The debate over whether to invest “passively” through index funds or “actively” through professionally managed funds has largely been resolved in favor of the passive camp. Decades of empirical data have made the case for passive and the result has been the persistent growth of index investing for both individual and institutional investors. Yet, in defiance of this trend, the financial industry continues to create and sell trillions of dollars in increasingly complex products with much higher fees. These so-called “alternative” financial products have made huge fortunes for managers of hedge funds, private equity funds, and other exotic products. Unfortunately, by and large, they fail to provide value for the investors that have been lured into believing that complexity brings higher returns.
David Swensen of the Yale Endowment was a pioneer in the use of alternative assets. The good performance of this strategy in the 1990s and several books by Swensen lauding its merits attracted many imitators to the “Yale Model.” At the same time, the rise of low-cost index funds on traditional equity products drove the wily Wall Street marketing machine to promote new products with high fees. As a result, from 1997 to 2018 hedge fund assets under management grew from $118 billion to $3.5 trillion. Over the same period, the number of active private equity firms grew more than tenfold, from fewer than 1,000 to roughly 10,000. In the case of educational endowments like Swensen’s Yale, the average exposure to alternatives has risen from 12% in 1990 to 34% in 2002 and to around 60% of total assets today.
Unfortunately, Swensen was not able to sustain the high returns achieved in the 1990s, the “Golden Age of alternative investing.” Ironically, the popularity of the Yale model may have been its undoing. Over the 2010-2019 period Yale returned 11.1% annually compared to S&P 500 returns of 14.7% and returns of 11.4% for a traditional 70/30 stock/bond mix. This is before the operating expenses of the Yale endowment which total 0.38% annually. Nevertheless, Yale continued to be one of the best performing university endowments over this period.
The most recent study of the performance of public pension funds and university endowments, “HOW TO IMPROVE INSTITUTIONAL FUND PERFORMANCE,” by Richard M. Ennis (link) describes how the Yale model has destroyed value for institutional investors. Desperate for higher returns in a world of overvalued assets and low prospective returns, these funds have allocated over a trillion dollar s to alternatives and have nothing to show for it. As a group, they would have been much better off buying a few Vanguard index funds.
Ennis’s study of 46 public pension funds highlights the following:
- Only two of the 46 endowments outperformed with statistical significance.
- A composite of the funds surveyed underperformed by 155 bps per year for the 12 years ending June 30,2020, and the composite underperformed in 11 of the twelve years.
- Alternatives, which represented 30% of assets, provided no diversification benefits, acting equity-like in their risk profile, with added leverage.
- Poor performance is not tied to size of the fund. In fact, most underperformance was attributed to exposure to alternatives.
Ennis’s survey of university endowments identified even poorer performance than for public pension funds. This is remarkable given that the staffs of endowments are considered to be more skilled and are paid multiples more than the public servants that typically staff pension funds.
Here are the key findings from Ennis’s research:
- Endowments with assets greater than $1 billion underperformed by 1.87% per year over the period and trailed the benchmark in 12 out of 12 years.
- Alternatives represented 60% of the asset allocation of endowments, providing no diversification benefit but dramatically increasing costs. Ellis estimates that the fees paid to managers by these endowments run at about 1.8% of assets per year and explain almost all the underperformance.
- The performance of endowments actually is overstated, since they do not include their own operational expenses in their performance numbers. In the case of Yale these expenses were 0.38% of assets under management.
Ellis estimates that pension funds paid around $70 billion in fees to Wall Street in 2020 all of which they could have saved by investing in low-cost index products. Endowment funds paid $11.5 billion in fees plus about $2.5 billion in expenses (salaries, rents), all of which they could have avoided by investing in index funds.
Ellis’s data on endowments comes primarily from the annual NACUBO-TIAA (link) study of endowments which reports on the sector’s overall results. Using this same source Fiduciary Wealth Partners, a firm that provides investment advice to high net-worth clients, has tracked the returns provided by the top quartile performing endowment funds for the past twenty years and compared these to returns achievable through low-cost index funds. FWP confirms Ellis’s finding that even the elite of the endowments have destroyed value. The two charts below show (1) the portfolio allocation of low cost index funds used by FWP and (2) the 10-year rolling returns of this model portfolio including all fees compared to the composite returns of the top quartile endowments. The 70/30 index portfolio has outperformed in every 10-year rolling period and by a considerable margin over the time frame considered. This is before considering the internal operating expenses of the endowments.
Implications for public pension funds around the world
The case of U.S. pensions and endowments should provide a good example for the world. The lure of complexity and the belief that sophisticated high-fee managers can add value after fees is as prevalent in public pension schemes in Latin America and sovereign funds around the world as it is in the U.S.
Ellis describes the situation of the public pension funds of the City of Los Angeles as a microcosm of what ails public pension systems around the world. Taxpayers of the city back six different public pension funds representing different groups (teachers, fire-police, city employees, water-power, county employees and state employees.) All these funds replicate a similar investment cost-base and follow similar “diversified” investment processes. The final result is an immense index-like fund with an expense of 1.1% per year. This cost, in the end is born by the taxpayer.
The obvious path for these public pension funds would be to merge and simplify their investment processes through low-cost indexing approaches. However, this is difficult to do because of the resistance from the agents currently involved in the process: the managers, investment professionals, trustees and outside advisors that have a stake in the current system.
This situation of Los Angeles is repeated across the world.
An extreme example this is the Chilean AFP system of privately managed pensions. Designed by Chile’s “Chicago Boys” free market ideologues in the 1980s, the AFP model was based on the conviction that private competition would bring about a fruitful combination of minimal costs and maximum returns, to the benefit of Chilean pensioners. However, after 35 years of the AFP model we can see a situation similar to the one of the the City of Los Angeles. The system has high costs which hurt returns for pensioners; seven AFP firms compete for customers, replicating high administrative and marketing costs, for a relatively small pool of assets of $200 billion. The primary beneficiaries of the AFP system, as in Los Angeles, are the agents (owners of the AFPs, managers, administrators, regulators). Much better results could be achieved by a small committee deciding on a long term allocation strategy and allocating the system’s funds to index products.
In fact, there are a few examples of funds that have followed the path recommended by Ellis.
One example is Nevada’s $35 billion Public Employees Retirement System (link). Unlike Los Angeles and Chile with their teams of managers, administrators, marketers and advisers, the CIO, Steve Edmunson, manages the fund by himself. Following Warren Buffet’s advice, Edmunson shuns fees and practices inactivity. Nevada’s funds are allocated to ETFs and a few trades a year suffice to keep them aligned with the long-term strategy. With an investment staff of one person, Nevada’s costs are 5 basis points (0.05%) compared to the 1.5% average estimated by Ennis for U.S. public pension funds.
excellent analysis