The cost of bad asset allocation

A study of 300 US pension funds by CEM Benchmarking reinforces the importance of asset allocation, highlighting the performance of asset classes, as well as new evidence on correlations between asset classes. Alex Beath, author of the study, discusses the implications for asset allocation with Amanda White.

A CEM Benchmarking study “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States Between 1998-2011,” has revealed the power of asset allocation as a driver of performance, and how asset class correlations add vulnerability to diversification.

Alex Beath, author of the study that looked at the asset allocation, fees and returns of 300 US pension funds with combined assets of $2.8 trillion from 1998-2011, says during that period the defined benefit pension plans included in the study increased their investments in alternative assets – private equity and hedge funds, real estate and other real assets such as commodities and infrastructure – by nearly 400 percent on average.

CEM used its extensive databases to examine how this reallocation to alternatives paid off in terms of gross returns and realized returns net of fees charged by investment managers.

And basically it didn’t.

Large corporate plans were the best performers among the funds analysed and this was due to their higher allocations to long duration as part of a liability matching strategy.

The report concludes that many pension funds could have improved their performance by choosing different asset allocation strategies and optimizing management fees.

CEM found that listed REITs were the best performing asset class over the period, and that hedge funds were the worst performer.

“Hedge funds didn’t just perform poorly but it also revealed that on average hedge funds look like US large cap stocks,” Beath says. “Hedge funds have a lower volatility than US large cap so that is a benefit, but they perform like US large cap stocks, but have much higher fees.”

In addition to the correlation between hedge funds and US large caps being very high, the study revealed a very high correlation between private real estate and REITs, and between private equity and US small cap stocks.

“If you look at raw data it looks different but once you correct the data to account for lag then you see there is a very strong correlation,” he says. “You might think by investing in these asset classes you are increasing diversification but you are not at all. Thinking you are de-risking by adding in uncorrelated asset classes like private real estate is totally an illusion.”

The performance differences in the cohorts of funds analysed in the study are due primarily to their asset allocation differences, the study found.

Large corporate plans were the best performers, and this was due to those investors allocating more to long duration fixed income, which is a direct result of those funds more consciously investing according to liability matching strategies.

“These large corporate funds had a much higher net return compared to public funds due to a shift in asset allocation prior to the financial crisis and a timely increase in long duration fixed income and a decrease in US large cap stocks. Corporate funds are more interested in liability matching than public funds and embrace LDI, which means they are more likely to alter allocations.”

The study found that corporate sector plans reduced their average allocations to US large cap equities and US broad fixed income securities by 19.6 percentage points and 10.3 percentage points, respectively, with the largest declines among the largest plans, those with total assets of more than $10 billion. Over the same period, allocations to long duration US bonds and hedge funds increased 16.9 percentage points and 5.0 percentage points, respectively, and again most dramatically among the largest plans.

Public sector plans also reduced on average their allocations to US large cap equities (by 18.7 percentage points) and to US broad fixed income (by 11.0 percentage points), although the reductions in both cases were somewhat larger for mid‐sized plans.

Unlike corporate sector plans, however, the allocation to long duration US bonds among public plans was notably unchanged over the period as public sector plans did not embrace LDI to the degree of their corporate sector counterparts. Public plans on average increased their allocations primarily to non‐US equities (by 11.0 percentage points), TAA/hedge funds (by 4.6 percentage points) and private equity (by 6.0 percentage points).

Large corporate sector plans were the best performing among all major pension fund cohorts classified by fund type and fund size, achieving an average annualized compound net return of 7.54 percent over the period 1998‐2011, significantly outperforming the 6.61 percent of all funds combined.

Linking the asset allocation decisions to performance and to determine the potential impact of a shift in asset allocations on portfolio net total returns over the period 1998‐2011, the study looked at estimates for each year of the marginal benefit or loss of a one percentage point increase in the portfolio weight for each of the main asset classes, with the average annual impact shown in the bottom row.

The estimates reveal that US long duration fixed income, listed equity REITs, and other real assets (infrastructure, commodities, etc.) would have provided the largest marginal increases to total portfolio annualised average net returns of 4.4 basis points, 3.9 basis points, and 3.8 basis points per year, respectively, for each percentage point increase in allocation over a period that includes the financial crisis.

Other portfolio allocation shifts that would have appreciably increased portfolio net total returns over the period include reduced exposure to US large cap equities (2.9 basis points per year for a one percentage point lower allocation), increased exposure to private equity (2.8 basis points per year for a one percentage point higher allocation), and reduced exposure to TAA/hedge funds (2.1 basis points per year for a one percentage point lower allocation).

In terms of costs, not surprisingly, US fixed income was the lowest at around 17 basis points, with costs increasing up to 10 times that in private equity.

The CEM study also touched on implementation styles with the performance of small public funds highlighting the cost of using fund of funds.

“You can explain why different cohorts of funds do better mostly by looking at asset allocation, which explains about 90 per cent. But with small public funds you can’t do that, their asset allocation is fine and so they should have got average asset performance, but their private equity lagged so much because they use fund of funds – the fund of funds performance lagged even before fees were considered.”