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Can pension funds beat the market?

A new study appears to lob a spanner into the spokes of passive investing.

(Photo: Daniel Grill/Getty)

Large Canadian and U.S. pension-funds, which actively invest 75% to 85% of their portfolios on average, outperformed their benchmarks from 1990 to 2008 before and after adjusting for risk and costs, concludes a study titled “Can Large Pension Funds Beat the Market?

The pension funds beat the market thanks mostly to security selection (45 basis points), followed by market timing (27 basis points) and asset allocation changes (16 basis points), declare authors Aleksandar Andonov (Maastricht University), Rob Bauer (Maastricht University) and K. J. Martijn Cremers (Yale University).

Some previous studies have looked at pension-fund investing but not as comprehensively, note the authors.

The active-passive investing debate has been investigated at length in the mutual-fund realm. The general conclusion from these studies is that mutual funds underperform the market by the amount of their fees.

Pension funds are not as constrained as mutual funds. They are able to apply strategic portfolio management across a wider range of assets including private equity, real estate and other assets. They also don’t have the same incentives to chase short-term performance since they are not competing to attract inflows of capital and/or boost remuneration tied to the amount of assets under administration.

Costs are different from mutual funds too. U.S. pension funds have total investment costs averaging 35.25 basis points per year while Canadian pension funds average 25.65 basis points per year. One would expect U.S. pension funds to have lower costs because they are larger and should have economies of scale. What could explain the lower cost of Canadian pension funds, the authors conjecture, is better governance and management.

Changes in asset allocation generate the least alpha (16 basis points) because pension funds tend to have similar asset allocations. They typically invest about 55% in equity, 35% in fixed income and 10% in alternative asset classes.

Security selection generates the most alpha (45 basis points). The authors of the study attribute all of the U.S. outperformance in this component to momentum strategies. In Canada, most of the outperformance is related to avoidance of the “Nortel effect” in the early 2000s.