Asset owner challenge to balance public, private markets
Monday, May 2, 2016
BY ALLEN R. GILLESPIE | MAY 2, 2016
The South Carolina Retirement System Investment Commission has been criticized internally, externally, and publicly for its high allocation to alternative investments. Our state treasurer, Curtis M. Loftis Jr., who also is a member of the commission, sums up the criticisms as we earn too little, alternative investments cost too much, they are too complex, and they put taxpayers and retirees at risk. He claims the commission should have bought greater amounts of our index funds.
Yes, RSIC could have allocated more to index funds, but not every alternative investment is a stock. So an equity index fund is not the right benchmark or comparison set. Nor is the goal to beat our peers. It is to pay benefits consistently, over a long period of time, not one Federal Reserve-induced market cycle.
Yes, at RSIC we could have allocated more to an index fund, but we would not be indexing the broader capital markets, and therein lies a conundrum.
No one can deny that institutional private equity, real estate and hedge funds are a significant part of the capital markets. Preqin in June 2013 put the size of the private equity industry at $3.6 trillion — that is a lot of market cap missed by equity indexers. Real estate is a market roughly equal in size to the equity markets, and like equities mixed between private and public opportunities, lots missed by the indexes there. Public debt markets are currently characterized by low and negative interest rates. These are capital market realities.
Efficient markets rely on a large number of active participants to make them efficient. Indexers need management teams to properly allocate capital and active investors to arbitrage away inefficiencies because index fund investors do not buy more of a security when its relative price is down. Index fund investors increase their relative security weightings when prices are up. The assumption is that price and value always match, which within reason, most of the time they do thanks to active investors.
Passive investing and active investing are symbiotic. As a result, long-term relative excess returns between the two are time dependent and cyclical. The primary advantage for passive investing is cost, but there is no reason active management cannot be low cost, just ask the “fundamental” indexers. Private equity fees of 2% and 20% above the 8% preferred return are not mandates; these fees are negotiated contract terms.
In addition to keeping cost low, indexers enjoy a free ride on the backs of active investors. Most of the time this works well, until companies go private or never go public at all. Therein lies another conundrum that unfortunately, from a public policy perspective, is increasingly common.
According to the World Federation of Exchanges, in 1998 an index fund of all U.S. traded common stocks would have represented investments in 8,884 companies, whereas in 2013 that same index fund would have only 4,914 companies. Meanwhile, Pitchbook Data Inc., a private equity research firm, listed 1,517 private-equity-backed companies in 2000 but 7,571 private-equity-backed companies in 2013. Score one for active investors; they decided not to play with the index funds. This increasing privatization of the markets is a really bad public policy outcome.
Over the last two decades as a market participant, I have watched as regulations like Sarbanes-Oxley have made it increasingly expensive and difficult for companies to be public. Regulators have sought to protect individual investors to such a degree that institutional investors have said we will just invest and trade among ourselves — we have de-democratized our capital markets by forcing them to go dark and by limiting them to institutions and accredited investors.
The public equity markets reached what should have been peak absurdity just before the financial crisis. This period was characterized by private equity funds using public pension fund money to buy public companies in order to take them private, while private equity fund companies themselves went public. Unfortunately, the Fed's quantitative easing and zero-interest-rate policies have extended the financially engineered environment, which is why investors now believe in private equity unicorns and set-it-and-forget-it indexing at the same time.
The goal of private equity should be to grow private businesses, hopefully to the point where these businesses could become public and close the illiquidity discount between private and public market valuations. The private equity industry should not be about rearranging the balance sheets of previously public companies with Fed-induced leverage or seeking to use institutional public pension fund money to stay forever private.
Another issue with institutional private equity results from the actions of investors themselves. Public pension fund private equity programs constantly recycle cash distributions back into private equity funds, subjecting the capital to more fees and expenses over time. A better solution would be to become a systematic, passive holder of private equity over time by taking distributions in stock to the extent possible. In short, by continuing to hold successful private companies, over time a public fund could have broad exposure to a large number of businesses while bending its cost curve lower. The results over a long period of time would probably be similar to the Jeremy Siegel's study “Long-Term Returns on the Original S&P 500 Companies,” but on the private markets.
Any serious market professional would agree with our treasurer that costs matter. Passive indexing has a place, but it cannot survive without active management. Private equity has a role, but it should not be scaled to de-democratize our public markets.
Alternative managers need to be more transparent when working with public plans, and public plans should think about their collective impact on public markets. Meanwhile, the Securities and Exchange Commission should encourage sensible securities law and rule reforms that promote, rather than discourage, fair markets.
For example, a 65-year-old with enough income and assets is considered an accredited investor, but is he the right investor for a private equity-backed software company when compared to a 30-year-old who understands computers, has an education and a large discounted future value of income but who might fail to qualify as accredited under current regulations. Regarding market microstructure, in Las Vegas a chip laid is a chip played, but in our financial markets, regulators and exchanges have allowed order cancelations and order types to grow exponentially. Investors now worry about the next zero plus tick, trading latency and the Fed put or policy to bailout the stock market, more than long-term capital formation — just ask Ben Bernanke and his new employer. By combining market makers, bad rules, and Fed policy, we have made our financial markets prone to periodic flash crashes. The math to obtain the value of a perpetuity discounted at a rate near zero leads to infinitely high asset prices and small interest rate changes that bring an investor back down to earth. At the same time, the effects of negative to positive, or positive to negative sign changes on the discounted values of cash flows encourage investing either in cash-burning unicorns or any positive cash flow for incremental changes in rates, all calculated on the next tick and central bank move. These risk issues create another conundrum for liquid market participants.
Finally, the Federal Reserve should cease its asset-inflation policies, which push the price of assets beyond the reach of retail savers while destroying fair public markets and price discovery. Public policy makers now worry about income inequality, productivity and job creation, but the solutions to these issues are not in new policies but in fixing the failings of the ones we already have.
Yes, capital markets are efficient, but they require active and thoughtful participation, and for public plans, this requires investing in both private and public markets but with a better understanding of how our markets are linked, the risk they entail and the cost they impose. n
Allen R. Gillespie is a commissioner of the South Carolina Retirement System Investment Commission, Columbia, and chief investment officer and chief compliance officer of FinTrust Investment Advisory Services LLC, Greenville, S.C.
via Pensions and Investments' website on May 2, 2016