For Pensions, Active Investing Pays Off

A new report from CEM Benchmarking claims to have settled, at least in part, the active versus passive investing debate for defined benefit pension plan sponsors.

Financial research and benchmarking provider CEM Benchmarking says its most recent report contains enough data to prove active investing is worthwhile for pension funds, if executed efficiently and effectively.

As noted in the report, “Value Added by Large Institutional Investors Between 1992‐2013,” it is a widely held academic and investment industry belief that active investors have, on average, no real advantage over passive investors over the long term, and can even see worse performance over time due to higher fees. This view on investing strategy is rooted in the efficient market hypothesis, researchers explain.

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Historically, a problem with testing the benefits of active versus passive investing is that the separation between alpha (market outperformance) and beta (market-attributable returns) is not always clear. “Where one set of benchmarks demonstrates a non‐zero alpha, another set can almost always be found that shows that the alpha is zero,” the report suggests.

But while some say the question of active versus passive cannot be definitively answered, CEM Benchmarking believes the answer can be made clear by looking at enough information. To that end, the firm conducted extensive analysis on its pension performance data set, composed of more than 6,600 data points drawn from a global set of defined benefit (DB) pension plans—along with a handful of sovereign wealth funds—spanning the 1992 to 2013 time frame

“Not only can we definitively answer the question of whether it is possible [to outperform with active management], we can also quantify to a large degree how these institutional investors do it,” CEM notes. “What advantages do they have? Where have they added value? Is the value added really alpha, or is it beta in disguise?”

The results are striking: Gross of investment management expenses, CEM says, pension funds have secured 58 basis points (bps) of value added returns through alpha-seeking opportunities. Net of investment management fees and expenses, the outperformance is much more muted, at 16 basis points of returns added. According to researchers, a deep regression analysis indicates that beating the market is rooted in active asset management paired with cost savings gained through scale and managing assets in‐house.

The result is nuanced further in the CEM report: “We emphasize that the standard deviation of the gross and net value-added populations, at about 267 and 265 basis points, are large in comparison with the averages at 58 and 16 basis points gross and net, respectively. For any single pension fund, this result is likely just as important as the non‐zero average. The standard deviation indicates the range that a typical plan, with a typical active versus passive management ratio of 4:1, can expect its value added to stray from the average. So, while the long-term average gross and net value added are decidedly non‐zero, in any given year many funds will trail their benchmarks, often by substantial margins.”

Report authors continue by observing that, clearly, funds engaging in active management need to consider whether the potential gains are worth the risk quantified by the standard deviation.

Controlling Costs Leads to Better Alpha 

Pension plans vary widely in their construction, including the amount of indexing used, the report points out. Funds also vary according to factors such as asset scale, the amount of assets managed internally, the amount of assets managed actively and the makeup of the asset mix.

All of these factors will impact the success of pension funds’ active investing value add efforts, the report says.  

“For example, indexing, managing assets internally, and increased scale are all expected to reduce costs and increase net value added (all other things being equal),” the report continues. “Attempts to beat the market by active management, by contrast, are expected to increase gross value added.”

Not surprisingly, researchers find the balance between enhanced gross value added from security selection, on one side, and diminished net value added from increased costs, on the other, determine whether active management is worthwhile. What is more challenging than this realization is actually disentangling and quantifying these differences for a given pension fund, or for pensions in general.

To this end, researchers did a regression analysis on the gross and net value added for each pension fund in the large sample, according to a simple model that takes into account 1) the percent of each fund’s holdings that are internally managed; 2) the percent of each fund’s holdings that are actively managed; 3) the size of the funds; and 4) a variable constant for each of the sample four regions.

CEM finds the following:

  • Pension funds increased their net value added by +7.6 basis points for every 10-fold increase in holdings due to lower investment management costs;
  • Funds increased their net value added by +22.1 basis points by managing their assets in‐house due to lower investment management costs;
  • Funds increased their net value added by +38.7 basis points by actively managing their assets in an attempt to beat the market (note this is less than the +71.7 basis points gross due to investment management costs); and
  • The regression constants, themselves, are also reduced going from gross to net value added because indexed investing, while inexpensive relative to active management, also has associated investment management costs.

Researchers conclude that all of this goes to show that, contrary to the efficient market hypothesis, pension funds have been able to beat the market consistently using elements of active management. However, fees associated with active management consistently eat up nearly 75% of the 58 basis points of gross value added, leaving only 16 basis points of net value added for stakeholders.

“This illustrates in stark terms why funds must measure and manage their costs,” the report concludes.

More information about obtaining or participating in CEM Benchmarking research is here.

A Little Friday File Fun

In Ambridge, Pennsylvania, police used Facebook to find a man wanted on as.sault charges. An hour after the incident, he posted on Facebook that it was “time to leave PA.” That didn’t give officers much of a clue, but days later, he made another Facebook post with a selfie on a Greyhound bus and a message that he was headed to South Carolina. According to the Associated Press, police arrested him when the bus stopped in Ohio. The Ambridge police chief said, “We like it when dumb criminals assist us.”

In Minneapolis, Minnesota, the Ruff Start Rescue, an animal shelter that partners with the Minneapolis PetSmart to have its adoptable animals displayed at the store, said a three-month-old kitten was stolen from the store, and the man accused of taking the cat was caught on the store’s security cameras. However, according to UPI, less than 24 hours later, the kitten was found in a box outside of a PetSmart store in nearby Roseville. A note left with the kitten said, “I didn’t have money and had planned to give the kitten as a Valentine’s Day gift. I’m sorry.”

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In Belém, Brazil, a merchant left a grocery store to investigate a commotion across the street. The commotion was caused by a robbery and the thief opened fire, hitting the merchant on the left side of her chest. She staggered back into the store and was quickly taken to get medical attention. It was discovered that the bullet was stopped by the metal underwire in the merchant’s undergarment. The woman only reported feeling a burning sensation.

In Wichita Falls, Texas, a man took cash to the tax office to pay his property tax, among which was a roll of tightly wound $1 bills. Tax officials requested that he unfold the bills so they could count them, and the man launched into a tirade. According to Reuters, the man engaged in an anti-government rant where he showed his anger about paying taxes. He refused to leave the office, and law enforcement was called and arrested him.

In Tampa, Florida, Hillsborough County Sheriff’s officials say a couple had been sleeping in a dumpster outside a convenience store when the dumpster was emptied into the back of a garbage truck. The couple started screaming and banging on the sides of the truck. According to the Associated Press, rescue crews were called and removed the man and woman from the truck. Deputies originally believed they were homeless, but learned they were highly into.xicated after hanging out at a nearby casino.

 

This is what happens when you tell a cat “NO!”

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What is a cat to do when faced with a door of snow?

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It looks pretty cool when a train plows through snow.

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