Should Iowa's public funds go passive?

Some investors want more index funds in state's largest public pension fund

Paper money. (MGN)
Paper money. (MGN)

A growing number of investment experts, including Warren Buffett, say index funds are the way to go for long-term investments because you can skip pricey fund managers who likely won’t outsmart the market.

Some local investors are pushing for Iowa’s largest public pension fund, the Iowa Public Employees’ Retirement System, or IPERS, to shift to index funds to maximize tax dollars and employees’ retirement pay.

“We owe it to current IPERS members and future members to squeeze as much cost out of the investments as possible,” said Mike Finley, a Cedar Falls investor who teaches high school and college students about financial literacy.

IPERS is a pre-funded retirement plan for 340,000 current, former and retired public employees. Employee contributions are matched by the public agency that employs them to make investments intended to pay for retirement benefits down the road.

Of IPERS’ nearly $27 billion investment portfolio, one quarter is invested in index funds, which are funds that invest in all or most of the stocks in a market index to get a return equal to that of the index.

Three-quarters of the IPERS’ portfolio is actively managed by fund managers that include BlackRock, Mellon Capital Management and AEGON. IPERS’ estimated costs for 2012 were $95 million, although Finley argues this doesn’t include all the indirect costs of making frequent trades.

IPERS investment return of 10.1 percent in fiscal 2013 was below the 10.6 policy benchmark and the 12.6 percent median return for the peer group of other large public funds. The IPERS portfolio also was below the benchmarks for the three-year, five-year and 10-year investment returns.

“I’m not denying we’ve had some trouble with our active strategies,” said Karl Koch, IPERS chief investment officer. “IPERS’ active stock managers have failed, as a group, to consistently outperform the markets, despite our efforts to find skillful managers.”

The IPERS investment board, which met April 4 in Des Moines, has considered going to a more “passive” approach, which includes investing in more index funds, Koch said.

“Of course, just as this debate unfolded, the active management strategies in our U.S. and international stock portfolios have done very well over the past one to three years, so it isn’t clear that passive always wins,” he said.

But there is evidence index fund investing, over the long term, produces better results than active management.

Rick Ferri and Alex Benke, two veterans of the financial services industry, compared several index fund portfolios to active fund portfolios and found the index funds outperformed the actively-managed funds between 80 percent and 90 percent of the time, according to a white paper published last June.

Buffett, in a Huffington Post interview on YouTube, tells individual investors to choose index funds.

“If you buy a piece of American industry and you’ve got a cross section, you’re going to do well over 10 or 20 or 30 years,” the Omaha businessman and investor said. “But you’re not going to do it if you try to dance in and out every day.”

The California Public Employee Retirement System, which administers benefits for nearly 1.7 million public employees, uses passive management for 70 percent of its equity fund, which is the largest share of the total portfolio valued at $283.5 billion on Dec. 31. Active fund management “is more expensive and we’ve been greatly conscious of fees,” CalPERS Spokesman Joe DeAnda said.

CalPERS’s investment returns were 13.2 percent in fiscal 2013, well above IPERS, but they were on par with IPERS for the three-year average and worse than IPERS at five years.

IPERS has had success with active management in some asset classes. AEGON, which manages about $500 million in an active high yield bond strategy, has beaten its benchmark by about a full percentage point each year since IPERS hired them, Koch said.

“I guess if some folks had their way, we would fire them and go passive,” he added.

IPERS’s estimated management costs for 2012 also were lower than the peer average, according to CEM Benchmarking.

Tom Yates, a retired Iowa City High teacher, said he’s been pleased with IPERS’s investments, in general, but he would like to see the managers buy more index funds. “I could go with lower costs up front,” he said.