Should Wyoming Rethink Investments?

Despite Recession, Time May Be Right

By Ben Gose

Are Wyoming’s leaders being too conservative with the billions of dollars in our permanent funds?

It sounds like a crazy question to be asking today, as the country muddles through the worst financial crisis since the Great Depression. But at a time when stocks and other assets remain cheap, at least one investment expert in the state believes Wyoming has the opportunity to “buy low” and structure its portfolio in a way that more closely mirrors what nearly all other managers of endowment-type funds are doing.

Wyoming is among a handful of resource-rich states that, at least during boom times, takes in more money than it needs to run the government. In 1974, the Legislature created the Permanent Wyoming Mineral Trust Fund, using a portion of the severance taxes on minerals. Today, that fund is nearly $4-billion, and another pot of money, the Permanent Land Funds, which generates cash through the sale and lease of state lands, is worth $1.8-billion.

Only about half of the $5.8-billion in those two funds is currently invested in stocks, hedge funds and other “owner” assets. The rest is in cash and bonds. That puts Wyoming on the conservative fringe of the nation’s billion-dollar funds that are designed to exist in perpetuity. Investments designed to earn equity-like returns typically make up 75 to 100 percent of the corpus of permanent funds in other states, including Alaska and New Mexico, and in the nation’s foundations and college endowments.

State Rep. Bryan Pedersen (R-Cheyenne), a financial consultant who serves on a Senate select committee that helps set investment policy, thinks Wyoming should put as much as 80 percent of its permanent money into “alternative investments” like hedge funds and private-equity funds. Similar strategies have led to fabulous long-term returns for endowments at Yale University and Harvard University, among others.

“Now that our toes are wet, we need to jump in and embrace modern fiduciary practices,” Pedersen says. “The state exists in perpetuity. We need to be capitalizing on investments that are in line with our time horizon.”

Certainly Pedersen does not reflect the majority view in the state. Today, many Wyomingites are probably asking: Why did we ever start putting the state’s money in the stock market in the first place?

But many Wyoming residents also view the permanent funds as our legacy—what will remain, decades or even centuries from now, when all the valuable minerals are stripped from the state’s land.

“Once that coal or oil or gas has left, we’ll never see that again,” says Rep. Jack Landon, Jr. (R-Sheridan), encapsulating a view that many legislators share. “What we’ve done is we’ve taken some of the family wealth of Wyoming, and we’ve tried to capture some of the value of those assets, not only for this generation, but for future generations.”

Over the coming decades, Wyoming may develop new industries that replace the massive role that minerals play in the state’s economy. But it may not—the state’s record in kick-starting new industries is middling at best. And if the state does not find a replacement, the permanent funds will become even more important in determining whether Wyomingites continue to enjoy low taxes and other amenities that the mineral wealth currently enables.  Investment income is already the largest source of non-tax revenue for the state’s budget.

So-what to do with the family wealth? The question is a corollary to the one raised by Sam Western’s recent Wyofile articles, which found evidence that Wyoming was not capturing enough severance tax on the minerals extracted from our state.

Wyoming’s future is not only tied to getting fair value today for its oil, coal, and gas. Over the very long term, an even more important question will be how wisely it invests the dollars it receives for those minerals.

Do you stick the mineral wealth under the mattress, so you know it will be there for a rainy day?

Wyoming is conservative by reflex, a habit developed over more than a century of boom and bust. It is a state that has known no shortage of hardship, starting with homesteaders who tried to scratch a living out of the sagebrush. Minerals companies—often from out of state—flock to Wyoming when prices are high, only to flee when prices collapse. In Lander, where I live, houses went for a song after nearby iron and uranium mines closed in the 1980s.

John Hay III, president of Rock Springs National Bank, and a member of an investment advisory committee to the state treasurer’s office, says a conservative investment policy for the permanent funds can act as a countervailing force to the state’s turbulent economy.

“We’re very much affected by what commodity prices are, as they go up and down,” Hay says. “Wyoming tends to be more conservative because we have greater swings than other states have.”

A bumper sticker from the 1980s bust is telling: “Oh God, please give us one more boom. We promise not to piss the next one away.” At the beginning of this decade, we did get another boom—one of unprecedented proportions. The permanent mineral trust fund rose from $1.5-billion in 1999 to nearly $4-billion today, largely based on severance taxes pouring into the fund.

And Wyoming is determined not to piss it away—even if its conservatism might mean sacrificing better investment returns, and a better quality of life for state residents, over the very long term.

Joe Meyer, the state treasurer, notes that the first time Wyoming residents were offered the chance to invest permanent-fund assets in equities—in the 1980s—they voted it down. (See article about how Wyoming’s continuing focus on income is leading to some decision-making that may be hurting growth of the permanent funds.)

In 1996, voters finally approved ownership of stock in the permanent funds.  Current state law caps the percentage of permanents funds in stocks or any equity-like asset, including hedge funds and private-equity funds, at 55 percent (even though the actual percentage in equities is slightly lower–around 50 percent). Meyer does not think the Legislature or the state’s residents will be interested in raising the cap any time soon.

“If you get too greedy in this investment world, someone bites you,” Meyer says. “This is a bad environment in which to say, ‘Let’s take more risk.’”

But when is the right time to take on more risk—when times are good and prices are high?

The record suggests that Wyoming becomes more comfortable with risk at the wrong times. Investment decisions are approved by the State Loan and Investment Board, which includes Gov. Dave Freudenthal and the four other elected officials—Meyer; Max Maxfield, secretary of state; Rita Meyer, state auditor; and Jim McBride, superintendent of public instruction. The board is advised by Michael Walden-Newman, the state’s chief investment officer, and R.V. Kuhns & Associates, an Oregon-based firm that has served as Wyoming’s consultant since 1999.

Wyoming began putting money into stocks in 1999—just before the tech-fueled bull market began to deflate. It steadily added to its equity exposure—eventually raising the cap to 55 percent—amid the bull market that began in 2003.

And starting in 2006, the state began taking much greater risk with its bond portfolio. In 2005, about 90 percent of its $4.4-billion bond portfolio was managed in house, and invested in fairly risk-free bonds like Treasury bills. By April of this year, the state had done an about-face. To diversify its bond holdings and generate more income, it had placed 80 percent of the bond portfolio in riskier credits handled by outside managers.

Those outside bond funds are now nursing losses of $168 million, versus a $24-million gain for the smaller, in-house portfolio.  In July, Wyoming became the lead plaintiff in a class-action lawsuit seeking to recover losses on a $40-million investment the state made in mortgage pass-through certificates issued by failed savings and loan IndyMac.

As stocks were hitting bottom in March of this year, R.V. Kuhns suggested that the state become more defensive. In early April, the investment board sharply reduced the state’s holdings in small and mid-cap stocks, and slightly reduced holdings in international stocks, while modestly boosting the percentage in bonds. Since then, stocks have gone on a tear—with small and mid-cap and international stocks leading the way higher.

It’s not textbook advice to increasingly embrace risk during good times, and then shy away from it when markets head south.

“Be greedy when others are fearful,” says Warren Buffett, the legendary investor and chairman of Berkshire Hathaway, “and fearful when others are greedy.”

Still, without question, Wyoming’s overall positioning remains conservative—and that posture helped the state hold on to its money amid the steep slide in the stock market that began in late 2007.

The state treasurer’s office manages about $11-billion altogether—including the $1.1-billion workers-compensation fund, which has less than a quarter of its assets in equities, and the $3.6-billion State Agency Pool, which helps cover the daily operations of state government and is invested entirely in cash. Combined, the $11-billion pool lost only about 8 percent of its value during 2008.

Even in the state’s most aggressively invested funds—the permanent mineral trust fund and state lands fund¬-Wyoming errs on the side of caution, with nearly half its assets in bonds or cash. That kept the total loss at the permanent mineral trust fund, for example, to only about 17 percent in 2008—far less than the 38 percent decline in the Standard & Poor’s 500 Index.

The state is gradually increasing equity holdings in the smaller and newer permanent funds, including the $428-million Hathaway Scholarship Fund and the $96-million Higher Education Endowment Fund, to make them look more like the permanent minerals trust fund. But that policy is being questioned by some in the Legislature, including Roy Cohee, chairman of the Select Committee on Capital Financing and Investments, who argues that not all permanent funds should have the same risk profile.

In the permanent mineral trust fund, for example, pay-outs can and do vary depending on how investments perform and how much income is produced. The Hathaway fund, meanwhile, operates more like a pension with an obligation—the state has promised future high-school graduates that a scholarship will be available if the student earns good grades.

Cohee says the Hathaway fund should move to a “vastly reduced risk-reward strategy” to insure that the money is there to cover the cost of scholarships.

“It’s my opinion that the Hathaway money should be earning a guaranteed rate of return, so that we know we’ll have funds to pay for the scholarships, because that’s the pledge we’ve made,” he says.

That may be a reasonable strategy with the Hathaway fund.  But with the permanent mineral trust fund and the Permanent Land Funds-which act more like endowments than pensions—Wyoming retains a far-more conservative asset allocation than other states with similar funds. That policy has buoyed the state in the short term, but it may leave Wyoming lagging behind others over the long term.

Like Wyoming, New Mexico has two large permanent funds fueled by land sales and leasing, and severance taxes. The two funds, worth a total of nearly $11 billion, have target allocations of 12 to 15 percent for bonds and cash—less than a third as much as Wyoming puts in those conservative asset classes.

Thanks to their heavy stock exposure, the New Mexico funds suffered steep losses over the year ending this March, and returns of zero to 1 percent per year for the five-year period—lagging well behind Wyoming’s 3.11 percent annualized return over the last five years.

The $31-billion Alaska Permanent Fund—the gigantic fund, fueled by severance taxes, that allows the state to pay its residents for living there ($3,269 per person in 2008)—also earned less than one percent per year for the five years ending this March.

Wyoming outperformed because it invests more conservatively. The Alaska fund has only 22 percent of its assets in bonds or cash—less than half as much as Wyoming. The rest is primarily in stocks, hedge funds, real estate, and private-equity funds.

Michael Burns, the chief executive officer of the Alaska Permanent Fund, says state legislators haven’t grumbled about the fund’s asset allocation—they understand that equity-like assets pay off over the long term, which is why they’re comfortable holding a relatively small amount in bonds and cash.

Alaska had a cap on equities that was similar to Wyoming’s until 2005, when the leaders of its permanent fund persuaded legislators to remove any limitations on how they can invest, aside from “prudent investor” laws that apply to managers of nearly all public and non-profit monies.

When the cap in Alaska was lifted, the state quickly increased its allocation to riskier assets.

“You’re either an owner or a lender,” says Michael Burns, the fund’s executive director. “Over time, being an owner is more profitable.”

Treasurer Meyer—and no shortage of other folks around the state—see the steep losses in Alaska, New Mexico and elsewhere as vindication of Wyoming’s conservative approach.

“Around the nation, you have retirement systems and endowments that are in a world of hurt,” Meyer says. “They say, ‘Wait 10 years—the market will come back.’ Well, maybe it will and maybe it won’t.”

But what looks like a great strategy today may turn out to be a loser for Wyoming. Over very long periods, markets do tend to come back—rewarding those who shoulder risk with higher returns.

Consider the $17-billion endowment at Yale University. The endowment has taken some hits in the past year, dropping 25 percent in just the six months ending in December. But in the prior decade, which included the three-year bear market ending in 2002, Yale’s endowment earned a remarkable 16.9 percent per year.

Yale has a net allocation to cash and bonds of essentially zero percent.

“When evaluated with a time horizon appropriate for a long-term investor, the university’s equity-oriented, well-diversified portfolio continues to provide the best foundation for future investment success,” the university’s 2008 endowment report said.

Many Wyoming residents won’t see much in common with Yale. But both Yale and Wyoming have the same opportunity and challenge: how to structure multi-billion endowments to provide for this generation and future ones.

Wyoming’s permanents funds are our endowment. We pay out 5 percent per year from the permanent minerals trust fund to augment the state’s budget, in much the same way that foundations and colleges pay out about 5 percent of their endowments to make grants or support campus operations.

A generation ago, the typical charitable endowment had a plain-vanilla portfolio that might even look like yours—with about 60 percent in stocks and 40 percent in bonds. That’s even a little bit more aggressive than Wyoming’s permanent funds are invested today.

But starting around 1990, a handful of endowment managers-Yale’s chief investment officer, David Swenson, was among the first-began moving toward a different model. They sharply reduced holdings of stocks and bonds, and increased ownership of private equity, hedge funds, venture capital, oil and gas partnerships, timber, and real estate.

They were embracing what’s known as “modern portfolio theory”: some assets would zig when others zag, reducing volatility, and enabling the endowment to earn strong enough returns to make payouts today—and still grow the fund on an inflation-adjusted basis.

I make my living writing about philanthropy, and for the past five years I have written the story that accompanies The Chronicle of Philanthropy’s annual survey of investment returns for the nation’s biggest endowments. Year in and year out, the big college endowments, with in-house investment experts and a commitment to wide diversification in equity-oriented assets, routinely trounce the smaller charitable endowments that invest more like Wyoming does.

That approach could work for the people of Wyoming, as it has for the students and professors at Yale.

But the state seems inclined to move in a different direction.

The recent collapse of nearly all asset classes has tempered the enthusiasm of some legislators who earlier had been warming up to the idea of putting more funds into equity-like investments.

“A year ago I may have thought maybe we should go I a little bit more into some of these alternative investments,” says Representative Landon. “I think we’ve all come to have a greater appreciation for the risks associated with some of those assets.”

For better or worse, any changes that would nudge Wyoming’s permanent funds closer to the risk tolerance embraced by nearly all other perpetual endowments may have to wait for the next bull market.

“Right now,” Treasurer Meyer points out, “we look pretty damn good.”