The Maryland Public Policy Institute
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Investing Maryland's $37.1 billion state pension fund exclusively in index funds would save millions in management fees and boost returns, a pair of Maryland think tanks say.
The Maryland Tax Education Foundation and Maryland Public Policy Institute want to see the system stop hiring Wall Street firms that actively manage investments by trying to pick winning stocks and bonds. Instead, it wants to see the system rely on index funds.
Index funds are a type of investment in which, rather than a using a changing assortment of stocks or bonds, a portfolio mirrors the stocks in a benchmark like the Standard & Poor's 500 index.
Index funds don't add or drop stocks very often, so they charge investors lower fees than actively managed funds. In many cases, active fund managers have had a hard time beating index-fund returns.
"Active management is basically a fool's game," said Jeff Hooke, the chairman of the Maryland Tax Education Foundation.
Hooke, a managing director at a Washington, D.C. investment bank, said investing exclusively in index funds would save about $150 million a year. The pension fund administers benefits for 127,000 state retirees and beneficiaries and 245,000 current and former state workers.
Hooke has been making the call for wider use of index funds for several years without much success. But his efforts, and that of the Maryland Public Policy Institute, could gain more attention.
The Maryland State Retirement and Pension System reported July 27 that its investment portfolio returned a paltry 0.36 percent for the 12 months ended June 30. That fell well short of the 7.75 percent target the system assumes it will earn when it figures out how much the state needs to contribute to the system. However, it beat the 0.08 percent the pension system said it would have earned had all its money been invested in indexed investments.
The picture is more positive over a longer period. Over three years, the fund is up 11.17 percent, including a 20.04 gain in the year ending June 30, 2011.
Index funds have their supporters, such as Robert Mewshaw, a Lutherville money manger. Mewshaw invests about 98 percent of the $210 million he manages for clients in index funds.
"What does an active manager bring to the table other than high fees?" Mewshaw said.
A large chunk of the state pension fund — about 18.5 percent or $6.8 billion — is already invested in index funds. And when it W comes to investments in U.S. stocks, the percentage is much higher, about 58 percent. The goal is to increase that figure to 75 percent of U.S. stock investments, said state Treasurer Nancy K. Kopp.
Kopp calls the question of active versus passive investing a legitimate issue, but says getting rid of all actively managed investments wouldn't make sense. Kopp, who chairs the pension fund's board of trustees, said it would keep the fund from investing in things like private equity and hedge funds for which there are no comparable indexes.
"We're trying to do what is most beneficial long-term for the fund," Kopp said. 'We're not looking at it ideologically."
The idea of investing more of the pension fund in index funds is a good one, said State Comptroller Peter Franchot. But moving to index funds exclusively is "a recommendation that moves in the right direction, but it's too radical," said Franchot a pension fund trustee.
Franchot said he wants to see the pension fund increase its indexed investments to 70 percent. That would leave room for alternative investments like hedge funds.
Raquel Guillory, a spokeswoman for Gov. Martin O'Malley, said the governor trusts the pension fund's board "will continue to make decisions that are in the best interests ofthe members ofthe pension system."
Some state pension funds have as much as 25 percent of their investments in index funds, said Keith Brainard, research director for the National Association of State Retirement Administrators. Brainard is not aware of any state that has its entire investment in index funds. He calls that strategy "simplistic and not well-informed."
As for AFSCME Maryland, the public employees union wants to keep the pension system's current investment strategy.
Switching to index funds exclusively would make the system's investments less diversified and increase the risk for AFSCME members, said Sue Esty, the union's assistant director.