In a lengthy interview in yesterday’s Journal, David Swensen, the longtime chief investment officer for Yale’s endowment, had an implicit warning for public pension funds and other supposedly “sophisticated” investors (ha ha) whose overseers think that they can beat the market with “alternative” investments in things like private equity, real estate, and derivatives. While it may seem like closing the barn door after the horse has escaped, trampled the cat, and been run over by an 18-wheeler, Swensen’s words are still important for public-money stewards who may be tempted in upcoming years to become even more creative in their investments to make up for the last year’s losses.
Says Swenson of pension funds and other institutional investors whose managers “think they are emulating Yale” in delving into asset classes beyond stocks and bonds, “they are not.” Unlike Yale, “[m]ost endowments use … consultants, rather than making their own well-informed decisions. You can divide institutional investors into two camps: those who can hire high-quality, active-management investors and those who can’t.”
Swensen excoriates this consultancy world, as well as “funds of funds,” which arewere hedge funds whose claim to fame was that they picked a portfolio of other hedge funds in which to invest. “If an investor can’t make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds?” Swensen asks sensibly. As for the consultants, they “make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered.”
Swenson concludes that he doesn’t think an institutional fund, including a pension fund, can be successful in employing a sophisticated investment strategy unless it employs in house “20 to 25 investment professionals who devote their careers to looking for investment opoprtunities. … If you’re not going to put together a team that can make high-quality decisions, your best alternative is passive investing,” meaning stock and bond index funds and the like.
The techniques that Swensen rightly excoriates are exactly how big public pension funds have executed their own “alternative” investment strategies (although New York State absolutely does deserve some credit for having stayed far away from Bernie Madoff). That is, the public funds have employed consultants, often politically connected ones, and they’ve hired outside managers to do the investment work.
But, as Swensen points up, those outside managers are only as good as the internal managers — in the case of public-pension funds, ultimately the elected officials — who choose them.
Indeed, Swensen doesn’t go far enough here. Even the supposedly best and brightest of internal managers in the private investment world with far superior, earlier information than the information that public pension funds ever got made disastrous choices over the past decade.
In the case of the public funds, then, it’s fair to say that it’s a random process marred by politics.
In light of this grim analysis, Swensen’s suggestion — that institutional investors whose overseers can’t or won’t do their own tough analysis stick to passive investing — is worth thinking about for the public pension funds.
Would elected officials ever direct public funds to even consider analyzing the benefits and costs of such a switch?
If they do, one thing they’ll surely consider, at least in private: Passive investment just doesn’t create the same opportunity for public-sector pension-fund managers to dole out patronage-laden fees (and get campaign contributions and post-public-sector job opportunities in returncoincidentally).
And a passive investment strategy would make it more difficult for public-fund managers and elected officials to convince themselves that they could cut volatility in investment returns.
This delusion has been immensely valuable to elected officials, because it has enabled them to award ever-higher benefits to public-sector workers during the good times.