The Week in Public Finance: Pay to Play, High Investment Fees and the Small Business Credit Crunch

A roundup of money (and other) news governments can use.
by | April 14, 2017

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Pay to Play? Hardly.

Pennsylvania is going with passive funds. That was the message this week from State Treasurer Joe Torsella, who says he plans to move the state’s $1 billion in actively managed public equity (stock) funds over to index funds within six months.

Index, or passive, funds are known for their lower fees and lower volatility. Rather than managed by a trader, these funds are built using computer models that are designed to mimic the performance of stock indexes like the S&P 500. Torsella expects the shift to save at least $5 million a year in fees.

The treasurer’s announcement is part of an effort to return faith in the office after his predecessor left in disgrace amid a pay-to-play scandal. Former Treasurer Rob McCord pleaded guilty in 2015 to federal charges that he used his office to influence future investment deals and other contracts as a way raise cash for a failed gubernatorial bid.

The Takeaway: The decision to switch to passively managed funds and save money on fees is a growing trend among large investors. Nevada’s $35-billion pension plan, for instance, has long embraced the strategy. And within Pennsylvania, the $509-million Montgomery County Employees Retirement Plan shifted most of its investments to index funds in 2013. So far, the plan has out-performed the state's pension plan -- and at a far lower cost.

While Torsella's announcement is ostensibly about the state’s own investments, it raises the possibility that the treasurer will push for a similar shift in the state’s troubled pension funds. If he does, he'll have to get a consensus: Pennsylvania’s pension funds are controlled by boards.

Either way, Torsella said of the decision: “We shouldn’t treat investing public funds like a casino game, trying to ‘beat’ the market, and paying casino prices to do it.”

Rolling the Dice

Speaking of actively managed funds, a new report released this week by the Pew Charitable Trusts looks at public pension funds’ use of highly volatile "alternative investments."

Unlike public stocks and funds, alternative investments can mean anything from hedge funds to real estate investments. They are known for being far less transparent in terms of their day-to-day performance, and for having higher fees because they are actively managed by someone who is making daily investments and trades in the pursuit of high returns.

In its analysis, Pew found that the 73 largest state public pension funds’ “shift to more complex investments has significantly increased fees, volatility and potential losses.” Already, roughly $4 billion in investment fees are unreported each year. The report also noted that “funds with recent and rapid entries into alternative markets ... reported the weakest 10-year returns.”

The Takeaway: As public pension plans have become more pressured to keep up high returns, they have turned over more of their investment portfolio to these high-risk, high-reward investments. Few people believe that investing in alternatives is a bad idea outright, but the chorus of concerns around transparency and high fees has grown louder in recent years. Pension plans from California to South Carolina have been trying to get a handle on what they’re actually paying these fund managers.

The main question for institutional investors: Are the higher fees worth the performance? Without full disclosure of those fees and, as a result, not knowing the overall cost of these investments, that’s a question that few folks can honestly answer.

Small Businesses, Big Credit Crunch

Small businesses create about one-third of the nation’s jobs, but their access to credit continues to be a significant problem. In a survey released this week, just one-third of small businesses with $1 million in annual revenues or less actually got all the financing they asked for last year.

More than 1 in 4 didn’t receive any financing, according to the Federal Reserve's 2016 Small Businesses Credit Survey. The remainder -- 38 percent -- got only a portion of the financing they requested. (This year’s national survey collected nearly 16,000 responses from across the country.)

Why so tough? “Very often,” said one of the federal reserve officials who worked on the report, “it just boils down to low personal credit scores and insufficient credit history.”

The Takeaway: The financing struggles chronicled in the survey highlight a growing trend among small businesses: Without access to more traditional forms of credit, they turn to other means. The survey found that small business are two times more likely than larger firms to apply to online lenders for credit.

The rapidly growing market is largely unregulated and, therefore, can sometimes be unscrupulous. Online lenders are much more likely to charge higher interest rates and set burdensome repayment terms than regulated banks. That’s a problem for any government that wants its small businesses to thrive.

Some states are looking to regulate online lenders. So far, though, they've been unsuccessful. A bill that would have done so last year in Illinois failed to gain enough traction.

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