It’s time for public pension funds to abandon active management and alternative investments and adopt a one-size-fits-all portfolio.
In a new paper, Richard Ennis, founder of consultant EnnisKnupp, argues that U.S. public pensions have failed to leverage the $6 trillion they have in assets to become what he calls the lowest-cost producers of investment returns. Instead, they have herded into an expensive portfolio model, which includes a huge allocation to alternative investments and which has failed to deliver good risk-adjusted returns.
Public pensions now have an average exposure to equities of approximately 70 percent in highly diversified portfolios. That in and of itself isn’t bad. But their herding behavior has also resulted in “more than a trillion dollars [in] alternative investments after alts ceased adding value to institutional portfolios more than 10 years ago,” wrote Ennis in the paper, called “A Universal Investment Portfolio for Public Pension Funds: Making the Most of Our Herding Ways.”
“And yet, the heavy use of active management, and alts, in particular, has cost the funds dearly. Public fund managers need to understand that their strength is not active money management. Rather, it is their potential to become the lowest-cost producers of investment returns on the planet,” continued Ennis.
Ennis outlines the benefits for public pensions of implementing a standard and universal investment portfolio, attributing many of the weaknesses of the current model to well-known behavioral biases and wishful thinking. Institutions, after all, are still run by humans.
“It helps if we can learn to live with what markets can realistically be expected to deliver, and not harbor hopefulness for something more when it’s not in the cards. Smart institutional investing also requires that we acknowledge our strengths and weaknesses,” wrote Ennis.
For the 13 years ending June 30, 2021, 59 U.S. public pension funds have underperformed a global benchmark by a wide margin — an average of 1.21 percent per year. In fact, the underperformance essentially equaled the average expense ratios of the fund, which clocked in at 1.2 percent, according to the paper.
What’s more, Ennis determined that only one of the funds created significant alpha, or risk-adjusted returns beyond the benchmark, often a measure of investment talent. Thirty four of them generated negative alpha. “The analysis indicates a systemic problem rather than merely a string of bad luck,” the paper argues.
Going deeper, Ennis finds that public pensions don’t benefit from their big allocations to alternatives. The performance of these portfolios are explained fully by stocks and bonds. The effort and the staff required for alts is essentially wasted. “The finding that the correlation between a composite of funds with an average alts exposure of 30 percent and a marketable securities benchmark is near-perfect runs counter to the popular notion that the return properties of alts differ materially from those of stocks and bonds.”
Given the failures, Ennis is calling for an asset manager to create and market what he calls a Universal Investment Portfolio for Public Pension Funds. The passive model would mirror how pension funds in the aggregate are allocated, with expenses falling as assets under management grow. Ennis projects that the model, which would have 28.6 percent in U.S. bonds, 51.8 percent in U.S. stocks, 7 percent in international stocks with currencies hedged, and 12.6 percent in non U.S. stocks, could potentially rank in the top quartile of funds because of its low costs. And it could be profitable for an asset manager. “When the UIP fund reached one trillion in assets under management, a fee of one basis point would produce $100 million in revenue. I believe a manager with existing deep passive management capabilities could turn a tidy profit on a fee like that for managing a single portfolio,” wrote Ennis.