Public pension funds invest a mean of 30% of their assets in expensive alternative investments and have due to this fact underperformed passive index benchmarks by 1.2% annually for the reason that 2008 global financial crisis (GFC). Large endowments, which on average invest twice as much in alternative investments, have underperformed passive index benchmarks by 2.2% per 12 months for the reason that global financial crisis.
These unlucky results typically receive little attention because regulators of public pension funds and foundations often use home-grown performance benchmarks that give an unduly positive impression of performance. You should use passively investable benchmarks that reflect the funds’ average market exposure and risks over time. Their “custom” benchmarks are complex, opaque combos of indexes, often nebulous and invariably subjective of their design, that lower the bar by 1.4 to 1.7 percentage points per 12 months in comparison with easy, solid index benchmarks.[1]
In this post, I examine institutional investment performance from a special perspective. My focus is on whether institutions are fulfilling their investments. For public pension funds, I compare industry-wide returns to the typical actuarial earnings assumption that has prevailed for the reason that global financial crisis. With foundations, I compare the return that’s achieved NACUBOThe large fund cohort pursues a standard goal for colleges and universities. This goal is to realize a typical foundation issuance rate that increases over time consistent with price inflation. In each cases, I would like to find out whether the institutions met their requirements, not how well they performed in comparison with market benchmarks.[2]
Public pension plans create public liabilities. The actuaries in command of the plans estimate the worth of those liabilities and determine an annual contribution amount that might ultimately fund the liabilities. Their work includes determining a return rate on the invested funds that ensures that the pension financing calculation works in the long run. Public pension managers often state that their top investment priority is to realize the actuarial return assumption. This gives them peace of mind that they’re doing their part to be sure that their pension obligations don’t go unfulfilled. The Center for Retirement Research at Boston College indicates the typical actuarial return assumption for giant pension plans. Between the financial years 2008 and 2023, this value averages 7.4% per 12 months.
Colleges and universities typically try to spend a sustainable percentage of their endowment funds to support the institutional program. According to NACUBO, spending percentages vary from school to highschool and over time, recently averaging 4.5% of endowment value for giant endowments. The cost of pursuing higher education has historically risen faster than consumer prices. Accordingly, a separate measure of price inflation, which Higher Education Price Index (HEPI) is often used to estimate cost increases for colleges and universities. Taken together, a goal spending rate plus inflation (measured by HEPI) is commonly used as a guide to capital gains needs. “HEPI + 4.5%” has been 7.0% per 12 months for the reason that 2008 financial 12 months.
Investment policy decisions
When determining investment policy, investment managers must make a crucial decision. They can use index funds (almost free) in a ratio that suits their risk tolerance and taste for international diversification. Alternatively, they’ll use energetic managers – including for alternative investments – who’re considered particularly competent within the hope of achieving the next return than with passive investments.
In selecting index funds, the institution relies on theory and evidence regarding the merits of energetic funds and trusts that capital markets will generate sufficient returns to satisfy financial needs. If it chooses energetic management, the institution assumes that the markets are significantly inefficient and that the institution is among the many minority of energetic investors who can exploit perceived market inefficiency. And most try to accomplish that through inefficient, clumsy diversification: Many institutions deploy 100 or more energetic managers lumped together. Active versus passive is an important investment policy decision for institutions in terms of meeting their financial needs. Over the past few a long time, institutions have largely embraced energetic management, with a specific concentrate on assets within the private market.
How well has the energetic strategy served institutions within the 15 years for the reason that global financial crisis? As with most studies of this kind, the outcomes rely on the time period chosen. I imagine that the post-GFC period provides a good representation of the circumstances impacting investment strategy evaluation.[3]
Figure 1 analyzes returns for public pension funds and huge school endowments from fiscal 12 months 2008 to fiscal 12 months 2023. The return goal within the case of public pension funds is the actuarial return assumption described above. For the foundations it’s HEPI + 4.5%. The “actual return” for public pensions is that of an equally weighted composition of 54 large funds. The “actual return” for the foundations is that of the NACUBO cohort network for giant funds. In each cases, the indexed strategy is a mixture of indices with the identical market risks and risks as their respective compositions – a kind of best-fit, hybrid market index.[4]
Both sorts of institutions have failed to satisfy their institutional investment goals for the reason that global financial crisis: public funding lagged by 1.3 percentage points per 12 months, and foundations lagged by 0.6 percentage points. However, the indexed strategy essentially met the necessities of the general public plan and significantly exceeded those of the foundations.
Exhibition 1. Actual returns and indexed strategy vs. targets 2008-2023.
| Public | equipment | |
| Return destination | 7.4% | 7.0% |
| Actual return | 6.1 | 6.4 |
| Indexed strategy return | 7.3 | 8.7 |
Figures 2 and three illustrate the outcomes graphically. In each cases, the investment objective is represented by the horizontal line with the constant value 1.00. The other rows represent the cumulative returns of the energetic and passive strategies relative to the goal. For each sorts of institutions, the low-cost indexed strategies generated sufficient returns to satisfy the goal. However, in no case was this the case for the actual energetic strategies. Their high investment costs proved to be an excessive amount of of a burden.
Exhibition 2. Public funds: investment returns vs. actuarial return assumptions.
Appendix 3. Large foundations: investment returns vs. HEPI + 4.5%.
Last words
The goals of institutional investors remain unfulfilled. What to do? Tennis great Bill Tilden had an answer: “Never change a sweepstakes; Always change a loser. Institutions have persistently pursued energetic management, wasting helpful resources in the method. It’s time they allowed the market to occur as an alternative of attempting to defeat it with brute force. To achieve this, regulators must concentrate on achieving their goals, not on how well they performed in comparison with market benchmarks.
REFERENCES
Aubry, JP 2022. “Update on Public Retirement Investments: Have Alternatives Helped or Hurt?” (Topic overview.) Center for Retirement Research, Boston College.
Ennis, RM 2022. “Are Foundation Managers Better Than the Rest?”, 31 (6) 7-12.
———. 2023. “Lies, Damn Lies, and Standards: An Injunction for Trustees.”
32 (4) 6-16.
Hammond, D. 2020. “A Better Approach to Systematic Outperformance? 58 years of foundation service.” 29 (5) 6-30.
Sharpe, WF 1988. “Determining a Fund’s Effective Asset Mix.” (September/October): 16–29.
——— . 1992. “Asset Allocation: Management Style and Performance Measurement.” Winter: 7-19.
[1] See Ennis (2022, 2023).
[2] See Hammond (2020) and Aubry (2022) for similar sorts of studies.
[3] Quite a bit has modified for the reason that early days of different investing. Before 2008, there was no accounting requirement to mark private assets to market. We find evidence that this circumstance likely contributed to the positive dynamics of institutional returns between 2000 and 2008. In the early 2000s, private asset markets were much smaller and fewer developed than they’re today; They are rather more efficient and liquid today. Buyout valuations have almost doubled for the reason that early days. Hedge fund assets increased tenfold between 2000 and 2007, dramatically intensifying competition for profitable deals on this space. Interest rates now represent an actual hurdle for leveraged private investors. Despite all this, costs remain stubbornly high. In our view, it’s unlikely that we are going to see a repeat of the exceptional alternative investment performance we observed within the late Nineteen Nineties and early 2000s.
[4] See Sharpe (1988, 1992).
