Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
A warning on alts from abroad
Australia’s super funds are in the process of aping their overseas brethren by increasing their allocations to alternatives like private equity, but a new paper by Ennis Knupp co-founder Richard Ennis questions whether that’s where the strength of any pension fund lies. Alternatives have failed to deliver good risk-adjusted returns, he argues, and are expensive to boot – so big funds should just go all in on low cost investing instead.
To prove his point, Ennis constructed a benchmark for a composite of 59 large public funds using four broad market stock/bond indices. The public fund composite underperformed the benchmark by an average of 1.21 per cent per annum over the 13 year study period, and did so consistently – in 12 of the 13 years. The cross-section of returns of individual funds showed that only one of the 59 had a statistically significant positive alpha; 34 had statistically significant negative ones.
“Even though in practice the funds collectively have a 30 per cent allocation to alternative investments, e.g., private equity, private-market real estate and hedge funds, the stock-bond benchmark explains the performance of the composite for all intents and purposes; alternative investments do not have a meaningful impact,” Ennis writes.
“The finding that the correlation between a composite of funds with an average alts exposure of 30 per cent 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. That, after all, is an oft-cited reason for incorporating alternative investments in institutional portfolios. But as we see here, alt returns simply blend in with broad market returns in the context of standard portfolio analysis.”
US public pension funds have increased their allocations to alternatives dramatically in the last 20 years, from around 10 per cent in 2001, motivated by a belief that these markets were inefficient owing to their opacity and the lack of skilled managers within them. But greater pricing efficiency and their higher costs have since wiped that inefficiency out, and Ennis’ research shows some alternative asset classes stopped adding value shortly after the GFC.
“For their part, public funds need to come to terms with their nature. Given the large size of their portfolios, the limitations imposed by their operating environment and penchant for diversification, they should embrace their singular comparative advantage. It’s not active money management, that’s for sure. Rather, it is their potential to-collectively-become the lowest cost producer of investment returns on the planet. That is where public pension funds should ultimately congregate.”
Ennis instead proposes a “Universal Portfolio” for US pensions, mirroring the benchmark he proposed: 51.8 per cent in US stocks; 28.6 per cent in US bonds; 12.6 per cent in non-US stocks; and 7 per cent in non-US stocks with currency hedged. This would operate as a purely passive portfolio, with an expense ratio that declines as assets grow and which would perform in the top quartile of US funds as a result.
“It obliges us to resist the temptation to fill the gaps in our understanding with mythology or contrivance. 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. In the case of managing public pension funds, the pay-off for getting it right would be huge.”
Of course, some alternatives commonly used by US pension funds are less favoured Down Under – particularly hedge funds. Ennis has been an outspoken critic of the turn to alternatives for some time, noting that they behave much like “efficiently-priced traditional assets” but are more costly – and so don’t perform better than public markets when returns grow more muted there.
“(There is no) precedent for alts being the better bet when stocks are in for a sell-off,” Ennis wrote in March. “Deep into a bull market, though, we encounter this canard regularly. A golden applefigures prominently in fairy tale literature; here we have the golden alpha of the fairy tale of alternative investing.”
