Rudy Fichtenbaum and a simple question for STRS and Callan

Where’s the Alpha?

Rudy Fichtenbaum 

August 24, 2023

Sometimes a picture is truly worth a thousand words, and this truism would appear to apply to understanding STRS returns. Since I have been on the Board, I have been arguing that active investing is a losing proposition. The STRS staff likes active investing -- picking winners and losers--because they get rewarded for beating benchmarks. The alternative to active investing is known as passive investing, which is index investing.

At the last Board meeting, in the discussion over Performance-Based Incentives (PBI a.k.a. bonuses), I pointed out that STRS has for years been comparing gross returns to benchmarks at the asset class. This is cheating. What is being done is not illegal because the policy of allowing gross returns to be compared to benchmarks has been approved by the Board, although it may very well be the case that most Board members did not know exactly what they were approving, or the implications of what they were approving.

I pointed out the use of these gross returns was totally misleading and asked why we were not deducting all expenses, both internal and external, from investment returns at the asset-class level. The response from the STRS staff was that we don’t have the internal expense data at the asset-class level, and so the best we can do is use semi-gross returns i.e., returns that are not net of internal expenses.

Why is this important? Think about it this way. Suppose you had a choice between putting some money into Bank A or Bank B. Bank A pays 5% interest but charges a 1% fee. Bank B pays 4.75% interest and charges a 0.25% fee. Hopefully it is obvious that if you deposit $100 into Bank A your gross earnings will be $5 compared to $4.75 in Bank B. But after fees you would have earned $4, net of fees from Bank A and $4.50 in Bank B. For STRS it is only the net amount i.e., the amount of money after fees that matters when it comes to paying benefits. So, in measuring performance all that really matters is the net return.

Well, it turns out that there is expense data at the asset-class level in a report that the CEM provides the Board every year. And according to CEM, they get their information from the STRS staff. I will have more to say about these expenses in a future post. But for now, I want to show you an example of why expenses matter and offer proof that passive (index) investing outperforms active investing.

The graph below shows annualized five-year net returns (returns after expenses) for STRS large-cap stocks from 2016-2020. The analysis ends at 2020 because that is the last annual CEM report made available to the Board. The first bar (in green) shows STRS internal passive returns for large-cap stocks was 16.4%. In 2020, passive investing accounted for 39% of large-cap stocks held by STRS. STRS active returns, where the STRS investment staff picked winners and losers, accounted for about 57%, shown by the second bar (in red). The return for internal active investing was 15.7%. For the most expensive active investing, external active investing, the return was 15.3%.

How important are the differences in returns? Total asset value of large-cap stocks in 2016 was $23.6 billion. Hypothetically, if all the large-cap stock had been invested passively, all other things being equal, STRS would have had an additional $951 million in assets when compared to STRS active management and $1.1 billion when compared to external active management.

The STRS staff and our consultants from Callan have repeatedly argued that STRS is rewarded for active investing i.e., they earn alpha, which is the return for active management. But the evidence seems to suggest otherwise. And so I ask, where’s the alpha?