After a disappointing 2019, the top-ranked South Dakota Retirement System did some housekeeping in the first quarter of 2020, including buying a million shares of an index ETF.
State pension funds control a lot of money, and the fact that tiny South Dakota, the 47th most populous state in the country with only 884,000 people, have a retirement fund that manages over $15 billion really shows us how big pension funds are. That works out to over $16,000 per person in the state, and a whole lot more when you break this down by the far lesser number of people covered by this plan.
It takes a lot of money to fund people’s retirements though, especially with the increased life expectancy people have these days, so these funds need to be big. Pension funds are actually in considerable trouble, where relying on poorly thought strategies has seen them notably underperform market returns year after year and left them in a position where they can no longer meet their obligations on their current course.
At the heart of this crisis is their misunderstanding of the risk side of long-term asset management, and these funds are clearly long-term, looking to manage this pension money and grow it over time so that their retirees can be taken care of from it. They think that they are managing risk well through this culture of fear and confusion, a culture that is so strong that even failure does not provoke an honest appraisal free of their biases.
Now that the decade long stock market party might be over for a while, where the shock on what was once a very stable economic environment may take quite a while to resolve, and with bonds being so bearish, this will really leave these pension funds in a bad spot. Even the embarrassingly low 4.9% that the SD pension fund achieved in 2019 surely is going to be more difficult to achieve now that the bull market appears to be over and we may be running flat to mildly down for a while.
The SD pension fund has actually been the best of the best as far as state pension funds go, but being the best of a bad lot may shouldn’t be that much to crow about when your returns underperform the market by this much. The SD fund hasn’t done all that badly when we look at 10 year returns though, and this is how they earned the title of the best performing state pension fund, with their 11.1% average return coming reasonably close to the return of the SPDR S&P 500 ETF, the benchmark for the market, and easily beating the state pension fund average of 9.5%.
The whole idea behind managing your own portfolio is to achieve above-average performance though, and when you fail at this year after year, this should only be seen as failure, whether or not you beat other state pension funds. The SD Investment Council makes this goal of beating the market pretty clear when they claim that “the Council’s goal is to add value over the long term compared to market indexes.” Stating a goal and actually achieving it isn’t the same thing though, and the structure of their investments actually guarantees that they will fall short of this goal as it turns out.
The excuse that is always given for this is that they are accepting lower returns to manage risk, and that’s actually the crux of the matter, although we don’t want to just rely on platitudes to guide us here. With $15 billion on the line, this merits at least a few questions being asked.
Like many investors, the Council seeks to manage risk by way of asset diversity. They state that “risk is managed by diversifying across multiple asset categories and reducing exposure to expensive assets.” We’re left to wonder how they define “expensive assets” though, but the very idea that an asset could be considered expensive is worrisome in itself.
Perhaps they are referring to stock like Apple, which they just trimmed their position last quarter by 6%. They also mercifully reduced their position in GE by 73%, a stock that has nosedived by 82% since July 2016. It took them this long to sell though and they still have a position in this horrendous stock, apparently without shame.
They also bought a million shares of SPY, the ETF that tracks the S&P 500, which is interesting considering that this is what they are out to beat, in word anyway. We would think that the time and effort that they have put in to do so would allow them to separate the good stocks in this index from the bad and actually at least be in a position to achieve their goal, but that hasn’t been the case in reality. Perhaps if you can’t beat them, you join them, although this position in SPY only represents a fairly small percentage of their assets under management.
With both stocks and bonds having such a stellar year in 2019, we need to wonder how it was even possible to underperform so badly, only earning 4.9%. While SPY had a total return of 29.7% last year, even the most conservative strategy, going 100% in U.S. treasuries did much better than they did, with the benchmark iShares 20+ Treasury ETF returning a total of 16.5% in 2019 and is now up a further 20.5% in 2020.
There’s only one way for this to even be possible, and it’s by making some pretty awful investment decisions. They are supposed to be beating the stock market, but when you get spanked this badly even by the treasury market, the tamest and most conservative game in town, they should be hanging their heads low, not just trying to use the excuse of returns vary by year.
Missing the stock benchmark by 24.8% and the treasury benchmark by 11.6% isn’t easy at all to do, and requires that you be staying the course with some really bad investments. The problem here isn’t so much that they are diluting their returns with bonds, as when even the bonds beat you, the only thing left to cause this is poor stock selection.
To make this even more transparent, their total return over the last 2 years, not counting 2020, has been 12.8%. This number has certainly declined a lot this year, with the hit that their stocks have taken. The 2-year total return of the treasury benchmark is 46.1%, including 2020. This just isn’t a miss, it’s a butchering.
While we are critical of long-term funds leaning too much on bonds, due to their not really having the need to balance assets, when you are this bad at picking stocks, this sort of asset balancing may actually be a good idea, to help save you from yourself.
Since stocks go up a lot more than bonds over time, this is why such a balancing strategy virtually guarantees that you will fail at beating major stock indexes as they claim to be seeking to do. Treasuries have been very hot over the last couple of years, where their value has been run up incredibly by the market, and not only cannot this be counted on going forward, it is expected to take a big turn in the other direction soon, meaning that significant losses may be expected instead of the big gains we’ve seen lately.
It Doesn’t Matter if Your Ideas Are Wrong If You Don’t Care
The SD Council has a bigger problem than this though, and while they are right in that you don’t want to completely focus on short-term returns like this, the very fact that such a thing happened is very disturbing. Without even looking into the matter, we know that whatever criteria they are using to pick stocks is just terrible, because whatever they think will happen to these stocks years from now, the market has wholeheartedly disagreed with their analysis.
The SD Council describes their valuation process as follows: “The Council invests in assets believed to be undervalued from a long-term perspective. The valuation process is based on the view that the worth of an asset is the present value of future cash flows.”
This might seem reasonable to those who do not know much about how stocks work, and this actually comes pretty close to describing how the market prices stocks, where we take the estimated future value of the stock and discount it by degrees of certainty. We can use Apple as an example, where investors will pay a big premium for the stock since the stock is expected to be worth more down the road, from both business performance and continued investor interest.
The investor interest part does serve to skew the results as well, by taking this future expectation and adding to it by having this higher expected value increase demand and price in turn. The SD pension fund does still hold a good piece of Apple, over half a million shares, so this is a stock that has met its criteria, but so did GE, on the complete opposite end of the scale, This shows how wishy-washy their approach is, where two extremes, one of the best stocks and one of the worst can both fit their bill.
We like the idea that the Council is at least looking forward in some way, but if the threshold is so low that GE just fell below it and they are still holding some of this with GE’s prospects so relatively terrible in comparison to other stocks, we know just from this that their valuation scheme is clearly broken.
While we may wish to speculate on the future value of a stock, when we see the actual results come in so terribly, where the market’s future valuation of a stock keeps going down more and more, and we just refuse to admit we are wrong and try to fix the problem, the root cause of our terrible performance has been revealed.
It is not so easy to predict the future at the best of times, and the most we can come away from is a general idea, not the sort of certainty that you would wish to quantify and have these guesses represent your entire strategy, not even caring about how the future valuation by the market itself has done or even where it might be headed.
Regardless of how we may choose to measure the future value of a stock, and looking to predict future cash flows is not a good way at all to do this because it is far too removed from a stock’s price even if we could predict this with any acceptable degree of certainty, we need a way of measuring how we are doing. Seeing a stock like GE decline by over 80%, for instance, screams at us at how wrong we were, but not if we don’t even listen.
The most we can ever do with any acceptable degree of accuracy is to rate companies based upon what we believe are their future prospects in the marketplace, not their future cash flows but their future profitability, in a very broad way, and then ensure that our expectations are being confirmed by the way the market values our stocks in the future. For instance, Apple looks good in the future in a general sense, and GE doesn’t look so good, but that alone isn’t enough. We also need to see stock prices confirm this, and without looking, we are simply choosing to blind ourselves.
GE has had some particular issues with cash flow recently, so it’s not hard to see why their view may have declined finally with this stock. This is not news to the market though and the market did not put the value of this stock down by 82% for no reason, but if you aren’t paying attention, your decisions can indeed lag reality for this long and by this much.
The most disturbing part of the SD Council’s 2019 annual report, and the sentence that illuminates their confusion like no other, reads as follows: “The Council believes market return expectations should be based on forward-looking, long-term cash flows rather than extrapolation of past returns, which tend to relate inversely to future results.”
We’ve already discussed their reliance on future cash flows, but we now know that they are relying on these calculations entirely, come hell or high water. Ignoring “extrapolation of past returns” means that they are willing to completely ignore what is going on in the market, and that’s the scary part.
We have no idea where they get the idea that past returns are inversely related to future results, and there may have been a time long ago when this may have been true to some extent, in the ticker tape days, but surely hasn’t been the case for a long while. While this isn’t as bad as intentionally seeking to buck trends like value investing tries to do, if you choose to ignore them completely, you had better have a good working crystal ball, and theirs is laying on the floor in pieces.
They Definitely Can’t Beat the SPY, so Joining Them is Definitely Better
This cashes out to the view that the market’s future valuation of stocks is irrelevant, and we instead choose to not even pay attention to this in favor of what we believe is a better way. When our better way is not a good one at all, we are doomed to that because we don’t even entertain comparisons, we aren’t even using any sort of real benchmark outside of our ideas, as grandiose as they may turn out to be.
We can’t even back-test such a thing, to see how good or bad our ideas are, because that would involve looking at past results. Instead, they continue to keep the same course, damn the torpedoes, and when they get hit with one like last year, and this year so far, and they still don’t even care to watch either what has happened to your ship or the trouble that this course is headed for, putting it on autopilot based upon a course that has proven to be poorly charted, you only invite more trouble.
At least the SD pension fund have avoided the pitfalls of private equity investing that has been a real plague upon pension funds in general, as they don’t hold any of this stuff, and aside from holding 10% of their portfolio in real estate, they are down to stocks and bonds right now. With neither stocks or bonds looking very bullish right now, and bonds being so bearish over the longer-term, where they can really only decline in value from here, they are likely going to be hit with even bigger torpedoes, where they may long for the simply awful 4.9% that they achieved last year.
It’s fine to want to build a better mousetrap, but if what you build is so bad that the only thing it traps is you, and just stick with it and ignore the pain, this does not bode well for the pensioners in South Dakota.
As long as the SD Council remains infected with these broken ideas about investing, carried over from the days of Howdy Doody, they will remain stuck in the distant past and continue to fail miserably at the task they have taken on, to provide better than market returns, not much worse ones.
The million shares that they just bought in SPY is a start, and given that they have not fared well against the performance of this index, the fact that they can’t beat the index or even come a country mile from it would only serve to narrow the gap between this index and their returns. They can use all the help they can get, and this is at least a step in the right direction.
The Council needs to sit down and take an honest appraisal of how well they are actually doing at achieving their stated goal of beating the market, and this has to be the minimum goal here since they could just put all their money in SPY. We can only imagine the SD Council clutching at their chests at this prospect, and the combination of fear and confusion that these funds are in the grips of is at the heart of the problem.
These funds need to realize that they have the luxury of staying the course, more so than individuals do because they need to worry about retirement, but people retire gradually with a pension plan so they can handle whatever ups and downs the market goes through as it ascends over time.
It would be too much to expect these people to step aside during bear markets, but they don’t have to if they don’t want to, as they can just ride the wave up. They have already proven they can’t pick stocks well, and an index fund is perfect for those who cannot, saving them from themselves, which pension funds need badly.
When they take out the measuring stick which all funds are compared with, which happens to be SPY, and don’t measure up, that should provide them all the insight they need to get started.