Chicago City Pensions are Broke

Why doesn’t this surprise me?  Nice expose at the Chicago Tribune on city pensions.  Click there and read the whole thing.  We knew Illinois was broke.  Now Chicago pensions are broke too.

Of course, crony capitalism was at play.  Political favors were paid with union pension money.  It sounded good on paper I am sure.  The pension administrators gave money to “Private Equity” funds that invested the money.  Of course, the private equity administrators were friends of Chicago government.

Instead of highlighting all the political corruption, the Trib does a good job of that, I want to highlight a broader point.

You can’t beat the market. From the Trib article,

“The perception out there is that private equity returns are better than returns in the public markets,” Kaplan said. “But the data that’s needed to make those determinations just aren’t there. The best available information suggests that they are about equal to stocks.”

“But the S&P is a stock index made up of 500 companies worth $10 billion to $200 billion. Against public market indexes that track smaller companies, the firm hasn’t done as well. The Russell 2000 Index, for example, has had annualized returns that are more than double SB’s returns.

One Chicago pension fund that steered clear of private equity and real estate seems to be weathering the financial crisis better than other city funds.

By sticking to a portfolio of basic stocks and bonds, the Metropolitan Water Reclamation District pension fund’s assets lost 14 percent of their value from 2005 to 2009, according to financial documents reviewed by the Tribune. Meanwhile, the teachers, municipal and laborers funds lost more than 20 percent, and the firefighters fund lost more than 33 percent.

“Our board is very conservative in its approach,” said Susan Boutin, executive director of the water district’s fund. “They feel they have a commitment to employees and retirees to not take on those kinds of risks.”

The water district also spends less on consultants, asset managers and administrative expenses as a percentage of total assets than the other city funds.

Other funds are paying huge fees even for investments that have failed to meet their expectations. For instance, over the last seven years, the teachers and municipal pension funds have invested $30 million in the Chicago-based private equity firm Hispania Capital Partners. So far, the investment is worth $4.2 million less than what was put into it.

That’s one of the worst performances found in the Tribune’s analysis. But every year, because of management fees, Hispania’s end of the deal grows. So far, it has received $2.3 million in fees.

SB Partners, a small private equity firm run by the former chief executive officer of Shorebank out of a single-family home in Holland, Mich., received $9.4 million from the municipal and laborers pension funds since 2000 while collecting more than $940,000 in fees.

It has invested in eight companies, including a string of Taco Bell franchises in Mississippi, Florida and Alabama; a water-heater leasing company in Wisconsin; and a single-location pharmacy in Denver.

At the end of 2009, SB had an annualized rate of return of about 4 percent, according to pension fund documents.”

Coincidentally, there is an article in the Wall Street Journal by Burton Malkiel. It talks about buy and hold investing.  “Low-cost index funds regularly outperform two-thirds of actively managed funds, and the one-third of actively managed funds that outperform changes from period to period. Even the very few professional investors who have beaten the market over long periods of time—Berkshire Hathaway’s Warren Buffett and Yale University’s David Swensen, for instance—are quick to advise that investors are likely to be much better off with simple low-cost index funds than with expensive actively managed funds.”

This is an important concept for the average investor.  Toss your money into a passive mutual fund and dollar cost average.  Over the long haul, you will make more money, and spend less money in fees.  The markets of the past two years have proven that concept beyond a shadow of a doubt.

Certainly you should diversify.  Buy the S+P, the Russell, and other countries indexes.  But, buy passive no load indexes.  When it comes time to retire, you will be glad you did.

If you want to seek higher returns, you have to assume more risk.  Using futures and options can increase returns.  Why is the cash equity market efficient when futures markets are not?  The answer is margin and time. Futures markets respond to information and have volatile moves up and down depending on a lot of factors. But as the time of expiration draws near, futures markets get less volatile and approach the price of the cash market.  Options follow the Black Scholes mathematical formula, but also move around a lot in response to news, speculation and time.

Other ways to seek higher returns are to invest in start up companies.  You could also start one by yourself.  But if you put money in a VC fund or a Private Equity fund, the returns are 100% determined by how savvy that manager is.  They aren’t determined by the market.

University of Chicago Booth Graduate School of Business professor Eugene Fama first hypothesized the theory of efficient markets in 1962.  He has been proven correct.  Time to give him a Nobel Prize for Economics.

These are important lessons that everyone needs to know.  No one can consistently beat the stock market. No one.

tip of the hat to Instapundit, thanks for the link!

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    You mean us ‘little people’ have to accept more risk to get higher returns. Not so much the big boys, if their ‘risk’ actualizes, they just get the government to bail them out, and skip home with millions in their pockets. La la la!

    • pointsnfigures

      Actually “West and Jill”, you decrease your risk by investing passively. You accept the beta risk of the market, not the beta risk of an individual sector or stock.

  • lisa

    Shorebank involved again? It seems to be a breeding ground for Chicago’s crony capitalism.

  • Horn

    There are several dozen investors who have consistently beaten the market over several decades, over millions of trades in some instances: Jim Simons for one has averaged over 30% per year for almost 30 years now.

    John Neff beat the market by 3% annually over 36 years, and that is after all costs and fees. Your bolded statement is entirely, 100% wrong.

    It’s simply really, really, really hard to beat the market. Just like it’s really, really hard to make the NBA. But the really smart, technologically savvy people DO beat the average person. You are entitled to your own opinion, but not your own facts.

    • pointsnfigures

      Horn, you are incorrect. You can pick a few people that have beaten the market. But on the whole, no one has. Everyone can find a needle in a haystack. The average investor cannot beat the market.

      Would be interesting to see how Neff, Simons and anyone else beat the market. Did they open their books to have their returns audited? Was it on one stock that they might have had some inside knowledge (not illegal inside knowledge, but intuitive knowledge) Peter Lynch also beat the market-one or two stocks accounted for most of his gains.

      For every fund manager that beats the market, there is a fund manager that doesn’t. As the article says, “Low-cost passive (index-fund) investing remains an excellent strategy for at least the core of every portfolio. Even if markets may not always be efficiently priced, index funds must produce above-average returns after costs. All the stocks in the market must be held by someone. Therefore, if one active portfolio manager is holding the better-performing stocks, then some other active manager must be holding those with below-average returns. But active managers charge substantial investment fees, and their buying and selling of securities in their attempt to beat the market generates significant transaction costs (and possibly greater taxes). Index mutual funds and their exchange-traded-fund (ETF) cousins do not trade from security to security, and they charge rock-bottom expenses (usually well below one-tenth of 1%).”

      It is possible to beat the market if you assume more risk by juicing the portfolio with options, futures etc. But the average Joe on the street cannot beat the market. Not only do they not have enough information, but the entire system is stacked against them.

      It is totally irresponsible to sell the average Joe on the notion they can beat the market. You do them a disservice.

      • Anonymous

        “You can pick a few people that have beaten the market. But on the whole, no one has.”

        The article says that “no one can consistently beat the market; no one.” Horn pointed out that it has been done. Has Warren Buffet not consistently beaten the market? Peter Lynch? The Prudent Speculator? I consistently beat the market in the 90s, and have reaped the rewards since.

        So, yes, there are some who can consistently beat the market, and it’s not a needle in the haystack either.

        Now, on the other hand, if you have billions in pension funds, and have politicians in your face saying where to put your money, I would certainly agree, it’s hard at that point to beat the market. The small investor, as warren Buffet has always noted can sit and wait for the perfect pitch and then hold and hold…no one to report to. There are a lot more out there because you’ll never hear of them. A friend of mine does this strategy (if you can call it that) and guess what? He has consistently beaten the market, which I define by the way as about the 7% the market gets for returns on average over long periods of time.

        • pointsnfigures

          hdavehh, Warren Buffett hasn’t beaten the market every year he has operated. Peter Lynch didn’t every year. As you said, Buffett and Lynch saw deals that no one else got a look at.

          Joe Average Investor cannot beat the market. We are talking about pension funds here. Working people that relied on a fund manager to invest wisely. Why wouldn’t anyone advocate putting money in a passive no load fund. It’s criminal what happened in Chicago.

          • Anonymous

            Actually, Buffet and Lynch invested in deals that everyone could look at but ignored, especially Lynch. Buffet was also good at buying private, well managed companies that any other well heeled investor could have pursued but chose not to, because many investors love the glamor stocks and not the money makers like See’s candies, Jordan’s furniture and Nebraska Furniture Mart. One of Lynch’s investments was Dunkin Donuts. If you had bought that single stock as an individual, you would have beaten the market in truly magnificent multiples.

            Joe the average investor CAN beat the market. I know. I am Joe the average investor. And I have beaten the market consistently over a long period of time. How do I know? I add up my own results.

            Funds will never beat the market in part because they ARE the market, especially when you have billions, see an opportunity, only to find out that you really can’t get a great price on a small company because you have too much to spend. That’s the big difference between big and average Joe.

            Pensions are a nightmare because they overpromise benefits they can’t deliver. Another story altogether.

      • Mike


        Your first paragraph says it all. “You can pick a few people that have beaten the market. But on the whole, no one has.”

        How can you say a can pick a few people who have beaten the market and in the very next breath say that no one has? It seems that you should be saying that the average investors is unlikely to beat the market and leave it at that.

        Further, if you come from the trading floor, then you know hundreds of people who beat the market for years. The key to beating the market is finding inefficiencies and exploiting them. In the days of trading pits that meant standing next to the broker who would show you his deck. Today the inefficiencies are more subtle but they are still there

        • pointsnfigures

          Mike, I think I delineated clearly between futures and cash equities. You can beat the market in futures. Why? Margin. Markets are volatile. You can’t beat the market in cash equities on a consistent year over year basis, unless you have more information than the market.

          We call that insider trading. It’s why Senators and Congressman consistently beat the market when they are in office! (and why the net present value of a campaign makes sense!)

      • b b

        i think that you tend to overgeneralize, for these reasons amongst many others:- there is a huge herd of wolves, the so called institutional money managers. their goal is not to beat the market but to optimize their year end bonus based on their relative performance to benchmarks.- most money managers are confined within a sector and most can play only the long side. how much does a money market fund manager make now? what are his options to improve?- there are politburo style asset allocations that make most of the time significant outperformance nearly impossible. needless to say, such confines do not attract the best managers.none of this is the result or the cause of EMH in action, it is the result of non economic decisions which have overwhelmed the market with the development of the mutual fund industry.

        • pointsnfigures

          The market is a huge, faceless amoeba. There are several groups interacting for their own self interest. Institutional fund managers certainly act in their own self interest, so do money managers.

          I think your point is correct and strengthens, not weakens the argument for the average investor to invest in a no load, low fee mutual fund that replicates the market.

          • b b

            i agree with you if you are trying to say that the average joe has as much a chance beating the market consistently as much as he has a chance of beating roger federer on the tennis court. but this is just saying that if a person is not good at something he should not be expecting great results. with the proper dedication, training and reslove and with good incentives to outperform anyone could beat the average of the market.yes, there are good traders and good managers that outperform, i bet you are in this group, but the market as a whole is just as good… as the market as a whole.

          • pointsnfigures

            BB, I am a pretty shitty stock trader. Used to be a really good futures trader. But futures markets are inefficient by design. Stocks are not.

            Very very few people can beat the market. It’s so small in the realm of statistics that we are talking 3 or more standard deviations from the mean.

          • b b

            i beg to differ with you quite a bit: all markets are inefficient pretty much all the time. the price is where supply and demand intercept, things like fundamental value matter little, it is all about momentum that is mostly driven by expectations of some sort…
            and given the omnipresence of prices that are fundamentally divorced from the valuation process we end up having busts and bubbles. it is indeed true that value is the use that you derive from an item and price is what the next greatest fool is willing to pay you to possess that same item…

            how many of the stockholders excercise their rights as such? and how many are holding stocks with the sole expectation to gain from capital appreciation and some dividends along the way? could a market be efficiently priced if value is more or less irrelevant?

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  • Georgiaboy61

    Defined benefit pensions should be illegal in the public sector; they are financial “weapons of mass destruction,” to borrow Buffett’s phrase. Of course, Illinois is going to go to Obama, hat in hand, for a bailout. After all, it’s the Chicago Way!

  • journeymananalyst

    Richard P. Howard ran the T.Rowe Price Capital Appreciation stock fund from 1992-2002 and the fund was UP every year, far surpassing the SPX. He is now managing separate accounts for Prospector Partners in Guilford, CT and has had positive results for seven of the past eight years, again outdistancing the SPX by a huge margin. His new mutual fund now has a three year track record and just received a 5 star rating from Morningstar and is ranked 2nd out of over 400 funds in its categoryover the three years ending 9/30/10. This guy defies your conclusion.

    • Jeff Carter

      Can the average investor replicate his return? The answer is probably no, and that’s why we pay him the big bucks. But if every investor invested with him, then he would be the market.
      Can we replicate it? Probably not. If he killed the market by a lot, that means there were a lot of money managers underwhelming the S+P. The people that picked him were lucky.
      Was he only trading stocks? Or did he also utilize options and futures? Makes a difference.
      Lastly, How’d he do after costs?

  • b b

    you are a believer in EMH? i want to take a picture with you before you change your mind :)