As noted in the report, “Value Added by Large Institutional Investors Between 1992‐2013,” it is a widely held academic and investing industry belief that active investors have, on average, no real advantage over passive investors over the long term, and can even see worse performance over time due to higher fees. This view on investing strategy is rooted in the efficient market hypothesis, researchers explain.
Historically, a problem with testing the benefits of active versus passive investing is that the separation between alpha (market outperformance) and beta (market-attributable returns) is not always clear. “Where one set of benchmarks demonstrates a non‐zero alpha, another set can almost always be found that shows that the alpha is zero,” the report suggests.
But while some say the question of active versus passive can’t be definitively answered, CEM Benchmarking believes the answer can be made clear by looking at enough information. To that end, the firm conducted extensive analysis on its pension performance data set, comprised of more than 6,600 data points drawn from a global set of defined benefit pension plans (along with a handful of sovereign wealth funds) spanning the 1992 to 2013 time period.
“Not only can we definitively answer the question of whether it is possible [to outperform with active management], we can also quantify to a large degree how these institutional investors do it,” CEM notes. “What advantages do they have? Where have they added value? Is the value added really alpha, or is it beta in disguise?”
The results are striking: Gross of investment management expenses, CEM says pension funds have secured 58 basis points of value added returns through alpha-seeking opportunities. Net of investment management fees and expenses the outperformance is much more muted, at 16 basis points of returns added. According to researchers, a deep regression analysis indicates that beating the market is rooted in active asset management paired with cost savings gained through scale and managing assets in‐house.
The result is nuanced further in the CEM report: “We emphasize that the standard deviation of the gross and net value added populations, at about 267 and 265 basis points, are large in comparison to the averages at 58 and 16 basis points gross and net, respectively. For any single pension fund, this result is likely just as important as the non‐zero average. The standard deviation indicates the range that a typical plan, with a typical active versus passive management ratio of 4:1, can expect their value added to stray from the average. So, while the long term average gross and net value added are decidedly non‐zero, in any given year many funds will trail their benchmarks, often by substantial margins.”
Report authors continue by explaining that, clearly, funds engaging in active management need to consider whether the potential gains are worth the risk quantified by the standard deviation.
Controlling Costs Leads to Better Alpha
Pension plans vary widely in their construction, the report explains, including the amount of indexing used. Funds also vary according to things like asset scale, the amount of assets managed internally, the amount of assets managed actively, and the makeup of the asset mix.
All of these factors will impact the success of pension funds’ active investing value add efforts, the report says.
“For example, indexing, managing assets internally, and increased scale are all expected to reduce costs and increase net value added (all other things being equal),” the report continues. “Attempts to beat the market by active management, by contrast, are expected to increase gross value added.”
Not surprisingly, researchers find the balance between enhanced gross value added from security selection, on one side, and diminished net value added from increased costs, on the other, determine whether active management is worthwhile. What’s more challenging than this realization is actually disentangling and quantifying these differences for a given pension fund, or for pensions in general.
To this end, researchers did a regression analysis on the gross and net value added for each pension fund in the large sample, according to a simple model which takes into account (i) the percent of each fund’s holdings that are internally managed; (ii) the percent of each fund’s holdings that are actively managed, (iii) the size of the funds; and (iv) a variable constant for each of the sample four regions.
CEM finds the following:
- Pension funds increased their net value added by +7.6 basis points for every 10-fold increase in holdings due to lower investment management costs.
- Funds increased their net value added by +22.1 basis points for by managing their assets in‐house due to lower investment management costs.
- Funds increased their net value added by +38.7 basis points by actively managing their assets in an attempt to beat the market (note this is less than the +71.7 basis points gross due to investment management costs).
- The regression constants themselves are also reduced going from gross to net value added since indexed investing, while inexpensive relative to active management, also has associated investment management costs.
Researchers conclude that all of this goes to show that, contrary to the efficient market hypothesis, pension funds have been able to beat the market consistently using elements of active management. However, fees associated with active management consistently eat up nearly 75% of the 58 basis points of gross value added, leaving only 16 basis points of net value added for stakeholders.
“This illustrates in stark terms why funds must measure and manage their costs,” the report concludes.
More information about obtaining or participating in CEM Benchmarking research is here.