Incompetence or Deceit?
By
Dr. Rudy Fichtenbaum
April 23, 2022
At the beginning of the last meeting of the STRS Board, there was a surprise item added to the agenda, a presentation by Bill Neville. Normally, Board members receive the agenda, all the presentations and pages and pages of other material late on Friday, the week before the meeting. But the presentation by Mr. Neville was added to Board packets at 7:59 AM on the morning of the meeting. Thus, I did not see the presentation until I turned on my computer to bring up what I thought was going to be the first item on the agenda.
Mr. Neville tried to justify his surprise presentation by saying that he was “listening to the ideas of members,” some of whom had suggested that STRS would be better off indexing our investments.Of course, any suggestion that we might not need a large investment staff needs to be laid to rest at every opportunity by Mr. Neville and the senior staff so that they can justify their enormous salaries and bonuses.
Immediately upon seeing and hearing Mr. Neville’s presentation, Mr. Steen and I both asked to get a copy of the data used to make the graphs in the presentation. Mr. Worley conveniently forgot about the request during his summary, and I politely reminded him of our request. I also wrote to him yesterday to remind him of our request. It is clear from the presentation that the graphs were made using Excel, and so the data is readily available. But I still have not received the data. So much for transparency!
Before I get to the topic at hand, I first want to explain why I believe active investing is a fool’s errand. Making money by trading securities happens when securities are bought and sold. Most of the time, people sell a security because they think the price is going to go down. But for someone to sell, there needs to be a buyer, and that person is buying based on the belief that the price will go up. So, in every trade, there is a winner and a loser. With trading, it is virtually guaranteed that 50% of the people win and 50% of the people lose. The problem is that trading is not free. For the 50% of the people who come out on the winning side of the trade, they need to win by more than the fees,or they also end up losing, too. This is why 94% of all large-cap funds underperformed their benchmarks between January 1, 2001, and December 31, 2020. Moreover, these are funds that are judged by real investable benchmarks--i.e., an index--not some “custom blended benchmark” or comparison to peers. Imagine an actively managed fund saying we do better than 70% of our peers when 94% of those peers are losing to an investible benchmark. It is for this reason that index investing has become so popular.
I advocated index investing when I ran for the Board, and I am still an advocate of index investing, something Mr. Neville is aware of since we have discussed this on several occasions. However, I want to be clear that I have never advocated investing all our funds in the S&P 500 or even in the Russell 3000, which is a broader index. Diversification, investing in asset classes that are uncorrelated, is important.
Mr. Neville claims that he asked Matt Worley if they could look at whether STRS beat the S&P 500 taking into consideration STRS’s net cash flows. Here is what he came up with:
First, it is not a mistake that Mr. Neville’s investment staff chose 1999 as the starting point for its analysis. As you can see from the graph, this was right before the dot-com bubble burst and that was followed by the Great Financial Crisis. The losses in the stock market in both crises were tremendous, which clearly puts a stock-only index at a disadvantage against any diversified portfolio. Even so, STRS barely survived the crisis in 2008, and it was these two back-to-back crises that led to the drop in funding. Mr. Neville and his investment staff like to promote the idea that their investments have helped restore STRS’s funding level. But the truth is that most of the improvement in STRS’s funding status, especially before 2021, was due to pension cuts (pension reform) that were made in 2012 and again in 2017 when the COLA was eliminated.
So, what does the graph show us? It shows STRS (the orange line) outperforming the Russell 3000(the green line) and outperforming the S&P 500 index (the blue line). Both the Russell 3000 and the S&P 500 are what we refer to as cap-weighted indices, which means that they are based on multiplying the price of a stock times the number of shares outstanding. Thus, the only thing that makes an index go up (holding the number of shares constant) is that the prices of the stocks in an index go up. When this happens, it results in a capital gain--i.e., the value of the individual shares that make up the stocks in the index go up.
At first blush, it appears that Mr. Neville has made his case: index investing is for losers, and had it not been for active investing strategy of STRS investment staff we would still be in a big hole. One of the things that you do when you think you have just made a devastating argument, especially in the middle of an election campaign, where all the incumbents have been the biggest cheerleaders for the staff, is immediately put your findings out in a newsletter to tell the entire world about your findings.
However, apart from cherry picking the starting date of the analysis, there is a more fundamental problem with the Neville-Worley conjecture. That problem would be evident to a first-year business student. Perhaps Mr. Neville and Mr. Worley were absent when their professors explained that there are two ways of making money when you own stock. The first occurs when the price per share goes up, known as a capital gain. That is what you see every day on CNBC or on your smartphone when you look at the Russell 3000 and the S&P 500 index. But the other way in which individuals or institutions make money by owning stock is through dividends. Dividends are the share of the profits that get paid to stock owners. Leaving that out of the analysis is such an elementary mistake that it is hard to believe that people in change of a $100 billion pension could make such an egregious error.
If you go to Yahoo Finance and type into the search bar “S&P 500 Total Return,” you will see a different S&P 500 index, one that shows both capital gains and dividends. Unless Mr. Neville and Mr. Worley don’t believe that dividends exist or that they are unimportant, that is the index they should have been using to see if their active management strategies are really paying off. There is of course also a Russell 3000 total return index, as well. What happens when you take dividends into account? Let’s see what the Watchdog found using the cherry-picked starting point chosen by Mr.Neville and Mr. Worley.
The dashed green line shows the Russell 3000 without dividends and the blue dashed line shows the S&P 500 without dividends. Lo and behold, the total return of STRS shown with the orange line beats both hands down. But now look at the solid green line and the solid blue line, and you will see that both the S&P 500 with dividends and the Russell 3000 with dividends beat the STRS total return. Still don’t think dividends are important?
Now let’s look at a starting point that is not cherry-picked, and we will see the results are even more stark. The graphs below show the difference between the performance of the Russell 3000 index (solid green) and the S&P 500 (solid blue) and the actively managed STRS return in orange.But have no fear--the solid orange line is slightly above the STRS benchmarks, and so despite the dismal performance compared to the Russell 3000 and the S&P 500, investment staff still “earned” their bonuses.
Given the amount by which the index funds have outperformed STRS’s active mismanagement strategy, it seems likely that one could construct a diversified portfolio anchored by index funds that would outperform STRS’s total fund performance.
Mr. Neville had three takeaways that are summarized in the E-update. I won’t repeat them since they are all demonstrably false. In fact, the only takeaways I see are the cuts in member benefits for active teachers and the elimination of a real COLA for retirees.
The question we must now ask ourselves is how is it that such a flawed analysis was presented and is now being promoted in the middle of an election by the STRS propaganda machine? Is it incompetence or was it an attempt to deliberately mislead the Board and the public so that the senior staff could continue receiving their huge salaries and bonuses? Either way, clearly it is time for new leadership at STRS. Mr. Neville and Mr. Worley should resign. Finally, STRS members need to elect a Board that will hold staff accountable by asking hard questions and by being skeptical of claims that are “too good to be true.” STRS is broken, and the only people who can fix it are the members.
Dr. Rudy
Fichtenbaum is Professor Emeritus of Economics at Wright State
University. He is an elected member of the STRS Ohio Board, filling a
retiree seat since September 2021. He and Wade Steen are the most
outspoken Board members who are pushing for reform on behalf of both
active and retired teachers, especially in their opposition to Board
members who follow the dictates of OEA instead of advocating solely
for the STRS stakeholders.
