Key Points:
– Large public pension funds underperformed passive investment by 1.0% per year in the decade ended 30 June 2018.
– Public pension funds are high-cost closet indexers, and the majority are expected to underperform in the future.
– The cost equation yields an estimated investment expense of 0.98% of asset value for the composite of public pension funds.
– Just 4% of the funds, net of cost, outperformed passive investment on a risk-adjusted basis.
The impact of expenses on public pension fund performance is significant, with large public pension funds underperforming passive investment by 1.0% annually in the decade ending 30 June 2018. According to a recent Journal of Portfolio Management article, this underperformance closely aligns with the independently derived cost of investment. The study also found that public pension funds are predominantly high-cost closet indexers, implying that the majority of these funds will likely underperform in the coming years.
The regression of a composite of 46 large public pension fund returns on a 70-30 stock-bond benchmark revealed market-like volatility, with underperformance of approximately 100 basis points per year. The analysis also estimated the investment expense of the composite of public pension funds to be 0.98% of asset value, coinciding with the observed margin of underperformance.
The risk–return performance diagram showed that just 4% of the funds, net of cost, outperformed passive investment on a risk-adjusted basis, further highlighting the detrimental effect of the cost of active investing on public pension fund performance. This suggests that extreme diversification combined with high costs is a recipe for failure.
In summary, the study indicates that the cost of investing has a highly detrimental effect on the performance of public pension funds, and extreme diversification combined with high cost is a recipe for failure in this sector.
