate and hedge-fund investments charged about 1.1 and 1.2 percent, respectively, last year. But the fees on public-market investments are in the 8 to 28 basis point range.
Is that too much? I don't know! It's super cheap compared to most mutual funds; on the other hand, New York City pension funds have a ton of money, and they really should get a fee break. "New York pays 0.2 percent a year for investment management" doesn't strike me as particularly offensive, but obviously the $2 billion thing offends some people. (One easy trick: Express it as a 10-year cost, rather than an annual cost, and it sounds 10 times as big!) Also apparently upsetting is the fact that those fees eat up most of the managers' outperformance. That again doesn't offend me: In a competitive market for investment performance, managers should charge fees equal to their outperformance. Actually my simple dumb model for investment management fees is that managers should, on the whole, charge more than the value they add, since (1) good managers who add value should charge fees equal to the value they add, (2) bad managers who don't add value should charge fees equal to the value that the good managers add, and (3) there are at least as many bad managers as good ones. So I think New York's pensions are doing rather well in getting the managers to give up any of their outperformance.
Also, while the managers may have "gobbled up more than 95 percent of the value added," versus the benchmark, that doesn't mean that they gobbled up a meaningful amount of the funds' total returns. Here are returns for NYCERS, apparently gross of fees (?) :
So for instance in U.S. equities the funds got annual returns of 8.24 percent for 10 years, versus annual fees for U.S. equities of about 0.08 percent. So the funds got 99 percent of the returns on their investment, and the managers got 1 percent of those returns. Again, paying managers 1 percent of the returns they generate does not seem particularly egregious to me, though I suppose there's an argument the other way.
The second big conclusion of Evans's analysis is that the pension funds are overpaying for private-equity and real-estate investments, to the tune of $2.5 billion over 10 years. This is not so much an argument about fees -- again, as far as I can tell, those fees run a little more than 1 percent a year, much higher than public-market fees but not obviously extortionate -- but about performance. This complaint is also odd, though less odd than the public-market one. As you can see in the table above, private equity and private real estate have significantly outperformed public markets over the last 10 years, returning 11 percent and 8.64 percent, respectively, versus 8.23 percent for U.S. public equities and 7.52 percent for the overall portfolio. But here's a slide from Evans's analysis with different numbers:
On his math, private equity returned 9.6 percent, well below its "public market equivalent" of 13.1 percent. Private equity seems, at least on my math, to have outperformed the public markets, but not to have outperformed its public market equivalent, which is just public-market performance plus an arbitrary bonus of 3 percent. New York's actually existing private equity managers underperformed its hypothetical private equity managers, who hypothetically provided above-market returns.
It is hard to know how offended to be by that. On the one hand, it's a bit harsh to say that managers who outperform the public markets, but underperform an imaginary number, are adding no value, or negative value, or are "a whopping negative -- a drag of more than $2.5 billion -- since the end of 2004." Like you could just make up a different imaginary number. A manager who provides returns that are above the market, but below your desires, is adding value; he's just not adding as much value as you want.
That said you can sympathize with Evans's math. Above-market "public market equivalent" comparisons are basically respectable: Private equity does tend to be less liquid and more levered than public equities, and if it provides only market-level or slightly-above-market returns, at higher risk and higher fees, then perhaps you should be investing in public equities instead. It would not be crazy for New York's pensions to conclude, from this math, that private equity's returns are not worth its costs, at least on average. Nor would it be crazy to conclude that some managers are worth the costs, and some aren't, and going forward the funds should only invest with the managers who are worth it.
None of this seems like a blanket reason to condemn "Wall Street," but, you know, politicians gotta politick. My takeaways are something like:
- New York pension funds' performance is fine.
- They pay fees that, over all, are quite low.
- Their alternative investments seem to somewhat outperform public-market benchmarks, though maybe not as much as they'd like.
Meh? That reading is very much at odds with stuff like this:
“We need to demand more value from Wall Street when they invest the hard-earned pension dollars of our workers, because right now money managers are being paid exorbitant fees even when they fail to meet baseline targets,” Comptroller Stringer said. “When you do the math on what we pay Wall Street to actively manage our funds, it’s shocking to realize that fees have not only wiped out any benefit to the funds, but have in fact cost taxpayers billions of dollars in lost returns. It’s clear that the status quo needs to change.”
“The fees are exorbitant and we’re not getting a good return on our money,” said Henry Garrido, executive director of District Council 37 and a trustee of the New York City Employees’ Retirement System. “That’s an insane process to keep doing the same thing over and over.”
That's kind of a weird thing for a trust fiduciary to say, isn't it? Trustees are supposed to act "as a prudent person would with 'reasonable care, skill and caution.'" Surely if you yourself confess that you are acting "insane," you are not doing your duties as a trustee? If I were a New York City pensioner I'd be a little disturbed to see my trustees running around calling their investment process insane.
But obviously this analysis is not about the investment process, or about a dispassionate evaluation of different asset classes. It's to take some shots at a vaguely defined enemy called "Wall Street." And Stringer is in a great position to do that: If you have a big pile of money, and you ask professionals to manage it for many years, and you add up the fees that they've charged over all those years, you will get a big number, and then you can complain about it without context. I am not so sure that this improves your investment process, or the public's understanding of how finance works. But obviously some people find it satisfying.
Disclosure: I do a lot of my investing in Vanguard index funds.
All I'm doing is dividing the fees by the assets under management for the various classes on pages 135 to 141. The AUMs don't quite match up with the total assets on the other pages, presumably because some assets are managed in other ways, but they're close enough.
Page 128 of the NYCERS report says "All investment results are time-weighted rates of return that are reported gross of fees, and are based on market values." I don't know how that squares with the comptroller's statement that private investments are reported net of fees.
I'm just assuming that last year's fees were the same as the previous nine years' fees, which may not be true; perhaps fees have come down over time. But if so it'd be weird to complain about the old fees now.
Ignoring fees because I genuinely don't know what that table is doing about fees.
The benchmark seems to be the Russell 3000 index plus 3 percentage points. So from the NYCERS annual report, which reports private-equity performance (11 percent annualized, or maybe 9.7 percent net of fees assuming that 11 percent is gross) and Russell 3000 performance (8.2 percent), private equity seems to beat the Russell 3000 but not Russell 3000 plus 3 percent. From Evans's analysis, though, which uses a somewhat different methodology, it looks like private equity slightly underperforms even the Russell 3000 without the extra 3 percent.
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