State gambles pensions on stock market games


WITH THE election of a Maryland state treasurer, it is worthwhile to take a close look at the performance of the state pension system. With $30 billion in assets helping to secure the benefits of more than 250,000 state workers, retirees and beneficiaries, it's critical that these investments be managed properly.

The pension system's past performance is not encouraging. It has lost a fortune through actively picking and trading stocks, with money managers and mutual funds, all in a futile effort to beat the market when a wealth of experience says that it is not likely to do so over time.

Last fiscal year, the pension system's domestic stocks under-performed the market by 1 1/2 percent when compared with the Russell 3000, an index of stocks used by the system to track the overall market. Over the past five years, the under-performance was more than 2 percent per year.

Discouraging as these figures are, they're unfortunately in line with the experience of other investors. Over the five years ended June 2001, the average mutual fund that actively picked stocks trailed the overall market by 2.2 percent a year. The City of Baltimore Retirement System posted similar results. Its most recent report, for the five years ended June 2000, shows domestic stock investments trailing the market by nearly 3 percent a year.

These percentages might appear small, but they add up fast. With nearly $14 billion invested in U.S. stocks as of June 2001, the state had a shortfall last year of more than $210 million. That's enough money to maintain the last phase of our tax cut. Over five years, the shortfall was well over $1.2 billion. That's enough money to fund the recommendations of the Thornton Commission to reduce inequities and improve Maryland schools.

How did this happen? The simple answer is the high fees and trading costs of actively managed investing. When the pension system pays transaction costs and fees, Wall Street's gain is the state's loss. And beyond disclosed fees and commissions, totaling $62 million last year, active stock picking lowers returns through the spread between bid and ask prices, market effects, system overhead and the underlying costs of mutual funds.

Could the state pick better managers? Possibly, but the odds of the state's managers collectively beating the market are small.

First, the state has more than 25 investment managers. Second, a look at mutual funds that actively pick stocks shows just how hard it is. In any year, only two out of five outperform the market, on average. Over five years, fewer than 20 percent beat the market. And as each year's list of "hot" money managers changes, past performance is simply no guarantee of future results.

Just think how hard it is to win in Las Vegas or betting on sports. Even a good card player or knowledgeable football fan loses over time. The house makes sure of this by adjusting the odds and establishing point spreads. This is the reality for investors as well. The state pays something akin to a point spread - let's call it the price-to-earnings ratio - with every trade. The market - just like a bookie - has set prices where an equal number of people are willing to buy or sell. And that's before costs.

What should the state pension system do? Responding to recent concerns, the system has said it will shift some of its investments from stocks to bonds and hire an investment consultant. While prudent, though, these moves do not address the key issue - how to choose stocks for the best long-term returns.

Common sense and overwhelming evidence suggest that to achieve the best results, the state should not try to beat the market. Instead, it should just try to track the market with an index fund, or what is known as passive investing. The state could "index" its entire U.S. stock portfolio at extremely low costs - about one-hundredth of 1 percent. Returns would be nearly the same as the market. That's the best that a group of active stock pickers are likely to achieve over time, before their costs.

Gary Gensler was undersecretary of the Treasury in the Clinton administration and was a partner of Goldman Sachs. He is the author of The Great Mutual Fund Trap, due out in the fall from Broadway Books.

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