It seems logical to believe that if anyone could beat the market, it would be the pension plans maintained by U.S. companies. Why is this a good assumption?
First, pension plans control large sums of money. As a result, they have access to the best and brightest portfolio managers, each clamoring to manage the billions of dollars in assets these plans control (and earn large fees in the process). Pension plans can also invest with managers to which most individuals don’t have access because they lack sufficient assets to meet the minimums of these superstar managers.
Second, the chances are minute that these pension plans have ever hired managers who did not have a track record of outperforming their benchmarks, or at the very least, matching them. Certainly, they would never hire a manager with a record of underperformance.
Third, it is also safe to say that these pension plans likely have never hired managers who did not make a great presentation in which they explained why they had succeeded in the past and why they would continue to succeed. Surely, the case presented was a convincing one.
Luxury Of Good Advice
Fourth, as individuals, it is rare we would have the luxury of personally interviewing money managers and performing as thorough a due diligence as the consultants that pension plans hire to advise them on manager selection. We generally don’t have professionals helping us to avoid mistakes in the process.
Instead, as individuals, we are generally stuck relying on Morningstar’s ratings; and despite the tremendous resources that Morningstar employs in the effort to identify future winners, it has not shown the ability to do so successfully. For example, 2010 research from Morningstar itself, “How Expense Ratios and Star Ratings Predict Success,” found that expense ratios were a better predictor of performance than their star rating system.
Fifth, many, if not the majority, of the pension plans in question hire these professional consultants, such as Frank Russell, SEI and Goldman Sachs, to help them perform due diligence in interviewing, screening and ultimately selecting the very best of the best. You can be sure such consultants have thought of every conceivable screen to find the best fund managers.
Surely they have considered not only performance records, but such factors as management tenure, depth of staff, consistency of performance (to make sure that a long-term record is not the result of a few lucky years), performance in bear markets, consistency of strategy implementation, turnover, costs and more.
It is unlikely you or your financial advisor would think of something they had not already considered, which begs the question: How does pension plan performance stack up against risk-adjusted benchmarks?
Persistent Performance Lacking
As I discussed earlier this week, a 2007 study of nearly 1,000 U.S. defined benefit and defined contribution plans found that their returns relative to benchmarks were close to zero, and that there was no persistence in the pension plans’ performance.
Another study concluded that if pension plan sponsors had stayed with the investment managers they fired for underperformance, their returns would have been larger than those actually delivered by the replacement managers they hired.
In the face of such information, why do plan sponsors engage the services of consultants when the evidence clearly shows they do not add value with their recommendations? In fact, they subtract it. Answering that question is the subject of “The Trust Mandate,” a book I highly recommend.
The authors, Herman Brodie and Klaus Harnack, examined the literature on pension plans and consultants and found:
- Plan sponsors are performance-chasers; they were attracted to whatever asset class or investment style had done well in the most recent period, typically three years.
- Consultant recommendations add no value to plan sponsors; the funds that are hired underperform the funds they replace over subsequent periods.
- Despite well-known diseconomies of scale, consultants tend to favor larger funds to be able to recommend the same funds to many clients and profit from economies of scale in terms of monitoring and evaluation.
- While sponsors prefer low fees, consultant recommendations are positively correlated with higher fees. Consultants have an interest in recommending complex (expensive) products because they require greater (costlier) due diligence and monitoring by the consultant.
- Survey results show that, when it comes to selecting asset managers, a stark contrast exists between plan sponsors’ own beliefs about future performance and those of the managers they hired. Plan sponsors who employed consultants appeared to abandon their own expectations in favor of the consultant’s expectations.
Conflict Of Interest
Brodie and Harnack’s research, based on extensive surveys, led them to conclude that an agency problem (that is, a conflict of interest) is at work, which explains the behavior. They note that the evidence is consistent with a preference on the part of pension plan sponsors for manager characteristics that can be justified ex-post to a trustee committee.
For example, decision-makers acting chiefly to reduce the risk of losing their jobs may be motived to select fund managers with a demonstrable record of successfully beating their benchmarks.
Their conclusions are consistent with those of Howard Jones and Jose Vicente Martinez, the authors of the study “Institutional Investor Expectations, Manager Performance, and Fund Flows,” which appeared in the December 2017 issue of the Journal of Financial and Quantitative Analysis. Using 13 years of survey data from Greenwich Associates covering plan sponsors with half of the institutional holdings in U.S. equities, they established a measure of the future performance that plan sponsors expect from their asset managers.
Where’s The Value?
Jones and Martinez found that, while fund flows correlate highly with past performance, there is no evidence consultants’ recommendations add value for those that follow them.
They concluded: “Institutional investors allocate funds mainly on the basis of fund managers’ past performance and of investment consultants’ recommendations, but not because they extrapolate their expectations from these. This suggests that institutional investors base their investment decisions on the most defensible variables at their disposal and supports the existence of agency considerations in their decision making.”
Jones and Martinez’s work highlights another important agency issue, specifically, the need to appear active. After all, the authors ask, if fund selectors are not engaged in selecting funds, then what are they to do?
They continue: “The consequence of this activity is a constant churn of hires and fires that, by any easily measurable metric, adds no value, but nonetheless necessitates the continuous establishment of new business relationships.”
The evidence clearly demonstrates that plan sponsors could eliminate the costs of the consultants they engage and improve their performance by simply using low-cost, passively managed funds, such as index funds, to implement their asset allocation plan.
However, it appears this won’t happen due to the behavioral/agency problem that exists. As long as sponsors consider the judgment of others who believe that, despite an overwhelming amount of evidence to the contrary, past performance and consultants’ recommendations are informative about future performance, they’ll behave as if they believe this themselves, even if they know it not to be the case.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.