Why would SEPTA hire two new investment managers when they don't know if the spending will result in any more cash going into the agency's retirement fund?
That’s essentially the question Lance Haver asked after the regional transit agency's pension committee voted to bring aboard two new investment firms to join the more than 40 others managing the pension fund's $1.4 billion in assets.
Management fees paid to private money managers has recently become a red-hot topic in the ordinarily gray world of employee retirement funds, and, now, SEPTA has joined the fray.
While SEPTA knows how much it has paid managers in traditional fees, the agency cannot say how much some of its alternative investment managers — real estate investment funds, private equity firms, and hedge funds — have skimmed off the top of the pension’s profits in carried interest.
Like many other public agencies, SEPTA has turned to alternative investment managers to seek better returns over a more traditional portfolio of stocks and bonds, a move that critics say exposes pensions to increased risks and volatility, and much larger fees, without providing significantly better returns.
Speaking before SEPTA’s board, Haver, a longtime progressive activist now serving as policy director of the Save our Safety Net coalition, cited Gov. Tom Wolf and Treasurer Joe Torsella in his call for a more cautious approach to money management. Wolf and Torsella have lambasted the state’s $50 billion Pennsylvania Public School Employees' Retirement System (PSERS) board for spending nearly a half billion dollars in 2017 on private money managers and called on PSERS to shift to low-fee index funds. Haver redirected that request at SEPTA.
“Nothing in the proposal that shows how the net return from the investment is projected to be higher than… investments in index funds,” Haver said. “We should not be investing money in funds if the return is lower than what we could earn without fund managers.”
SEPTA’s pension fund invests 61 percent of its assets in equity — 39 percent in passive funds, and 22 percent in actively managed funds. Fixed-income investments comprise another 23 percent and alternative investments, “including real estate, commodities, private equity, private debt, et cetera,” make up another 16 percent, said Tom McFadden, SEPTA’s chief financial officer.
Haver wants to see SEPTA invest more of its pension in passive funds, which are mostly stock index funds.
Index funds buy a broad swath of stocks, like shares in all the companies on the Standard & Poor’s 500. The investment strategy is simple — follow the ups and downs of the entire market, or at least a large chunk of it — so the management fees are also low compared to actively managed funds, where traders try to pick a handful of stocks in the hopes of beating the market.
The problem is, it’s exceedingly difficult to beat the market in the short-term, and almost unheard of over the long-term.
“There’s simply too much evidence that actively managed funds don’t provide sufficient additional return over and above the return on a passive fund with the same risk to offset the additional fees they charge,” Donald Keim, a professor at Wharton School at the University of Pennsylvania told City & State PA in August.
SEPTA isn’t the only government agency with a pension fund that relies heavily on actively managed funds and alternative investments. The Pew Charitable Trusts recently reviewed the investments made by the 73 largest state public pension funds for 2016 and compared those investments to historic trends.
According to Pew, pension funds across the nation have in recent years more than doubled the size of their alternative investments, which were allocated 26 percent of fund assets in 2016, up from 11 percent in 2006.
Alternative investments include money managed by private equity and hedge funds, plus investments in commodities and real estate that are considered riskier, but potentially more profitable, than traditional investments.
According to Pew, over the “last five to six years” pension investment performance has met target rates, “with average returns of about 7 percent.” SEPTA’s pension follows that broader trend — the fund’s expected return is 7 percent and over the last five years, it’s actual return has been 7.8 percent.
A pension fund’s expected return is used to calculate how much money an agency has to contribute: Higher expected returns means fund managers predict their investments to do well, so they don’t need to add as much new money in. SEPTA’s pension is currently 64 percent funded — just under the national average of 66 percent funded for state pension funds, and significantly better than the City of Philadelphia’s 45 percent funded rate.
Based on a weighted average of the fees charged by the agency’s money managers and the current market value of the fund’s investments, McFadden estimated that SEPTA will spend $7.6 million in management fees this fiscal year.
According to McFadden, the weighted average of the fees SEPTA pays its traditional investment managers — equity and fixed-income — is 34 basis points, or 0.34 percent of market value, slightly higher than the average Pew calculated of paid by state pensions nationally.
SEPTA’s alternative investment managers are paid significantly more: a weighted average fee of 129 basis points of assets under management. Not only is that fee amount higher than more traditional actively managed investment funds — and way more than low-cost index funds — it excludes a bonus that private equity and hedge funds give themselves off the top of profits called “preferred returns.” With preferred returns, when the funds hit a threshold return rate they are allowed to collect “carried interest” above that amount — often between 15 and 20 percent. So if the firm returned 10 percent, and the threshold was 8 percent, that firm would get 20 percent of the 2 percent difference before it sent SEPTA anything.
SEPTA invests with two hedge funds, one managed by Goldman Sachs and another by Magnitude Capital. Including Arrowhead Investment Management and Golub Capital Partners — the two firms approved at the September board meeting — SEPTA has 13 private equity firms managing investments.
SEPTA was unable to say how much its investment managers collected in carried interest bonuses in recent years — it isn’t something the agency actively tracks, McFadden said. Private equity firms and head funds often lock in investments for set time periods — 5 or 10 years — and it’s only after these time horizons that an investor can really know how well their investment in those funds performed. “It’s not easy to calculate,” said McFadden, who said tallying the carried interest amounts would take SEPTA’s lead investment advisor, PFM, a long time. “You got to really dig through the data.”
Despite the unknown amounts spent on higher fees, McFadden insisted that SEPTA’s reliance on alternative investments was sound investing. First, because SEPTA only pays carried interest when the PE firms or hedge funds beat thresholds set above their expected returns, it means SEPTA is still making more money than they would have with a more passive investment.
Alternative investments also helped SEPTA diversify their holdings, McFadden said.
“All of the alternative investments we have, they don’t correlate with normal fixed income or equity investments,” he said. In other words: If the bond market or stock market took a dive, the alternative investments should still do well, reducing the risk of crisis in an economic downturn.
SEPTA’s pension committee isn’t the only state agency making investment decisions without a complete understanding of the costs involved. Pew’s nationwide analysis found “wide variation in the disclosure practices of public funds, and in many cases found policies that make it difficult for policymakers, stakeholders, and the public to gauge actual fund performance.”
In addition to pushing SEPTA to abandon actively managed funds, Haver, the activist, also criticized SEPTA’s unwillingness to leverage the pension fund’s assets by investing them locally, and the lack of diversity among the money managers hired by the agency.
The three complaints are, to an extent, contradictory: more reliance on passive index funds would preclude alternative investments in local real estate, and adhering to stricter diversity hiring requirements would make either of those two investment strategies more difficult (but not impossible) to pull off.
In response, SEPTA said it promotes diversity in fund management hiring through its local and emerging manager policy, said McFadden. The program focuses on smaller money managers based in the region, not necessarily minority-owned firms. “While we don’t have a carve-out for minority hiring, it’s something that the pension committee may look at in the future,” he said.
McFadden did note that one of SEPTA’s larger, and more successful, managers is Edgar Lomax, a black-owned firm that has outperformed SEPTA’s index funds by 3 percent in recent years.
Haver’s recommendation to invest the pension fund locally — specifically into transit-oriented development projects in the region — was met with skepticism. Pension funds are traditionally invested conservatively, and real estate development is considered risky, especially when that development is limited to a specific area, where a regional downturn could be ruinous. “Taking that kind of risk — to invest ourselves, make the determination ourselves, as to what is a good development that we should put money into — is a risk that I'm not sure anyone is willing to take,” said McFadden.