Can Couch Potato Investing Do Better than the Teachers Retirement System of Texas?

OK, kids, let’s play a guessing game!

Who would win if you matched the Teachers Retirement System of Texas pension fund against a basic, low-cost index fund?

For the sake of the participants I’d like to think it would be the TRS. A lot is at stake.  With 1.5 million active and retired teachers from primary school through university level TRS is the biggest, by far, of the public pension funds in Texas.

But thinking the Teachers Retirement System would beat a simple alternative would be wishful thinking.

A popular Vanguard index fund beat the TRS

Here’s where the rubber meets the road. If TRS had invested in the index mutual fund I have mentioned more often than any other over the last 20 years, the system would be less under-funded. It wouldn’t be only 80.5 percent funded. Its $35.5 billion unfunded liability would be lower.

Shocked?

I was too.

In spite of being an advocate of simple, low-cost index investing for decades, part of me still wants to believe that if you put enough brain power together you can beat the markets.

But it isn’t so.

That’s what the numbers say.

According to the TRS 2017 annual report,   the annualized return of the pension plan over the ten years ending August 31, 2017 was 5.8 percent.  Over the same period, according to Austin-based www.portfoliovisualizer.com,  the annualized return of the Vanguard Balanced Index fund (Admiral shares, ticker VBIAX) was 6.77 percent — even though its risk profile is similar.

That’s quite a difference.

How many billions in a difference?

Over 10 years, it means that every $1,000 invested in the TRS fund grew to $1,757. Meanwhile, every $1,000 invested in the traditional 60/40-index fund grew to $1,925. The accumulated difference is 9.6 percent more.

This is far more than an abstract number. Like the vast majority of public pension funds, the TRS pension is underfunded. According to the 2017 report, it had lifetime pension promises that would require $181.75 billion in assets. It had only $146.3 billion to pay those promises.

It was $35.5 billion short. Actuaries call that shortage the “unfunded actuarial accrued liability.”

Trust me, you’ll find them in some of the very best places.

But if the fund had been invested in the low cost index fund, the pension would have had 9.6 percent more assets. That figures to an additional $14 billion. In other words, instead of being 19.5 percent under-funded, it would have been under-funded by  11.8 percent.

Is this just quibbling, another round of small beer? Maybe not. There are people today who still call $14 billion real money.

The cost of the low-cost alternative

I should mention that not every Tom, Dick and Harry has enough money to invest in the Admiral shares of Vanguard Balanced Index. Anyone with $3,000 can invest in the Investor shares of Balanced Index, but Admiral shares require a minimum of $10,000. The extra investment takes the annual expenses down to 0.07 percent, from 0.19 percent.

That wouldn’t be a problem for TRS. Indeed, with a deposit measured in billions, they could negotiate the costs to next-to-nothing and have still better performance.

So what’s the problem?

I think there are several.

It’s a cognition thing

The first is cognitive. Professionals in the investment business have lagged the rest of us. We’ve gotten the message about the futility of “beating the market.” That’s why money has flowed out of managed funds and into index funds for years.

But the pros aren’t willing to accept an evidence-based reality that has been proven and re-proven for decades.

How could that be?

Upton Sinclair first stated the reason:  “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

The professionals may be smart, insightful and magnificently credentialed, but it’s difficult not to stumble over so large a conceptual block.  

The second reason is related to the first. Having faced embarrassment at not being able to beat the market in publicly traded investments, professionals have embraced “alternative” investments that are much harder to measure and far more arcane than publicly traded asset classes. They also hope alternative investments will bring higher returns and provide the funding level needed to fulfill pension promises.

But hope is not a strategy.

Just as Warren Buffett has won his bet  that the S&P 500 will beat esoteric hedge funds, it will eventually be accepted that alternative investments pay their managers too well to provide good returns to their shareholders.

The third reason may be the saving grace for both pension funding and many professional careers at TRS. It’s this simple. The last 10 years have been tough for any money invested outside of the United States.

Maybe diversification will be more helpful in the future

Despite a major financial crisis, an all-American portfolio like Vanguard Balanced Index did better than portfolios that followed the mantra of diversification. Stocks and bonds in the U.S. trounced international and emerging markets. (You can see a bit of this in the table below. In 2017 international and emerging markets funds did better than domestic funds for the first time in years. That year is the only measurement period in which TRS beat the Vanguard index fund.)

The next decade could be the reverse— higher returns for broadly diversified portfolios, lower returns for portfolios limited to domestic stocks and bonds.

We’ll have to wait and see.

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo credit: Teachers Retirement System

(c) Scott Burns, 2018

Correction: The ticker symbol for Vanguard Balanced Index Fund Admiral shares was mis-identified in the table as VFIAX, it has been corrected to VBIAX.