Active US large cap adds nothing

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Large cap US equities is an efficient market and pension funds are better off indexing their allocations, saving billions of dollars in the process, according to new research by CEM Benchmarking.

Analysis of the returns of equity portfolios by US pension funds shows that large cap equities portfolios added zero value, even before costs, and investors would be better off getting beta returns and reducing costs.

The report’s author, Alex Beath, estimates up to 30 basis points could be saved by indexing US large cap equities exposures. That’s more than $8 billion in one year alone across the sample analysed.

CEM looked at the equity portfolios of large US defined benefit plans between 1996 and 2017 with a combined $2.725 trillion invested in large cap equities portfolios (adjusted for inflation to 2017 USD).

“That’s a lot of money you are paying to operate in an efficient market. For 22 years the largest funds in the US have never added value in that asset class. Why would you try to be active in this market?” Beath adds.

Net of fees these large cap US equities portfolios produced returns of between -0.24 and -0.5 per cent. Gross of fees the return range was 0.11 to -0.15 per cent (with 95 per cent confidence).

Part of the reason investors continue to invest in active large cap US equities is they are fooled into believing that their own abilities, in picking managers or stocks, is better than the market.

“Part of it is lack of data and if they do have outperformance over say a three-year period they get a bias and think they’re better at picking managers, but really that’s just valuing luck,” Beath says. “My personal belief is investors shouldn’t be looking at their own results in these asset classes but looking at peers and larger datasets so they can judge these decisions with data behind them and avoid the sample bias they get by just looking at their own decisions.”

While the research found that large cap US equity portfolios exhibit efficient market behaviour gross of costs, and underperform the market net of costs, small cap US equity portfolios outperformed the market gross and net of costs.

The research analysed US defined benefit fund portfolio data of $1.3 trillion of US small cap holdings (2,172 portfolios) which added 1.02 to 1.38 per cent before fees, and 0.35 to 0.71 per cent after fees, over the 22-year period.

“Investors should definitely be allocating their dollars spent chasing alpha to inefficient markets not efficient ones,” Beath says.

The results could have implications for the dollar amounts spent chasing alpha. The funds sampled have an average allocation of 32 per cent to large cap US equities. The total amount of which is unlikely to be redistributed entirely to chasing alpha elsewhere.

The average allocation to small cap US stocks was 6 per cent.

“The total dollars spent chasing alpha could decrease, active budgets could come down,” Beath says. But he also says that investing more in small caps makes sense given the correlations and the opportunity to pick up alpha because of the inefficiency.

“Should they be allocating more? Potentially,” he says.

The funds measured had an average of 3.4 mandates in large cap US equities and 1.8 in small cap US equities, with average mandate sizes of $2.26 billion and $324 million respectively.

Beath says that CEM’s research has shown that there are many asset classes that are potentially inefficient, and that US large cap equities is an outlier.

“Most academics study US large caps but that is efficient. That’s an outlier. In most of our cases we see that markets are inefficient in some way.”

Beath said with regard to equities allocations, an active global ex-US portfolio “makes sense” with a separate US indexed mandate.

According to Beath the difference in performance, due to alpha, between small and large pension funds is very small. There is a difference in performance but it is due to the cost savings of larger funds, not alpha, he says.

“Gross of costs there is no advantage to being large or small when it comes to alpha. After costs larger funds do a bit better – about 7-8 basis points for every 10-fold increase in size. But they don’t show any real ability to pick better managers.”

The funds analysed make up around half of the total defined benefit pension funds in the US.


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