It is time for public pension funds to abandon active management and alternative investments and embrace a unified portfolio.
In a new paper, Richard Ennis, founder of consulting firm EnnisKnupp, argues that US federal pensions have failed to leverage the $6 trillion in assets to become what he calls the lowest-cost generators of investment returns. Instead, they’ve committed to an expensive portfolio model that includes a huge allocation to alternative assets and doesn’t deliver good risk-adjusted returns.
Public pensions now have an average equity exposure of about 70 percent in highly diversified portfolios. That in and of itself is not bad. But her herding behavior has also resulted in “more than a trillion dollars.” [in] Alternative investments after alts stopped adding value to institutional portfolios more than 10 years ago,” Ennis wrote in the paper titled “A Universal Investment Portfolio for Public Pension Funds: Making the Most of Our Herding Ways.”
“Nevertheless, the heavy use of active management and alts in particular has cost the funds dearly. Public fund managers need to understand that active money management is not their forte. Rather, it is their potential to become the lowest-cost generators of investment returns on the planet,” continued Ennis.
Ennis outlines the benefits of implementing a standardized and universal public pension investment portfolio and attributes many of the current model’s weaknesses to known behavior patterns and wishful thinking. After all, institutions are still run by people.
“It helps if we can learn to live with what markets can realistically expect and not hold out hope for more when it’s not in sight. Smart institutional investing also requires that we recognize our strengths and weaknesses,” Ennis wrote.
In the 13 years ended June 30, 2021, 59 U.S. public pension funds have far outperformed a global benchmark — an average of 1.21 percent per year. In fact, the underperformance was broadly in line with the fund’s average expense ratio, which the paper said was 1.2 percent.
In addition, Ennis found that only one of the funds produced significant alpha, or risk-adjusted returns, above the benchmark, which is often a measure of investment talent. 34 of them generated negative alpha. “The analysis points to a systemic problem rather than a losing streak,” the paper argues.
Ennis digs deeper and finds that public pensions are not benefiting from their large allocations to alternatives. The performance of these portfolios is explained entirely by equities and bonds. The effort and manpower required for alts is essentially wasted. “The finding that the correlation between a composition of funds with an average alts exposure of 30 percent and a marketable security benchmark is near perfect goes against the widely held notion that the return characteristics of alts differ significantly from those of stocks and bonds differentiate.”
In the face of failures, Ennis calls on an asset manager to create and market what he calls a universal public pension fund investment portfolio. The passive model would reflect the overall allocation of pension funds, with spending falling as assets under management grow. Ennis predicts that the model, which would invest 28.6 percent in US bonds, 51.8 percent in US stocks, 7 percent in international currency-hedged stocks, and 12.6 percent in non-US stocks, is potentially due to this low costs could rank in the top quartile of funds. And it could be profitable for an asset manager. “When the UIP fund reached $1 trillion in assets under management, a one basis point fee would generate $100 million in revenue. I believe a manager with existing extensive passive management skills could make a decent profit on such a fee for managing a single portfolio,” Ennis wrote.