Hyper Activity Is Costing Large US Public Plans, Scholars Say

Large US public pensions are, on average, making alpha—but could be making more if they shifted a greater portion of their portfolios to passive investments, researchers say.

(February 28, 2013) – CIOs and their teams at major public pensions in the United States have been doing something right: A study has found these funds average 89 basis points of alpha per year due to asset management decisions.

But, according to a study, that number could be even higher if CIOs made the decision to, well, make fewer decisions. “Pension funds benefit significantly from time series momentum across multiple asset classes,” they wrote. “Our results thus suggest that pension funds, and especially the larger funds, would have done better if they invested in passive mandates without frequent rebalancing across asset classes.”

Authors Aleksandar Andonov, Martijn Cremers, and Rob Bauer (a member of The Professors, aiCIO’s just-released list of the top ten most influential academics in institutional investing) arrived at this finding by analyzing a CEM data set covering 557 US defined benefit plans from 1990 to 2010. Bauer and Andonov, both of Maastricht University, along with Notre Dame’s Cremers, broke down pension fund returns into three components—asset allocation, market timing, and security selection—and found that the second factor contributed a mean of 26 basis points of alpha annually.

Pension funds earned none of this 0.26% alpha through active rebalancing, however. “The 26 basis points abnormal market timing returns can be fully attributed to passive exposure to ‘time series’ momentum,” the authors wrote. “Time series momentum is the phenomenon that past returns in a particular asset class tend to be predictive for the return in the asset class … Combined with the insignificant security selection performance, this suggests that pension funds benefit from simultaneously investing in multiple asset classes, but would do better (after costs and on average) if they would have invested exclusively in passive mandates without frequent rebalancing across asset classes.”

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This call for passivity has been echoing from numerous corners of the institutional investing space beyond academia.

Last week, Lee Partridge of Salient urged the San Diego County Employees Retirement Association to drop certain hedge funds in their portfolio in favor of passive indexes, to take advantage of trend strategies like momentum without paying sky-high fees.

Likewise, Mercer Partner Brian Birnbaum stressed in a recent interview with aiCIO that going passive can be the best way for institutional investors to boost net returns: “What you want to avoid is having clients buy and pay multiple active manager fees to get exposure or access certain markets. You can do the same thing with index funds.”

Read the entire paper here.

(February 28, 2013) — Emerging market share prices have fallen back to 2002 levels, but investors should not take this as a sign to dive straight in, analysts at Deutsche Bank have said.

While valuations appear similar at an aggregate level, a note from the bank said this week, the underlying fundamentals are very different.

“In 2002, following a series of economic and financial crises, there was a positive shift towards capital-friendly economic policies and corporate governance taking place across most of the emerging market universe, which had gone almost completely unrecognised by investors,” the note said.

Between 2003 and 2007 a bull run produced a 450% rise emerging markets, but few investors took advantage, Deutsche Bank said. This was due to an aversion to the unknown and a reliance on past performance as a guide for future investment.

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A decade later and investors are much more open to the idea of investing in these markets, the bank said, despite conditions being no better – and in some cases worse – than before.

“By contrast today, the situation has reversed with no visible improvement in corporate governance in privately controlled companies and a pronounced tendency across the BRICS in particular, for increasing levels of state intervention to the detriment of minority investors, with the partial exception of India.”

The analysts said that practically all of the cheap sectors and stocks had fundamentals that were visibly deteriorating.

This month a survey of UK investment professionals found emerging market equities are seen as being undervalued. The CFA Valuation Index found just under half of respondents viewed emerging market equities as being undervalued or very undervalued, up from 43% in the first quarter of 2012. In comparison just 22% believed this month that emerging markets were overvalued compared to 27% in a year ago 2012.

A counterpoint to the Deutsche Bank argument was made by Jan Dehn, co-head of research at emerging markets specialist Ashmore Investment Management.

In an outlook note for the year, he estimated emerging markets to grow 6% in 2013, up from just over 5% in 2012, and to continue at a similar pace for at least a few years. This prediction was made against a backdrop of better global financial and economic activity and a pick-up in global manufacturing.

“As 2012 showed, emerging markets do not rely on strong highly indebted countries’ [developed markets] growth to have strong growth of their own. The bulk of growth in emerging markets is due to domestic factors. Emerging markets are not saddled with excessive debt loads, a number of countries are undertaking significant reforms, and last year’s monetary easing in many countries should bear fruit this year in terms of higher growth,” Dehn said.

To read the Deutsche Bank analysis, click here.

To read the Ashmore Investment Management analysis, click here.

Related content from April 2012: Is Emerging Market Debt This Year’s Junk Bond?