Indexing's Brave New World

With an abundance of new passive products, it’s time to redefine index investing, argues MIT’s Andrew Lo.

Indexes are becoming more than just market-cap-weighted portfolios, according to a new report from MIT.

“A confluence of technological advances has caused tectonic shifts in the financial landscape, creating winners and losers overnight.”With new passive investment products continuing to emerge, Sloan Professor of Finance Andrew Lo proposed broadening the definition of an index to include “dynamic indexes” such as smart beta strategies.

Indexes, he argued, should include any portfolio strategy that is completely transparent, investable, and rules-based. Dynamic indexes are any portfolio that fits this definition but is not market-cap weighted.

Instead, the dynamic indexes are weighted according to other factors—and not just value or momentum, according to Lo’s definition. Target-date and life-cycle funds, for example, change their asset allocations as they approach target dates, while hedge fund replication strategies replicate the betas of entire classes of hedge funds.

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The distinction is important, according to Lo, because dynamic indexes may contain more “subtle” risks, such as tail, illiquidity, or credit risk.

“Passive investing need not, and should not, imply passive risk taking, as it currently does,” Lo wrote. “If used properly, dynamic indexes can greatly benefit both investors and portfolio managers by allowing them to construct more highly customized portfolios that can achieve long-run investment objectives by managing short-run risks more effectively.”

But while the new brand of indexes can be used to an investor’s advantage, they also pose new challenges: The sheer number of financial products available requires greater education and training to evaluate potential risks and returns.

More importantly, the rise of smart beta leaves investors and portfolio managers exposed to misleading backtest bias.

“The number of new products is growing rapidly, and because, by definition, new products do not have live track records, estimates of their performance can only be based on simulated returns and are, therefore, noisier than for more-established products,” Lo wrote.

“Because simulations are, for many of these new products, the only way investors can develop intuition for the products’ risk/return profiles, decisions tend to rely much more heavily on biased performance statistics,” he continued.

When investing in smart beta indexes, therefore, Lo recommended treating all investment performance records with a “healthy dose of skepticism,” and using additional information and live-out-sample experiments to distinguish between luck and skill.

“A confluence of technological advances has caused tectonic shifts in the financial landscape, creating winners and losers overnight,” Lo concluded. “The winners are technology-savvy investors who understand their own risk preferences and financial objectives, and can appreciate the full spectrum of risks and rewards offered by today’s dizzying array of smart-beta and index products.”

Lo’s paper, “What is an Index?”, can be downloaded from SSRN.

Home > News > Manager Selection > CalPERS: $3.4B Fees, $24B Gains from Private Equity

Manager Selection November 24, 2015

CalPERS: $3.4B Fees, $24B Gains from Private Equity

The $300 billion public pension plan has released private equity performance fees for the period since 1990.

The California Public Employees’ Retirement System (CalPERS) paid $3.4 billion in performance fees to private equity managers over the last 25 years, the pension’s latest data has revealed.

CalPERS has achieved net gains of $24.2 billion since the private equity program’s inception in 1990, the data showed, which brought total private equity earnings (including the original value of the investments) to $53.5 billion.

“Private equity has the highest net returns in our portfolio.”The largest pension fund in the US also revealed it earned $4.1 billion in profits from private equity while paying out $700 million in carried interest for the 2015 fiscal year.

CalPERS has been criticized in the media for failing to disclose carried interest, but CIO Ted Eliopoulos defended the private equity program and said the pension had been “rewarded appropriately” for the risks it took.

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“Private equity has the highest net returns in our portfolio,” he said. “As a long-term investor, it is an important piece of our investment strategy and our mission.”

The much-discussed asset class also outperformed the $295 billion fund’s target return of 7.5%, CalPERS said, gaining 14.4%, 11.9%, and 12.3% for the 5-, 10-, and 20-year periods ending June 30, 2015.

“Our returns and profit sharing numbers indicate that we are prudently selecting our investment partners, and that they are skilled at managing CalPERS’ investment,” said Réal Desrochers, the managing investment director for private equity.

The data was made public after CalPERS intriduced a new accounting tool for its private equity program, known as the private equity accounting and reporting solution (PEARS).

“The launch of the PEARS system and release of these numbers is a significant step for CalPERS,” said Henry Jones, chair of the pension’s investment committee. “Private equity is a complicated asset class and the board and investment office staff will now have even more insight into our program.”

On a conference call Tuesday, Eliopoulos said 98% of its active general partners (GP) complied with CalPERS’ requests for information.

“There are still issues the private equity industry needs to address. CalPERS will continue work with LPs to standardize reporting and advocate to regulators.”“Going forward, with this extremely high compliance rate, we will not do business with firms that refuse to provide this information to us,” he said. “For new fund commitments, we are requesting and requiring GPs to provide information on fees, costs, and carried interest.”

Eliopoulos continued that today’s fee disclosures will be meaningful to the public and the marketplace.

“There are still issues the private equity industry needs to address,” he said. “CalPERS will continue work with limited partners to standardize reporting and advocate to regulators.”

CalPERS currently has about 10% of its total portfolio, or $28.9 billion, invested in private equity.

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