Survey Finds 24% of Funds Fall Significantly Short of Their Asset Benchmark

A study on investment manager performance by State Street’s corporate level think tank, the Center for Applied Research (CAR), suggests that after risk adjustment, 24% of funds fall significantly short of their asset benchmark, while 75% of funds approximately meet their benchmark but generate zero alpha.

Of institutional portfolios, less than 1% achieve superior results after costs.

The paper, titled “By the Numbers: The Quest for Performance,” looks at how institutional investor’s asset allocation strategies have changed and how they are managing to navigate the quest for superior risk-adjusted performance in a low-return world since the financial crisis.

The paper, produced in partnership with the Fletcher School of Law and Diplomacy at Tufts University, offers perspective through understanding how investors are coping with the challenges of portfolio construction and strategic asset allocation amidst low returns. The qualitative research draws on quantitative analysis based on face-to-face interviews with 200 institutional investors for a previous paper called “Influential Investors.” The analysis focused on investment decisions of university endowments, global pension funds, and sovereign wealth funds. The approach was to examine investment patterns in institutional portfolios as a baseline for understanding changes in the investment process using input from global investment management industry professionals.

“As the headwinds of the crisis continue to blow, we find that innovative investors have accepted and seek to exploit the more complex and integrated nature of portfolio risk,” said the paper.

Looking at performance, CAR analyzed quarterly returns from 1998 to 2012 across ten asset types, including U.S. equities, global equities, separate proxies for emerging and frontier markets, U.S. government and corporate fixed income and four alternative asset classes using proxies for commodities, real estate, hedge funds and private equity. The average annual returns of hedge funds (6.9%) and private equity (12.4%) were robust, though returns for both asset classes masked considerable variability across strategies and managers.

Commenting on the highlights of the paper, Suzanne Duncan, global head of research at State Street’s CAR, said: “What stood out to us is that when we ran the three scenarios of portfolios we found that adding hedge funds and private equity to the portfolios dramatically enhances return. In fact, returns increase by 70% enhanced return, which is marginal volatility. So given the economic environment and given the underfunding status, particularly among pension plans, that’s a meaningful number. And that’s a long time frame of data too—2003 to 2012—that means long term risk adjusted performance is enhanced dramatically.

“Number two is interesting in when we talk about enhanced performance for alternative investment, particularly hedge funds and private equity, because the gap is actually widening between the top quartile and bottom quartile within the alternative investment space. So you have to be careful that you pick the winners if you are going for that alternative strategy.

“When we calculated the mean performance between top quartile and bottom quartile we did it specifically in private equity by way of example. What’s interesting is that the performance gap between the top and bottom quartile has actually widened since the financial crisis. Since 2008 we have seen a pretty big level of divergence between top and bottom.

“One of the largest changes in the private equity space is that many of the large institutions are going public so there are trade offs with that. So when you’re looking at the nature of competition in the private equity market that’s an area whose performance changed since the financial crisis in how things have picked up and the speed of firms going public.”

The survey also highlighted the widening asset to liability gap. It found that most state pension plans in the U.S. have used an annual returns estimate of 8%, which is not supportable under current market conditions. Eighteen public pension plans have lowered their return assumptions to between 7.5% and 7.75%.

The takeaways in respect of performance are that institutional investors share heightened concerns about return volatility and the structural convergence of correlations between asset classes, and there is an acute awareness that tail risk is real and a sensitivity that it must be managed effectively.

During the entire period from 2002 to 2011, annual mean real returns of global pension funds varied widely, said the paper. With the exception of Columbia at 8.8%, returns were generally below 5%. Especially interesting is that fact that both U.S. and U.K. pension funds reported negative real annual mean performance during this period i.e. in neither country did pension funds earn returns above the rate of inflation. In the pre-crisis period, returns ranged from -1.3 % in the U.S. to a high of 9.5 % in Poland; again, U.K. and U.S. pensions earned the lowest returns. In the period since the financial crisis, most pensions have experienced a decline in performance with many negative, further accentuating their core challenge of closing the return-liability gap.

On the basis of their performance alone, endowments on average increased in size by nearly two-thirds in the 10-year period through 2011, despite very sizable losses in 2009, said the CAR paper.

Strategic asset allocation has shifted demonstrably over the last 15 years towards a greater use of alternative asset classes, including commodities, real estate, other real assets, private equity and various hedge fund strategies, said the paper. This extends not only to U.S. university endowments, but more broadly to wealth managers, it added.

Among university endowments in the U.S. there has been a progressive trend away from domestic equities and into international equities and alternative investments for more than 20 years. Endowment allocations to alternatives particularly have risen steadily over this period as holdings of domestic equities and fixed income have consistently declined in service of alpha and greater diversification value.

Within this asset class, hedge fund strategies have dominated, the research found. Among the large endowments (with assets in excess of $1 billion), allocations to hedge fund strategies drove the shift to alternatives beginning in 2000. After 2007, sharply higher allocations to real assets and private equity further accelerated the drive to alternatives.

Like endowments, pension funds have also been increasing annual short-term liabilities and their impacts are further accentuated by demographical factors common to most advanced economies, said the paper. Among OECD pension funds, the move to alternatives has been significant, rising from 6% to 19% of total assets under management from 2000-2012. Specifically in the case of aging populations with high demands for pension payouts, distribution pressures on both defined-benefit and defined contribution plans continue to grow as fixed income yields decline. Pension managers, regardless of the nature of their liabilities, have increased allocations to alternative assets and pursued greater diversification through higher allocations to emerging and frontier markets.

In the period of 2002 to 2012, the move to alternatives was greatest in the U.K. (an increase of 5.7x in percentage allocation), the U.S. (an increase of 2x) and Switzerland (an increase of 1.7x).

In the sovereign wealth fund sector, the top three funds—CIC, GIC and Temasek—accounted for 50% of all sovereign wealth funds transactions in 2011 and 2012. Four sectors,—financial services, natural resources, real estate and infrastructure—have accounted for 75-80% of all transactions in the same time period. (The top 10 funds control 79% of total sovereign wealth fund assets under management as of 2012.) Australia demonstrated the most marked shift toward alternatives, increasing its allocation from a low of 1.5% of assets in 2008 to more than 25% in 2010, including investments in real estate, infrastructure and other alternatives.

Lastly, the paper highlighted liability sensitivity, with nearly 50% of pension managers reporting actively using forms of asset-liability matching.