The costly fallacy of ‘asset class’ investment

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Pension funds and endowments have for years been pumping ever more of their cash into so-called alternative asset classes, such as hedge funds, private equity and infrastructure.

By picking the very best managers in these opaque and high fee-paying areas, they hope to secure the increasingly demanding pension promises they have made. 

The trustees certainly haven’t done anything by half measures. Last year, US public sector pension schemes had 28 per cent of their $3.6tn of assets in alternatives, while for large endowments, the figure was a truly heroic 59 per cent. It has all required the recruitment of hordes of fund managers. US endowments typically now have more than 100 of these each to run their cash (up from 18 in 1994).

Yet despite all this highly paid talent, the results have been mediocre. In a paper earlier this year, Richard Ennis, a respected US investment consultant, noted that those same funds underperformed index trackers by about 1 per cent annually since 2009, an outcome he attributed to all the extra expenses they were bearing.

Now in a new working paper, Mr Ennis takes issue with those who argue that funds have simply been unlucky and that, at some point, these strategies will resume the normal service they achieved when they consistently delivered superior returns between 1994 and 2008. Instead, he argues that the whole “asset class” logic is at fault.

First, let’s take the idea of alternative asset classes. The logic is that they offer some form of diversification from traditional assets. In theory at least, such “uncorrelated” returns hold out the possibility of a bump up in performance for each unit of risk a fund assumes.

But Mr Ennis challenges this assumption. He argues that most alternative asset classes are no more than active investment strategies. And far from leading to diversification, they actually achieve the opposite. 

Let’s take as an example a pension fund that traditionally invested 60 per cent of its funds in equities (in accordance with the traditional 60/40 equities-to-bonds split). So that proportion of the fund’s assets were split among at least a sizeable chunk of the 4,000 listed companies in the US. Now assume that the same pension fund has put 20 per cent of its assets in private equity. So a fifth of its cash is invested in just a few hundred companies. That is not a diversified position, it is a highly concentrated equity bet.

Then let’s take all those managers multiplying like rabbits — the corollary of the alternatives fetish. As Mr Ennis observes, there is some de-risking benefit that comes with larger numbers of managers, but that peters out at about 10. The more you pile on above that level, the higher the chance of these managers making active bets that simply cancel each other. All that you are left with is the “deadweight” of the fees you are paying to each.

There is, of course, one big counter to all this scepticism. What about the “golden age” of alternatives from 1994 until the financial crisis, when these strategies routinely outperformed markets? But in those early years, the amount of capital devoted to alternatives was small. That left more scope for mispricing that allowed managers to show their “edge” — whether through luck or skill. That’s far harder in today’s crowded alternative markets.

Mr Ennis’s stark conclusion is that the whole pension fund industry is in the grip of a collective fallacy. Trustees accept a system that delivers outcomes that “simply blend in with broad market returns” on which portfolios pay fees of between 1 to 2 per cent a year as opposed to the 0.5-0.9 per cent for traditional portfolios. At that level, underperformance is all but a mathematical certainty.

His suggested alternative is for pension scheme trustees to place far more money with low-cost passive funds and reduce the number of active managers dramatically. But the most important thing is to banish their belief in asset-class mumbo-jumbo that is condemning their funds to underperform. Mr Ennis jokes that trustees are thoughtfully donating 1 per cent of their assets annually to the fund management and brokerage industries for no benefit.

Trustees may not resent paying this gratuity, but it is less clear how it would sit with the savers who ultimately depend on these schemes. One day they will discover that the real joke has been on them.

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