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Peter Crabb: Idaho's public pension fund should ditch its active managers and invest in index funds

Steven Rattner, the Obama administration’s choice to help repair the auto industry, has been implicated in New York State's pension-kickback scandal. There is no reported evidence that Mr. Rattner broke any laws, but the scandal identifies a key ethical issue for the management of pension funds.

In response to this scandal, New York State Comptroller Thomas P. DiNapoli announced Wednesday a ban on the use of placement agents, paid intermediaries and registered lobbyists by the state's pension fund. These individuals essentially received commissions for helping financial firms obtain access to investment management fees paid by the fund.

The financial industry has always had to address the question of fiduciary responsibility. This occurs when any person has legal responsibility for managing somebody else's money. Public pension managers are in a position of trust with public employees and can see severe consequences for betraying that trust.

Managers of public pension funds generally follow strict rules for the selection of money managers. The Public Employee Retirement System of Idaho, or PERSI, is operated in accord with all applicable laws of the Idaho.

According to PERSI’s policies, the investment choices will be made “solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to the participants and their beneficiaries and defraying reasonable expenses of administration.”

“Investments will be made with the judgment and care under the circumstances then prevailing, which people of prudence, discretion and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds, considering the probable outcome as well as the probable safety of their capital.”

There are tough choices to make when it comes to choosing money managers. Money managers and other investment portfolio services come in many shapes and sizes.

The main distinction is based on the type of management involved – passive or active. Some funds simply try to track the movements of a particular index. That’s passive management. In other funds the investments are chosen by the managers. That’s active management.

Many individuals today understand the value of index funds - passively managed funds seeking to match the performance of a particular stock market or sector index. This is done by holding shares in all the companies of the index, or in a representative sample of those companies.

Most mutual funds today are actively managed, but index funds have grown in popularity. This may be due to the fact that most active managers have failed to consistently outperform the indexes. Active money managers have many things going against them. They have a tough time beating the market, and by most estimates less than one fifth do so over the long-run. Even with this relatively poor performance, active managers generally charge higher fees. There is little incentive for managers to try to beat the market unless they can get paid well for the efforts. It is also true that indexing is less costly, since there is a lower turnover of the assets in the fund.

With all these drawbacks, it begs the question why large pension funds, and particularly government-sponsored funds like New York’s and PERSI, continue to hire active investment managers.

The implication of a potentially large political scandal in New York (trading access to money-management fees) and the ongoing cost of monitoring active money managers suggest public pension funds would be better off indexing.

The financial crisis of 2008–2009 is evidence enough for a greater level of trust in our financial markets and all those involved in managing retirement funds. Indexing is the right way for these public servants to meet their fiduciary responsibility.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.