We have all sat through the 401k lecture about not trying to time the market. The investment professionals would have you 100% invested 100% of the time. That is not good enough for the State of Wisconsin Investment Board (SWIB). The board wants to be 120% invested 100% of the time.
SWIB trustees approved a plan at the January 26th meeting to leverage 20% of the state pension fund’s core fund to invest in Treasury Inflation Protected Securities (TIPS). TIPS pay a fixed rate of interest lower than regular Treasury bonds, but the face value of TIPS are adjusted to keep pace with changes in the consumer price index. As inflation rises, so do the interest payments and the face value of the TIPS.
Five school districts, Kenosha, Kimberly, Waukesha, West Allis-West Milwaukee and Whitefish Bay, are involved in lawsuits stemming from borrowing to invest in the derivatives. They, too, believed borrowing to invest was a good plan, until the investments went bad.
They learned the hard way there is no such thing as a free lunch. Will the state employees and the taxpayers, who trust the SWIB to make prudent investments for the growth of the pension fund, also discover their free lunch have a hidden cost?
According to the SWIB, the idea behind borrowing money to invest in the TIPS is to reduce the core fund’s exposure to equities. Equities are currently 90% of the core fund’s volatility. But the SWIB isn’t selling off equity to balance the portfolio. They did not want to reduce the possible return from stocks. They are borrowing to invest in the TIPS.
Only in Wisconsin government is investing on the margin reducing the risk for your portfolio. Pensions and Investments magazine is even calling the SWIB “pioneers.”
We may be only looking at the beginning of the SWIB’s buying on margin. The SWIB had considered borrowing up to 200% for investing, but chose for now this smaller amount.
Steven J. Foresti, managing director and head of the investment research group of Wilshire Associates Inc., said to Pensions and Investments that this is the future of investing for pension funds, and is advising clients to adopt the strategy. “…if the idea is to use leverage to manage risk and maintain diversification and current expected return levels, that is a free lunch.”
He also said that if a pension fund was leveraging to pursue return, “that would be different.” But that’s clearly what the SWIB is trying to do. The stated purpose of leveraging to invest in the TIPS is to maintain the returns from the investment in equity. SWIB is clearly borrowing to gamble, even if the loan is for the house payment they’re skipping to play Bingo at the casino.
Is this a reduction in risk? As much as diversification is good for your portfolio. However, the risk of stocks is independent of the risk of TIPS. Whether stocks go up or down is independent of whether the value of TIPS will go down. They could both go down, exposing the state pension to even more losses.
To make matters worse, the TIPS not only have to perform positively, but to make them a worthwhile investment they have to do well enough to cover the interest paid on the loan. If the TIPS lose value, the loss is even more exaggerated by the maintenance cost of the loan.
The SWIB says TIPS are one of the safer investments. But as Mike Shedlock of SitkaPacific Capital Management said, TIPS can be volatile, too. The time to invest in them was last March, according to Shedlock, before they rallied. The investor also runs the risk of flat growth in interest rates such as Japan has experienced for years.
Shedlock also said there’s even risk in running with the pack into leveraging for investment in TIPS. “If everyone says this is what we’re going to do, it drives the yield curve down.”
As I mentioned, the SWIB is not the only pension-governing body in Wisconsin to recently try leveraging to invest for long-term returns.
Unfortunately, as “pioneers,” there is a real risk that Wisconsin may be the cautionary tale.
By James Wigderson
Special Guest Perspective for the MacIver Institute