How Institutions Game Benchmarks

Richard Ennis argues that allocators are choosing a low bar to assess their performance, a practice that ultimately keeps active managers in business.

Illustration by II

Illustration by II

If you lower the basket and move the three-point line in close enough, even a 4’10” Institutional Investor reporter can compete with LeBron James — at least on paper.

Richard Ennis, co-founder of consultant Ennis Knupp, argues in an article to be published in the Journal of Investing that a version of this rigged game has long been happening in the investment world. Pensions, endowments, foundations, and mutual funds are using benchmarks that are easily beaten, a scheme that overstates the value of their investing prowess, active management, and the endowment model. It also results in massive fees paid to asset managers for average performance, he says.

If you want to learn how to modify the basketball court, or just how low the basket should be, you could consult San Antonio Spurs coach Gregg Popovich. If you want to know what data to look at to determine how big institutions are analyzing and reporting their risks and returns, you’d call Ennis. Ennis, a former editor of the Financial Analysts Journal, helped create the business of institutional investment consulting while at A.G. Becker, where he learned how to find and analyze the data at the heart of pensions, endowments, and asset managers.

In a new paper cheekily entitled “Lies, Damn Lies and Performance Benchmarks: An Injunction for Trustees,” Ennis concludes that the benchmarks that institutions use to judge their returns underperform gauges that are far more representative of the actual market exposures and risks in their portfolios by 1.4 to 1.7 percentage points annually. Not surprisingly, a majority of pensions, endowments, and mutual funds have beaten the benchmarks they devise. By using flawed benchmarks, pensions and endowments are painting a picture that shows that they’ve beaten a low-cost, passive portfolio, when in fact they’ve dramatically underperformed it.

For the 10 years ending in June 2020, 24 public pension funds reported that they had outperformed their benchmarks by 0.4 percentage points annually. Ennis then used returns-based style analysis to create a unique passive and investable yardstick of U.S. and international stocks and U.S. bonds for each pension. Under this scenario, Ennis found that these funds underperformed by an average of 1.3 percentage points annually.


An analysis of endowments was similar. Over the same period, 22 endowments reported beating their own benchmarks by 0.1 percent annually. Using more appropriate benchmarks, Ennis found that they underperformed by 1.3 percentage points annually, the same gap as the pensions. Ennis cites other research showing how the phenomenon happens with mutual funds.

The underperformance isn’t just an academic exercise. It underpins an argument not to use index funds.

“…Public pension funds and endowments, have been loathe to pick up on the realities of modern capital markets. Since the GFC, they have consistently underperformed passive management by the margin of their substantial costs when evaluated against fair benchmarks,” Ennis wrote.

While the cost of investing in stock funds, taking into account the move from active to passive, has declined from 1.04 percent of assets to 0.5 percent over the past 24 years, Ennis estimated that institutions doubled their expenses over that time period, from 0.6 percent to 1.2 percent. Much of that has come from the rising use of expensive alternatives such as private equity.

“There is big money to be made in asset management — on both sides of the table,” Ennis wrote. “For their part, institutional CIOs know they can earn much more when overseeing a complex, active investment program than if they were to adopt a passive approach at next to no cost. The benchmark gaming described here may be the best evidence that the CIOs themselves believe that the odds of beating the market are very long. And yet, they persist in gambling with moneys entrusted to them.” He argues that consultants also are complicit: They earn more when portfolios are complex. Trustees, though well intentioned, are not equipped to fight back against the recommendations of everyone else. The true stakeholders are taxpayers, public employees, and colleges and universities, who don’t have a voice in how their money is managed.

Although arcane, Ennis clearly lays out how benchmarks became distorted. He explained that multi-asset portfolios should be compared to a passive policy benchmark that is both investable and reported net of fees. That reveals whether active investment decisions have paid off.

Instead, public pension funds and endowments use strategic benchmarks that were designed for internal staff to understand where returns were coming from. Now these strategic benchmarks are often highly tailored and include a broad range of asset classes, including private market investments that aren’t traded on an exchange. In the end, strategic benchmarks are “subjective in their construction, often complex, ambiguously customized, fluid, opaque, and all but indecipherable to readers of financial reports,” he wrote.

Lowering or raising the basket matters. This reporter wouldn’t want to face James on a real court.

“In my opinion, gaming performance benchmarks is the biggest problem facing institutional investing today,” Ennis argued. “If conscientious trustees are misled by rosy reporting, how can they be expected to address chronically poor performance? Trustees must step back from investment operations (and temper their understandable enthusiasm for institutional success), to embrace their paramount responsibility, which is holding the whole stack of agents beneath them accountable.”