The biggest pension funds and educational endowment funds in the United States are playing a ‘loser’s game’ in the world of alternative investing, argues retired investment consultancy industry heavyweight Richard Ennis, but vested interests and dubious benchmarking practices are keeping the true stakeholders in the dark.
In two recent papers analysing the returns of large US educational endowment funds and pension funds, Ennis argues alternative investments have brought consistent negative returns for more than a decade and will probably keep doing so for the years ahead.
“There are a lot of people with vested interests who are still pushing these strategies,” Ennis tells Investment Magazine in a phone interview. “You’re not going to get a million or five million or ten million a year to manage an institutional fund if you put the whole thing in index funds.”
In a paper published in the Journal of Portfolio Management titled ‘Institutional Investment Strategy and Manager Choice: A Critique’, he takes aim at the performance of US educational endowment funds and pension funds, finding they significantly underperform passive investment.
His analysis of the performance of 46 large US pension funds in the decade to June 30 2018 found only one had generated a statistically significant positive alpha, and seventeen had statistically significant negative alphas. A separate analysis of 43 of the largest educational endowments found none had generated positive alpha and eleven were negative.
The straight-talking Ennis has recently authored a memoir called ‘Never Bullshit the Client: My life in investment consulting’. A CFA, he managed money at Transamerica, pioneered quant investing in the 1970s and helped create the field of institutional investment consulting at A.G Becker & Co.
In 1981 Ennis co-founded Chicago-based investment consultancy industry giant EnnisKnupp, the first consultancy to be recognised as a professional services firm. EnnisKnupp was acquired by human resources consulting giant Hewitt Associates in 2010, at the time with over US$2 trillion of assets under advisement.
Ennis’ paper states plainly: “In terms perhaps better suited to trustees of endowment funds with less than a billion in assets and others who may not be conversant with statistical jargon, the message here is this: Liquidate your alternative investments and put the proceeds into index funds. Do it now.”
Dragged down by alts
Ennis created a unique performance benchmark for each of the 46 public pension funds and 43 endowment funds, then regressed individual fund returns on their unique benchmark.
He found public pension funds underperformed passive investment by approximately 1 per cent a year for the 10 years ended June 30, 2018. The shortfall of educational endowments was 1.6 per cent a year.
There was a statistically significant relationship between underperformance and allocations to alternative investments, and the endowment funds fared worse than pension funds owing to their higher proportion of these investments.
Endowment funds were early adopters of what came to be known as the Yale Model in the latter part of the 1980s, putting heavy emphasis on alternative investments under the guidance of esteemed investor David Swensen.
Public pension funds now have 28 per cent of their assets in alternative assets, Ennis says in his paper, while large educational endowments have 58 per cent.
But while alternative investments brought strong returns in the decade from July 1999 to June 2008, they ceased to be diversifiers around 2008, Ennis says. Today, greater pricing efficiency and high costs have converged to wipe out any slim returns that remain to be made.
“In the case of hedge funds and private equity, there was just a tidal wave of capital pouring into what were very small markets… and it brought about greater pricing efficiency so the alternatives started behaving more like public markets,” Ennis says.
Private equity started losing its sheen and producing negative risk-adjusted returns in 2006, Ennis says, while hedge funds cracked a couple of years later.
Ennis also takes aim at what he sees as a widespread misunderstanding of the term ‘diversification’, arguing it is often confused with its opposite: ‘concentration’.
Some believe Swensen’s success in the 1980s was owing to him diversifying the portfolio, Ennis writes in another paper he is working on that has not yet been published, excerpts of which he provided to Investment Magazine. In reality, Swensen actively managed the Yale portfolio and did so aggressively, concentrating it such that now more than half is in illiquid assets that constitute a mere 4 per cent of the market portfolio.
Conversely, many institutional investors today employ a form of diversification which Ennis describes as “deadweight”, which happens when multiple active managers are employed and take offsetting active bets, leaving the investor without an active exposure but paying a fee to both managers. This practice accounts for a lot of industry underperformance, Ennis says, and is probably a factor behind alts losing their sheen after 2008.
“I think the investment markets, in general, were understandably chastened by the events of the great financial crisis,” Ennis says. “That was a huge wake-up call to a system that was awash in cash, much of it by virtue of leverage.
“So what happened is with this wake-up call combined with all the money that had poured into these areas, they were just in a position of underperforming by their very sizeable costs.”
Benchmarks are ‘slow rabbits’
Overseers of institutional funds are quick to point out they have outperformed their custom benchmarks, but in the “black art of institutional fund benchmarking”, benchmark designers have been known to take liberties with the applicable principles, Ennis writes.
The 10 largest public pension funds in his dataset reported having outperformed their custom benchmark by an average of 0.17 per cent per year over the study period, but those same funds underperformed Ennis’ equivalent-risk benchmarks by an average of 0.83 per cent a year.
“This suggests the custom benchmarks are slow rabbits in the parlance of greyhound racing,” Ennis writes in the paper. “It certainly raises a question about the objectivity of self-measurement.”
He tells Investment Magazine there is a “crying need for transparency of a much more fundamental nature”, which would include rates of return reported net of all expenses (and certified), along with historical annual rates of return, current and historical asset allocation, true full expenses disclosure, and ultimately “much less self-serving BS and spin in annual reports”.
Consultant advisors are typically supportive of alternative investments as “they have recommended this stuff in the past and have a stake”, while investment committees typically have active members of the alternative investment community, Ennis says.
The solution he puts forward for funds is that “institutional trustees place half their portfolio assets in a few broad stock and bond market index funds, sharply reducing their cost of operation and increasing the likelihood of out-performing those among their peers that choose not to follow suit. This goes for gigantic funds as well as small funds and both private and public funds.”
Trustees should then increase or decrease their passive investment percentage, incrementally but systematically, in the ensuing years, based on the performance of the active assets.
Otherwise, they face the prospect of ongoing and significant underperformance in the years ahead.