Do Public Pensions Need a Shift in Investment Strategies?

Public employee pension funds, endowment funds and other nonprofit institutional investors in the U.S. have underperformed properly constructed, passively investable benchmarks by a wide margin since the global financial crisis of 2008, contends Richard Ennis, an early pioneer of quant investing and co-founder of U.S. investment consultancy EnnisKnupp, in a research paper.

A composite of 46 large public funds underperformed a passively investable benchmark by 155 basis points (bps) per year for the 12 years ended June 30, 2020. The composite underperformed the benchmark in 11 years out of 12, according to his findings.

With public defined benefit (DB) pension plans’ holdings of $4.5 trillion (according to public plans data from the Center for Retirement Research [CRR] at Boston College), Ennis figures that underperformance of 155 bps per year costs stakeholders nearly $70 billion a year.

Ennis notes that a number of public pension fund officials might disagree with his findings and point out that their funds have outperformed their benchmarks or at least matched them. However, Ennis refers to public pensions’ benchmarks as “reporting benchmarks”—i.e., performance benchmarks of the funds’ own devising that they employ in their annual reports. He argues that his comparisons of returns of the reporting benchmarks of 24 of the largest U.S. public funds over the decade ended June 30, 2020, with the returns of “properly constructed,” passively investable benchmarks tailored for each of those funds found evidence of a sizable downward bias in the returns of custom benchmarks.

Ennis says the “extreme diversification” of public pension funds makes them more costly, “with poor prospects for keeping up with a passively investable benchmark over time.” Citing data from the CRR and Greenwich Associates, Ennis says large public funds use an average of 182 investment managers, commingled funds and partnerships; they index about 22% of their assets; and their typical allocation to alternative investments is approximately 28% of assets.

In the paper, Ennis makes some similar points about endowments’ investing. He notes that both public pensions and small endowments underperform by the amount of their cost. The solution, he says, is for fund trustees to invest purely passively at next-to-no-cost.

The paper, “How to Improve Institutional Fund Performance,” is available for download here.

Not Everyone Agrees

In a statement to PLANSPONSOR, Hank H. Kim, executive director and counsel of the National Conference on Public Employee Retirement Systems (NCPERS) in Washington, D.C. said: “Blessed with 20-20 hindsight, another analyst has come up with the idea that passive investing is better than active investing for public pension plans.

“Anyone can look back and detect patterns. Looking ahead is the perennial challenge for investors. Foresight is inevitably imperfect, and this is why professional investors arm themselves with as much information as possible, and then diversify and take steps to guard against downside risk.

“Index investing has a place in portfolios; Ennis himself has noted this, calculating that 22% of assets in large public plans are indexed. But in managing public pension assets for the long-term, professional investing and the flexibility to choose investments within carefully established guidelines have been a proven formula for decades. Matching the markets this year or next isn’t the goal of public pension funds; the goal is to keep the funds of contributors and employers growing prudently over the long haul.

“The ability to seize opportunities is lost in passive investing; so is the ability to exit an investment nimbly when markets are in turmoil. There is also growing body of academic literature to show that index investing contributes to the overvaluation of assets. A National Bureau of Economic Research study has shown that passive flows into the S&P 500 over the last two decades disproportionately increased the prices of its largest members.

“The late Vanguard CEO Jack Bogle, known as the father of the index fund, warned shortly before his death in 2019 that index funds, while a triumph for retail investors, could also yield broader and detrimental consequences. ‘If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era,’ Bogle wrote in the Wall Street Journal.

“It is naïve, simplistic, and potentially dangerous to suggest that a wholesale shift to index investing is in the best interests of public pension funds or indeed the U.S. economy as a whole.”

Any opinions stated in the study or in the statement to PLANSPONSOR do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.