INVESTMENT

Institutional Portfolio Criteria: Slow Rabbits?


Proper performance readings of public pension funds, endowments and other institutional investors are important to their trustees and stakeholders.

The performance of the fund is usually assessed by comparing the portfolio rate of return with the benchmark as an indicator. The following analysis reviews the benchmarking practices of the U.S. Public Pension Fund and seeks to find them: In reality, these funds have freed their enemies on slow rabbits.

Benchmark type

Institutional investors rely on two types of criteria when measuring total portfolio performance:

  • A passive investment standard (PB) There are usually several broad market-cap-weighted indexes. These could include Russell 3000 stocks, ACWI ex-US stocks and Bloomberg Barclays collective bonds. These indexes do not tend to overlap and cover a lot of the waterfront. PB is sometimes described as a Policy portfolio.

A PB expresses the concept of investor risk tolerance and diversified investing. It can also reflect a home-country bias or currency choice. Through PB, the investor says, “If I don’t have any information about market or asset valuation, I will be most comfortable with this portfolio.”

As the name implies, the criterion is investable and passively so: it is possible rather than speculative. It provides a baseline for determining whether portfolio management adds additional value to a purely passive implementation. Finance scholars and serious practicing researchers always use PBs to evaluate the effectiveness of investments. Indeed, PB is Essential Criteria for performance appraisal.

  • A custom, or strategic / composite, standard – I’ll take “custom” – in principle, a derivative of PB. Custom benchmarks (CBs) usually consist of additional asset class elements that describe how the portfolio manager wants to leave PB at the asset class level to achieve a strategically superior, well-performing portfolio.

In addition to stock and bond allocations, CB may include weights for personal equity, hedge funds, real estate, commodities and other alternative assets. Sometimes the therapeutic and alternative elements have multiple sub-elements, which makes CB complex, sometimes opaque, and sometimes difficult to replicate.

CB assets can help measure the effectiveness of investment strategies at the class level. If, over time, CB generates higher returns than PB, this indicates that the strategic allocation was better than the passive baseline. And if the actual return of the portfolio is higher than CB, it indicates that the implementation decisions also had a positive impact.

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Thus using the two criteria helps to differentiate between strategy and implementation in terms of performance quality. In a perfect world, two types of benchmarks would thus be determined and applied. Unfortunately, things rarely work out in the real world.

In practice, PB – the essential criterion – has gone along the way. Of most institutional funds, CB has become the only standard of use – or at least the only visible standard of public performance reporting. As a result, insights into the ability to make strategic decisions are lost on a policy basis.

As we will see, the exclusive use of CB has another, even more distorting effect: it presents a pink instead of performance reading.

Embrace the portfolio

Institutional portfolios often show year after year tracking with their CB. This results from how CBs are corrected over time. Corrections are sometimes inspired by changes in the distribution of resources, which can adjust the criteria. Often, though, amendments are a matter of periodically tweaking benchmarks that are more closely linked to the implementation of investment programs.

There is no doubt that benchmarkers see this type of tweaking as a way to legitimize the benchmark so that it is more consistent with the actual market, asset class, and factor exposure of the fund. It ensures that, to be sure. But it also lowers the quality of the criteria as a performance gauge, because the more benchmarks are created to match the measuring process, the less information can be provided. At some point, it completely ceases to be a measuring stick and becomes a mere shadow.

We talk about “benchmark hugs” in portfolio management. Here we have another twist to that theme: forcing benchmarks to embrace the portfolio.

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Infrared PBs

We have said that PBs are rarely reported. But we can, Guess Through a statistical analysis of the rate of return of the portfolio. We do this by retrieving portfolio returns on multiple distinct variables such as the three stocks and bond indexes mentioned earlier. This process provides appropriate weights or allocations for individual broad market indicators to estimate the best passive investable benchmark (I-PB). We can use these I-PBs and reported CBs to give a fuller, more accurate picture of total portfolio performance.

Multiple regression benchmarking techniques, developed by William Sharp, are a powerful means of estimating I-PBs.

CalPERS: A case study

The method of Calpers Performance Reporting is fairly common: it uses a CB and changes it with some regularity. So in addition to being big and prominent, CalPERS serves as a good representative for this sector as a whole. What has been followed in this way is not to exclude single CalPERS or to present it in an unfavorable light, but to show how public funds present the results of their investments.

The table below compares CalPERS’s total fundraising return with its CB and the type I-PB described above. IPBs hold 79% US and non-US stocks and 21% US investment-grade bonds.


CalPERS Benchmarking and Performance: An Analysis

The financial year is over CalPERS Total Funding Custom benchmark The difference Infrared passive benchmark The difference
2011 21.7% 21.8% -0.1% 23.6% -1.9%
2012 0.1% 0.7% -0.6% 2.2% -2.1%
2013 13.2% 11.9% 1.3% 13.8% -0.6%
2014 18.4% 18.0% 0.4% 18.6% -0.2%
2015 2.4% 2.5% -0.1% 8.% -1.4%
2016 0.6% 1.0% -0.4% 1.4% -0.8%
2017 11.2% 11.3% -0.1% 13.3% -2.1%
2018 8.6% 8.6% 0.0% 9.2% -0.6%
2019 6.7% 7.1% -0.4% 7.5% -0.8%
2020 4.7% 4.3% 0.4% 5.5% -0.8%
10 years
Annual return 8.54% 8.51% 0.03% 9.68% -1.14%
Annual SD / TE 7.4% 7.1% 0.5% 7.3% 0.7%
And2 With total funding .995 .991

CalPERS’s portfolio returns track CB to an extraordinary degree. The 10-year annual income differs by 3 basis points (bps), 8.54% vs. 8.51%. Each year, the two-return series runs on a virtual lockstep, as shown by the statistical fit measurement-a And2 99.5% and tracking error only 0.5% – and even by a general visual inspection of the annual return differences. For example, with the exception of 2012 and 2013, the annual return deviation from CB is not more than 0.4%. This is a skintight fit.

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The table also shows the return series of CalPERS I-PB. This, too, is a close statistical fit with the return of calpers And2 And tracking errors, although not as appropriate as CB. Moreover, there is a significant difference in the level of return. Although CalPERS’s 10-year annual return is virtually identical to its CB, it lowers I-PB by 114 bps per year. And it does so with remarkable consistency: every 10 years.

The deficit of return is statistically significant, a TStatus of -2.9. And it’s huge Economic Significance: The deficit of 114 bps in the $ 440 billion portfolio is about 5 5 billion per year, an amount that will finance many pensions.

It’s not just CalPERS

To repeat, CalPERS is not an external or an exception. Its approaches and results represent what my reviews have received about public fund performance. For example, I compared the same three return series for each of the 10 largest U.S. public pension funds. The results are presented in the following table.


Benchmark Return Comparison: General Average, 10 years to 30 June 2018

Easy average return of 10 years Row 1 Subtract Row 2 Row 2 Subtract Row 3
1. Average report (10 funds) 6.56%
2. Custom benchmark average 6.58% -0.02%
3. Investable Benchmark Average 8.11% -1.53%

The general average CB return basically matches the general average return earned by the fund. It differs by only 2 bps. Both series, however, lag behind the I-PB average by about 1.5% per year. At the level of personal funds বিস্তারিত details not reported here C none of the CBs had higher returns than the respective I-PBs. In other words, the deficit in benchmarking is large and wide.

What we notice with CalPERS is not an isolated problem but a chronic one: CB returns delay I-PBs by a wide margin. Funds are chasing slow rabbits.

What’s going on here?

There is an opinion among finance pundits that markets can expect reasonably efficient, diversified portfolios to perform below the (passive) criteria of properly constructed by approximate cost margins. I estimate the annual cost of a public fund investment of 1.1% of the value of the assets. We can reasonably conclude that investment costs are responsible for the lack of performance of public funds compared to their I-PBs.

CBs work less than I-PBs because they are designed and modified to match the portfolio structure. So, these are basically shadows or echoes of portfolios. As a result, public funds provide relatively neutral performance compared to their standards. But the overall effect of using CBs as a criterion is to mask low performance over 100 bps per year.

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Ultimately, trustees are responsible for how funds are managed and for their reporting. In practice, however, employees and mentors conduct performance reporting, including creating and revising standards. There is conflict here. These teams formulate strategies, conduct investment programs, and select investment managers. They are benchmarking and evaluating their own work.

To make matters worse, some public funds offer bonuses to employees based on performance compared to CBs. The trustees of the fund should instruct their staff and consultants that a PB should be included in all performance reporting.

The management of the public pension fund is hampered by agency problems. Here they have the opportunity to make a significant improvement. There is a need to quickly find rabbits to chase public pension funds.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Diesellife


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Richard M. Ennis, CFA

Richard M. He helped create the field for Richard’s co-founded Institutional Investment Consult at AG Baker & Co., the first consultant recognized as a professional services organization. During her career, Ennis has received Lifetime Achievement Awards from the CFA Institute and the Association of Investment Management Consultants. Graham & Dodd and Bernstein Faboji won the Jacobs Levy Award for their research. He has edited Financial Analyst Journal.



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