Investing has grown increasingly complex in recent decades, with hedge funds, commodities, real estate, private equities, foreign stocks and other assets thrown into a mix that traditionally was dominated by U.S. stocks and bonds. But do all of those extra moving parts improve bottom-line results? Maybe not.
A new study examined the shift by public pension funds into these more esoteric areas and their greater reliance on sophisticated external advisers, with less focus on traditional U.S. stocks and bonds. All of those added bells and whistles didn’t do much to improve returns and, in some cases, the strategies backfired. Pension plans might have done better by investing in a simple mix of stock and bond index funds, argue the authors of the study by the Center for Retirement Research at Boston College.
The study by authors Jean-Pierre Aubry and Yimeng Yin looked at investment results from 2000 to 2023 for various public pension funds, typically those run on behalf of state- and municipal-government workers. The results were compared with what anyone could expect to get if investing 60% in stock index funds and 40% in bond index funds. There’s nothing magical about a 60-40 mix, except it’s a common yardstick for a balanced portfolio.
Pension funds, with their alternative investments and reduce stock exposure, fared better when the stock market was sliding, as around the deep 2007-2009 recession. However, the 60/40 mix did better when the stock market was on a roll, such as over most of the past decade. Over the full 23-year period, investment results for pension funds compared to the 60/40 mix were virtually identical.
Complicating the analysis is the tendency of pension funds to report delayed results, especially with their alternative assets. Index funds, and other mutual funds and exchange-traded funds, report their results on a daily basis and are thus much more transparent. Authors of the Boston College study said they adjusted pension-fund returns to compensate for the lagged results.
Reduced pension-fund focus on stocks
Pension funds used to invest mainly in stocks and bonds, with many following a roughly 60/40 mix, but they have boosted their exposure to alternative investments lately. On average, public pension funds hold about 45% of their portfolios in stocks, about 33% in alternatives and the rest in bonds and cash.
Public pension plans typically set a target asset mix or allocation, based on inputs from outside consultants and their in-house investment staff. Some plans then adjust these targets in an attempt to beat the stock market. But this is easier said than done, especially as index funds have become better deals by reducing their shareholder-borne costs, as has been the case in recent years.
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Some pension funds hire external managers to manage specific investments, increasing the costs and complexity of these portfolios. “The question is whether all this shuffling of investments and greater reliance on complex assets — which comes with higher fees and more staff — is better than sticking with index funds of traditional stocks and bonds,” the report questioned.
For purposes of the Boston College study, the 60-40 portfolio was assumed to be 60% invested in the Russell 3000 Total Return stock index and 40% in the Bloomberg U.S. Aggregate bond index.
Changing the mix to 70-30 would not have affected the results by much, the authors said.
The Boston College report examined prior studies comparing pension-fund results against those of index funds. These results “consistently show that public plans in aggregate underperform index portfolios by 0.9% to 1.6%” per year, on average, the authors said.
Fancier approaches don’t always pay off
The key factor explaining these divergent results is how pension-fund assets have performed relative to the U.S. stock market. In recent years, they have failed to keep up.
“Unfortunately, this weaker performance has occurred just as public pensions have been increasing their reliance on these (other) asset classes, exacerbating their drag on the funds’ total returns,” the report said.
Critics counter that such findings are dependent on the time periods examined, with a focus on the years after the Great Recession. Maybe so, but it’s only over the past decade or so that pension funds have jumped on the alternative-asset bandwagon in such a big way.
“The key takeaway is that the long-term annualized return for pension funds is almost the same as that of the 60/40 portfolio, about 6.1% per year for both,” according to the study.
That implies that public pension funds aren’t producing notably better results from their reliance on complex investment strategies compared to what individual investors can generate on their own with a simple approach.
“If public plans cannot reasonably anticipate higher long-term returns from a complex active approach, they should stick with a simple and transparent strategy,” the report concluded.
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