Executive Director Martin Noven responds to Washington Post op-ed
A recent op-ed argued that “Maryland is wasting its pensioners’ money” by investing system assets in a diversified portfolio rather than simply investing the $70 billion portfolio in a couple of index funds. Doing so would cost the Maryland State Retirement and Pension System, and ultimately State taxpayers, billions of dollars in lost investment earnings. Of even greater concern, the proposal would significantly increase the risk to the portfolio.
Asset allocation has a far greater impact on both risk and return than manager selection or fees. Well diversified portfolios manage risk by ensuring that an investor does not “put all of his or her eggs in one basket.” Reliance on a portfolio that is limited to two index funds would be irresponsible for a pension system because of the very real possibility that both investments could suffer market declines at the same time. While an individual investor with a long investment horizon could wait until the market recovers, pension systems must continue to make payments to retirees and beneficiaries regardless of market conditions.
When managing investments in accordance with an appropriate asset allocation plan, it is important to manage fees properly, which we do. The use of index funds can make sense in efficient markets, where it is more difficult for a manager to beat the index. Other ways to reduce fees that are available to institutional investors include fee negotiations, co-investments, and internal management. Our professional investment team’s use of these tools to effectively manage fees greatly contributes to the substantial outperformance we have experienced.
Last year, we earned $13.3 billion in total returns, beating our benchmark by 2.3%, including $1.2 billion of outperformance, after paying $375 million in management fees. The System paid $373 million in performance-based incentive fees and carried interest to earn more than $1.5 billion in cumulative profits over time.
The highest performing asset class in the portfolio last year was private equity, which earned nearly 52% net of fees. If we had the benefit of hindsight, we would have invested the entire portfolio in private equities last year and generated billions of dollars in additional returns. However, without the benefit of hindsight, it would have been wildly irresponsible.
It would be similarly irresponsible to drastically increase our exposure to stocks and bonds in the manner that has been suggested at this point in the market cycle. Doing so would also be very expensive. Based on current assumptions, the suggested portfolio would be expected to produce a return of 5.4%, significantly lower than the System’s actuarial target of 6.8%. Adopting such a portfolio would cost taxpayers an additional $25 billion over the next twenty years. As the saying goes, “Penny wise and pound foolish!”