Pension fund returns trail market averages while the money managers they hire are among the richest people in the world. Is it coincidence or an unfair split of investment returns between the funds and their managers?
Pension funds are waking up from this comical misalignment of interests. They are firing active managers who underperform no-fee index funds. The Illinois State Board of Investment, which I chair, got rid of nearly all of them for this reason.
Some managers do, however, outperform market returns. But hold off on the high-fives — it's still often a rotten deal. For example, California Public Employees' Retirement System's private equity portfolio performed better than the broad equity market by about 4.5 percentage points annually over 20 years. But CalPERS could have had similar results by using the same leverage on an index fund. The real winners were the managers who CalPERS says were paid $3.4 billion from 1990 through 2015.
Manager compensation terms that once made sense can become egregious. Private equity firms charge fees on assets that don't exist — undrawn investor commitments. And hedge funds collect "performance" fees on market returns that are available for free through index funds.
So investors get taken advantage of even when returns beat benchmarks. I've long thought that pension funds need to push back, but first they needed a way to measure how much outperformance is lost to fees. So I developed my own rule of thumb: the Levine ratio. The formula is simple: Divide outperformance after fees by outperformance before fees.
Here's how it works. Let's say you hire a manager to picks stocks and he gets a 10% return (before fees) while the broad stock market was up 6%. That's 4 percentage points of outperformance before fees. If the manager charges a 1% fee, the outperformance after fees is 3 percentage points. The Levine ratio here is 75% (3 before/4 after) — the investor keeps 75% of the value created. That's a fair deal.
Everyone has their own definition of fairness. Arizona State University professor Sunil Wahal, a leading researcher on investment decisions, believes the higher the confidence level of outperformance, the more the manager can demand. But even with the best managers, the investors bear the risk of underperformance. That's why they deserve to keep at least half of any returns above index funds — a Levine ratio of 50% or better.
Pension funds have been lackadaisical in protecting their interests. Public-sector compensation constraints play a role. But pension decision-makers also often get a bit starstruck — defensive too; unwilling to admit mistakes.
It's time for this nonsense to end. The Levine ratio can hold both money managers and pension funds accountable — benefiting retirees, public workers and taxpayers, most of whom aren't among the richest people in the world.