Security selection beats allocation in return stakes

Can large sophisticated investors beat the market? And possibly more insightfully, how do they beat the market? These questions are explored in a recent ICPM research paper – asset allocation and performance of pension funds. Amanda White spoke to one of the authors, Aleksandar Andonov from Maastricht University.

Institutional investors shouldn’t bother with hedge funds; active fixed-income is a waste of time; and the ability to add alpha is most acute with private equity and real estate.

These are some of the more stark headline findings of a recent research piece funded by the International Centre for Pension Management (ICPM) – Can Large Pension Funds Beat the Market? But while headlines serve a purpose (albeit mostly short-term) the context and depth of the findings in this paper probably provide more benefit to funds than whether to invest in a certain asset.

One of the prevailing ambitions of ICPM is to fund academic projects for, and about, its research partners. This year a collaborative effort by academics at Maastricht and Yale Universities has completed what is claimed to be the first paper in pension fund academic literature that provides a comprehensive overview of pension fund asset allocation, market timing and security selection decisions over two decades, documenting how those decisions relate to their cost structure and performance.

Using the CEM database, the researchers study the asset allocation and performance of the US and Canadian pension funds in the period 1990-2008, asking the definitive question of whether large investors can beat the market; and if so can they do it by marketing timing across asset classes or by selecting securities within asset classes. It also explores whether they use active or passive approaches, internal or external management and whether there are dis-economies of scale.

They estimate and compare the important of asset allocation policy, marketing timing, and security selection for determining the differences in the performance between funds. To evaluate whether deviations from strategic asset allocation lead to differences in performance, the researchers risk-adjust the market timing and security selection return components. They look at the impact of size, costs and investment style on the performance at the total fund level and on various asset classes separately: equity, fixed income, real estate, private equity.

One of the paper’s authors, Aleksandar Andonov (pictured) from Maastricht University, was able to deliver the good news, that yes, pension funds are able to beat their benchmarks before and after risk-adjusting.

But the study revealed some interesting detail as to how, and why, they beat those benchmarks.

“Asset allocation matters but security selection matters more, in the difference between returns of the funds,” Andonov says.

“Most funds decide to go for herding behaviour in asset allocation, so because of that asset allocation doesn’t make much difference between funds.”

A typical pension fund in the sample invested about 55 per cent in equity, 35 per cent in fixed income and 10 per cent in different alternative asset classes, with only limited cross-sectional dispersion.

The paper found that security selection has a far greater explanatory power: 45-55 per cent in the US and 48-58 per cent in Canada; with asset allocation decisions explaining only 35-41 per cent of the return differences in the US and even less in Canada (24-34 per cent), with the balancing attributed to market timing.

The authors also relate the risk-adjusted returns (on a total fund or asset class level) for both the market timing and security selection components to the total size and liquidity of the funds’ holdings, the size and liquidity of the investments in a particular asset class, the investment costs and the investment style.

The investment style reflects whether assets are managed internally or externally, and whether the assets are managed passively or actively.

It found the average percentage of actively managed equity holdings of pension funds in the period was 73 per cent of US funds, and 84 per cent for Canadian funds.

Similarly 85 per cent of the US funds’ fixed income holdings were active, while that was 81 per cent of Canadians funds.

But Andonov says the paper revealed a large cross-section in returns in asset classes where value can be added in active management.

“With fixed income, active management added nothing, so why bother. Hedge funds on average also do really badly.

Private equity and real estate, on the other hand, were areas where active management could add alpha.

Interestingly the relationship between scale and performance is not uniform and depends on the asset class and investment style.

Larger funds realise economies of scale in alternative asset classes, especially real estate, while experiencing dis-economies of scale (largely through liquidity limitations) in equity and fixed income. Internal management is associated with improved performance and higher investment costs tend to reduce returns.

“Our results show that managing larger holdings externally is associated with reduced market timing skills because of liquidity effects.

“Internal management improves performance but it is not only a cost issue, it is governance issues as well, it’s about quality, alignment of interest,” he says.

Although US funds are on average larger than Canadian funds, this does not result in lower costs. The total investment costs of US pension funds are on average 35.25 basis points per year, whereas Canadian funds have lower costs of 25.65 basis points.