Public Equity Allocations Lead the Way for Public Pension Funds

The top-performing public pension funds this year are likely to thrive with a higher allocation to equities, according to Markov Processes International.

In 2023, public pension funds, endowments and other institutional allocators saw weaker returns from alternative investments like private equity, but stronger returns from public equities, which have historically underperformed the former, according to a review by Markov Processes International Inc.

The pension funds that performed best last year typically had higher allocations to equites, and MPI expects that trend to continue through 2024, based on the projected 2024 returns of some of the largest public defined benefit plans in the U.S.

According to MPI projections, the aggregate of 47 pension funds, each with more than $20 billion in assets under management, will return 11.3% gross of fees in fiscal 2024, a reporting period that for most ended on June 30. Most public funds have not reported their fiscal 2024 returns.

MPI’s methodology takes returns through the last fiscal year and regresses them against the return stream of other passive factors representing different asset classes, says Jeff Schwartz, MPI’s president. “This gives us a combination of factors that best mimics the return stream for each pension fund.”

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MPI’s model does not specifically track the asset allocation of each fund, and any change in a fund’s allocation for fiscal 2024 would not be reflected in the firm’s analysis.

“Using those factor exposures from last year, we can compare that to the performance of each factor through the present, and that allows us to come up with a prediction of what performance might be, assuming those factor exposures held constant since last year,” Schwartz says.

Schwartz also notes that although these factors will not always hold constant, MPI’s model is a good way to examine opaque investments and get an idea of what’s going on inside a portfolio.

“We know that those factor exposures are going to change over time, and we know this isn’t telling us what the actual positions are,” Schwartz says. “They’re quantitatively derived exposures.”

For fiscal 2024, the S&P 500 returned 24.6%, boosted primarily by mega-cap technology stocks, specifically the Magnificent Seven. In the same period, U.S. bonds returned 2.6% and private equity 7.7%.

Hedge funds, which are falling out of favor in allocator portfolios, returned 9.8%, and real estate, the only negative performing asset classes lost 4.3%, while commodities and natural resources each returned 5.0%.

“As U.S. public pensions calculate their FY2024 returns, we wanted to provide estimates on the MPI Transparency Lab of how their portfolios behaved this fiscal year,” said Michael Markov, MPI’s CEO, in a statement. “Some interesting patterns reemerged to echo FY2023, including the drag on returns from private markets (PE and real estate) and the overwhelming power that exposure, or lack thereof, to mega-cap domestic stocks had on the largest public pension portfolios.”

2024 Projections

Across the board, MPI projects public pension funds will outperform their 2023 returns. U.S. equities are projected to account for the most asset class contributions to fund performance across the board.

Among the pension funds that MPI projects to have the highest returns this year, the top two have among the highest allocations to public equities. MPI projects the Teachers Retirement System of Georgia to have the highest return this year at 16.3%. Of the largest public pension funds in the U.S., TRSGA has a 70% allocation to U.S. public equities.

In second place, MPI predicts, is the Kentucky Teachers’ Retirement System, with a return of 16.1% and a U.S. public equities allocation of 60.4%, the third highest among tracked plans.

Institutional investors like pensions invest on a long-term horizon, investing to meet liabilities decades out. These investors are not terribly concerned about the short-term performance of one asset class, but MPI’s analysis is intended more to highlight trends than to tell investors they have to make near-term asset allocation decisions.

“We are not trying to turn a spotlight on short-term performance when these infinite time horizon funds should be judged over much longer time periods,” says Schwartz. “We’re simply identifying over the past year, what differentiated how these funds did, and we think the entire investment world tends to look at these huge pools of assets just for clues on moves that people are making or trends.”

While private equity has faced two years of underperformance, in the long term, the asset class has outperformed public assets.

“Anybody with significant Magnificent Seven exposure the past year or two has a lot to show for it, but the funds that have the luxury of holding a lot of illiquids, that may still pan out over the long term,” Schwartz says. “It’s not time to say they’ve made bad bets, right?”

Weak Private Equity

Private equity dry powder is at an all-time high, as PE firms hold onto portfolio companies that were acquired at higher multiples when interest rates were lower, which in turn has constrained distributions to limited partners and general partners. That, in further turn, has led to weaker performance in the portfolios of institutional investors.

In fiscal 2022, the reverse was true: Private equity was among the only positive-returning asset classes in institutional portfolios tracked by MPI, while the S&P 500 declined nearly 20% due to inflation and other financial instability that came as the COVID-19 pandemic eased.

According to MPI, the pension funds with the lowest projected returns in fiscal year 2024 are among the highest allocators to private equity.