In reaction to criticism of costs and performance, Karl Koch, chief investment officer of the $27.65 billion Iowa Public Employees' Retirement System, Des Moines, posted on its website the following response on the use of active and passive investment management as well as performance and fees. The commentary is adapted by P&I from his two postings.
Iowa Public Employees' Retirement System's investment management costs were close to $115 million in 2013. On claims that IPERS could have “saved” more than $1 billion (in investment management fees) over the last 10 years if we would have just invested the IPERS trust fund in low-cost index funds ... we decided to see if that was true.
To test the contention, we modeled a low-cost passive investment approach and back-tested how well this strategy would have done over the last 10 years vs. IPERS' investment strategy. Interestingly, IPERS' investment program, after deduction of all investment costs and removing the impact of cash flows from contributions and benefit payments, would have added about $1.9 billion in extra value vs. the passive approach over that time period!
We also note that IPERS' portfolio did a better job of preserving value in 2008 when stock markets crashed. This is because IPERS' portfolio is better diversified than a simple 60% stocks/40% bonds passive index portfolio. This is important because the more value that IPERS preserves in “down” markets means less money that needs to be collected from members/taxpayers in the form of higher contribution rates to keep the pension system adequately funded.
Costs are important, but you can't focus on costs alone when running an investment program. Certain asset classes can be very expensive, but can also produce high returns and valuable diversification. For example, the private equity program accounts for about 50% of IPERS' annual investment management costs. Our critic would have you believe that we should get rid of private equity because of its high cost. So we looked at what we have earned from private equity since we started investing in 1985 vs. what we would have earned if those dollars were invested in a U.S. stock index fund. Investment costs were deducted from the private equity results to obtain “net of fees” results. We found that IPERS' private equity program has generated over $2 billion more than the passive approach would have earned — after payment of all the investment fees/costs! That is a lot of money that IPERS would have forgone if we had chosen to simply focus on cost and invest only passively.
IPERS is diligent about evaluating and containing investment costs. The IPERS investment board annually receives a benchmarking report from an independent third party that provides a detailed analysis of costs. IPERS has consistently been graded a “low cost” fund in the annual benchmarking reports. Furthermore, IPERS uses passive strategies (index funds) in its investment program to help control costs. We just do not agree that focusing on cost alone will always produce better investment results. We believe a well-diversified portfolio like IPERS' — even one that uses some active management and higher-cost asset classes like private equity and real estate — can produce better results than a 100% passive strategy.
IPERS does not dispute the validity of using low-cost index funds to passively obtain exposure to certain public investment markets. Our approach has been to diversify our investment strategies, using active, semipassive and passive strategies in asset classes where we think they will work best. We do not believe that recent underperformance of some active management strategies, or IPERS' recent underperformance against its policy benchmark, justifies a change to a 100% index fund structure, as proposed by some.
IPERS believes the best place to passively invest is in the most efficient markets — particularly the U.S. stock market. That is why IPERS has approximately 38% of its U.S. stock portfolio invested in traditional passive index funds, and another 29% invested in enhanced index strategies that charge very low fees and take low risk against their benchmarks. In contrast, IPERS' core-plus fixed-income portfolio has only 15% invested in index funds. Why? Because in IPERS' experience, active fixed-income managers have a better track record of consistently adding value, after fees, over passive index returns. In fact, IPERS' core fixed-income portfolio has produced annualized excess returns of 0.46% over its passive benchmark since inception in 1985.
Critics point to IPERS' recent underperformance against its policy benchmark as evidence that active management doesn't work. A longer perspective provides a different answer. According to Wilshire Associates Inc., IPERS' investment consultant, the IPERS fund has outperformed its policy benchmark by an annualized 0.25%, after fees, since IPERS started tracking total fund performance in 1979.
It should be noted, however, that IPERS' policy benchmark might not always be a good benchmark for evaluating the effectiveness of active management because of quirks caused by private market investments. For example, it is not always possible to keep IPERS' private equity program invested at its policy targets, and these temporary “misweights” impact the performance comparison, because the policy benchmark assumes that all asset classes are held at target weights. Likewise, there are no investible market indexes for private markets, and the “proxies” used for those markets in calculating the policy benchmark have not been very good proxies. Thus, performance gaps, good and bad, can occur that have nothing to do with active management.
Rest assured that IPERS evaluates passive vs. active management in its investment process. We are currently evaluating the use of more index funds in the real estate investment trusts portfolio, and I would not rule out the use of more index funds in some other asset classes in the future. However, we do not think it makes sense to forgo opportunities in private markets, or ignore success with active management in some asset classes, by adopting a 100% index fund strategy.