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Second-Guessing CalSTRS on Investment Strategy: A Case Study

Second-Guessing CalSTRS on Investment Strategy: A Case Study
Mar 21, 2024 by Richard M. Ennis

“CalSTRS to Weigh New Opportunistic Sleeve,

Eliminates 55% Limit on Private Assets”

 

So goes the headline of a recent article in Pensions & Investments, the industry newspaper for institutional investors. The article describes a proposed new allocation of up to 5% of fund assets. P&I reports, “The new portfolio would give CalSTRS flexibility ‘to identify, research and incubate new and compelling strategies’ that may fall beyond existing asset classes because of their structure, their benchmark or their thematic focus.” [1]

 

            California State Teachers Retirement System (CalSTRS), with $319 billion in assets at June 30 of 2023, has long been an investor in alternative asset types. Its allocation to alternatives rose from about 10% of assets in 2001 to about 44% in 2023. The recent alts figure compares to an average of 34% for large public pension funds in the US. Upon reading the P&I article, I decided to explore the merit of CalSTRS’s proposed strategic shift, which is likely to place even greater emphasis on controversial alternative asset types.[2]

Hogwarts Finance

Hogwarts Finance
Oct 26, 2023 by Richard M. Ennis

CIOs and consultant-advisors oversee about $10 trillion of institutional assets in the US. They have underperformed passive management by one to two percentage points a year since the Global Financial Crisis of 2008 (GFC).[1] They rely heavily on expensive alternative investments; and the more they have in alternatives, the worse they do.[2] Large institutions use scores of managers, making them high-cost closet indexers. Inefficiency abounds.

 

            What is lacking in institutional fund management today? Intellectual rigor, for one thing. The professionals are ignoring their canon. Lawyers coming before the bar are expected to know the law. Physicians, conspicuously, in my experience, attempt to adhere to the best medical science. Engineers do not improvise when designing bridges. But the people managing institutional assets behave not like they attended the Booth, Säid or Wharton schools to study finance but Hogwarts School of Witchcraft and Wizardry.
 

[1] I estimate public pension funds have underperformed passive management by 1.2 percentage points per year since the GFC. The figure for large endowments is at least 2.2 percentage points. See Ennis (2022a).

Endowments in the Casino: Even the Whales Lose at the Alts Table

Endowments in the Casino:  Even the Whales Lose at the Alts Table
Sep 21, 2023 by Richard M. Ennis

The alternative investments of college and university endowments have detracted from the schools’ performance across the board since the Global Financial Crisis of 2008. Large endowments—ones with greater than $1 billion in assets—appear to have handled their alternative investing better than the smaller ones. But whatever skill the big ones might bring to bear has not been enough to make them winners with these controversial investments.

Have Alternative Investments Helped or Hurt?

Have Alternative Investments Helped or Hurt?
Aug 03, 2023 by Richard M. Ennis

Despite all the attention paid to alternative investments in recent years, there has been little study of their impact on the performance of institutional investment portfolios, e.g., those of pension plans and endowed institutions. This paper attempts to help fill the void. It shows that, since the Global Financial Crisis of 2008, US public-sector pension funds realized a negative alpha of approximately 1.2% per year, virtually all of which is associated with their exposure to alternative investments. While exposure to private equity neither helped nor hurt, both real estate and hedge fund exposures detracted significantly from performance. Institutional investors should consider whether continuing to invest in alternatives warrants the time, expense and reduced liquidity associated with them.

Excellence Gone Missing

May 12, 2023 by Richard M. Ennis

Managers of institutional portfolios have long been seen as among the elite in the investment field. They typically possess advanced degrees and/or other professional credentials. They are fiduciaries for the largest and most complex investment portfolios on the planet. Many are paid fabulously. In terms of the collective merit of their work, however, I see room for improvement. Indeed, I question the excellence of much of institutional investing as it is practiced today.

Disentangling Investment Policy and Investment Strategy for Better Governance

Disentangling Investment Policy and Investment Strategy for Better Governance
Jan 03, 2023 by Richard M. Ennis
Institutional investors have failed to apprehend the difference between investment policy and investment strategy. Most trustees, CIOs and consultants don’t appear to know where one leaves off and the other begins. Trustees should concern themselves with institutional investment policy, the principal focus of which is controlling risk and ensuring liquidity. In practice, however, trustees have allowed their deliberations to encompass elements of active investment strategy. Consequently, performance accountability has become clouded. This paper discusses how trustees can fix the problem.

An Open Letter to Investment Consultants

Dec 27, 2022 by Richard M. Ennis
Institutional investors’ performance has been lackluster at best. Most use one or more investment consultants. I believe consultants can do a better job of helping their clients achieve satisfactory results. Here are some recommendations for doing so.

Lies, Damn Lies and Benchmarks: An Injunction for Trustees

Oct 19, 2022 by Richard M. Ennis
Most institutional investors, such as public pension funds and endowments, report their performance using biased benchmarks. The benchmarks are biased downwardly, meaning their returns tend to be less than a fair return for the market exposures and risk exhibited by the institutions’ portfolios. Significant samples of both fund types exhibit benchmark bias in the range of 1.4 to 1.7 percentage points per year. This bias enables a sizable majority of both types of funds to report outperforming their chosen benchmarks when, in fact, most underperform an appropriate passive-management benchmark by a wide margin. Benchmark bias masks serious agency problems in the management of institutional funds. For example, fund staff and consultants have strong incentives to justify complex, costly, multi-asset-class portfolios, for which they themselves are the benchmarkers. Trustees may feel they have no choice but to accept the benchmarking and reporting by staff and consultants, but this only perpetuates the problem. At the very least, investment trustees should step up and take control of benchmarking and performance reporting. For they are the ones charged with watching the watchmen.

A Universal Investment Portfolio for Public Pension Funds: Making the Most of Our Herding Ways

A Universal Investment Portfolio for Public Pension Funds: Making the Most of Our Herding Ways
Jun 16, 2022 by Richard M. Ennis
Herding is human nature. There is ample evidence of it in the management of public pension funds in the United States. Their effective equity exposures cluster about an average of approximately 70%. Extreme diversification is universal. These two aspects of herd behavior have proven benign. Where herding has had a detrimental effect is the funds pouring more than a trillion dollars into alternative investments after alts ceased adding value to institutional portfolios more than 10 years ago. One might say two out of three ain’t bad. And yet, the heavy use of active management, and alts, in particular, has cost the funds dearly. Public fund managers need to understand that their strength is not active money management. Rather, it is their potential to become the lowest-cost producers of investment returns on the planet. This article argues in favor of a one-size-fits-all approach to managing public pension investments—namely, embracing a Universal Investment Portfolio.

Are Endowment Managers Better Than the Rest?

Are Endowment Managers Better Than the Rest?
Apr 22, 2022 by Richard M. Ennis
  • I compare five aspects of investing large educational endowments and public employee pension funds: (1) operating environment and culture, (2) institutional characteristics, (3) expense ratio, (4) risk habitat and (5) risk-adjusted performance.

 

  • The most significant measurable differences between the two types of investing institutions are: (1) the amount they spend on investment management and (2) the degree of risk they take. In terms of risk-adjusted performance, endowments have underperformed public funds for the 13 years ending June 30, 2021.

 

  • There is no evidence that endowment managers have an edge over public fund managers of a type or magnitude that might translate to a performance advantage.

The Modern Endowment Story: A Ubiquitous United States Equity Factor

The Modern Endowment Story: A Ubiquitous United States Equity Factor
Mar 17, 2022 by Richard M. Ennis

The endowment model, presumed to be a paradigm of value-adding asset class diversification, is a thing of the past. Large educational endowment funds in the United States have heavily concentrated their investments—public and private—in ones that are moderately to highly correlated with the Russell 3000 Index. I estimate that large endowments have underperformed by 2.24% to 2.5% per year over the 13 years ending June 30, 2021. I estimate that their annual cost of investing is approximately 2.5% of asset value. Given the extreme diversification of the composite, which comprises more than 100 large endowment funds with an average of more than 100 investment managers each, there is every reason to believe that cost is the principal cause of endowments’ poor performance. During the most recent 5–7 years, which I refer to as the Modern Era, endowments have exhibited an effective US equity exposure of 97% of asset value, with frictional cash accounting for 3%. The overwhelming exposure to the US equity market raises important strategic questions related to risk tolerance and diversification for trustees and fund managers.

The Fairy Tale of Alternative Investing

The Fairy Tale of Alternative Investing
Mar 17, 2022 by Richard M. Ennis

Advocates of alternative investments, such as private equity, real estate and hedge funds, ascribe various benefits to alts. These include volatility dampening, little or no correlation with stocks and bonds, and powerful diversifying effects. Some say that it is alts’ supposed defensive character that has prevented them from keeping up with stocks and bonds during the bull market following the Global Financial Crisis of 2008, and that there is reason to believe alts will be particularly good performers in the event stocks experience a bear market. None of these claims stands up to critical analysis.

Cost, Performance, and Benchmark Bias of Public Pension Funds in the United States: An Unflattering Portrait

Cost, Performance, and Benchmark Bias of Public Pension Funds in the United States: An Unflattering Portrait
Mar 17, 2022 by Richard M. Ennis
I estimate that statewide pension funds in the United States incur annual investment expenses averaging 1.2% of asset value. A sample of 24 of them underperformed passive investment during the decade ended June 30, 2020, by an average of 1.4% a year. And yet, those same funds report that they outperformed benchmarks of their own devising by an average of +0.3% a year for the same period. This sharp disconnect raises questions about the usefulness of the funds’ performance reporting, as well as their heavy reliance on expensive active management.

Overexposed? Public Pension Funds Have A Lot Riding On The U.S. Stock Market, Possibly Even More Than They Realize.

Overexposed? Public Pension Funds Have A Lot Riding On The U.S. Stock Market, Possibly Even More Than They Realize.
Mar 17, 2022 by Richard M. Ennis
Despite efforts to diversify internationally, public pension funds in the US have a significant, latent home-equity bias. The home bias takes on added importance in light of the extraordinary valuation level of the US stock market. All in all, public funds are betting heavily on the home market and paying up to do so. Caveat!

Cutting Through the Fog of Asset Class Labels

Cutting Through the Fog of Asset Class Labels
Mar 17, 2022 by Richard M. Ennis
Institutional investors use myriad and often ambiguous asset class descriptions that obscure portfolio market exposures for anyone on the outside. This obfuscation makes it difficult to understand risk characteristics and complicates performance evaluation. Fortunately, analytical techniques exist to cut through the fog of asset class labeling.

The Endowment Model Defense That Wasn't

The Endowment Model Defense That Wasn't
Mar 17, 2022 by Richard M. Ennis
In his essay, "Don't Give Up the Ship: The Future of the Endowment Model", Larry Siegel chooses to expound on active investing in conceptual terms, with occasional reference to endowment management. This rebuttal contends that the Siegel essay is long on intellectual theory and short on proof. It takes issue with the rationalization of endowments’ significant underperformance over 12 years and counting. The case for active investing looks past the elephant in the room — theory and evidence casting grave doubt on the merit of diversified — i.e., myriad-manager — active investing like that of endowments. The exceptionalism argument falls flat. The article sidesteps the glaring deficiencies of the endowment model. Siegel simply posits the presence of “skilled employees” in university investment offices who will get the job done despite obstacles of their own making. This rebuttal finds the explanation unconvincing and concludes the endowment model is dead as a door nail.

How to Improve Institutional Fund Performance

Mar 31, 2021 by Richard M. Ennis
Public employee pension funds, endowment funds and other nonprofit institutional investors in the U.S. have a serious performance problem. They have underperformed properly-constructed, passively-investable benchmarks by a wide margin since the Global Financial Crisis (GFC) of 2008, some 13 years ago. Moreover, they have underperformed with remarkable consistency. The poor performance is no accident. Rather, it is structural in nature. Improving performance will require that fund managers make significant changes in their approach to asset management. Institutional investors across the board would be better off investing purely passively. Evidence for this is compelling. Institutions determined to outperform market benchmarks should (1) simplify their approach to asset allocation, (2) use far fewer managers and (3) significantly reduce cost.

Failure of the Endowment Model

Failure of the Endowment Model
Nov 26, 2020 by Richard M. Ennis
Large institutional investors in the U.S. commonly diversify their portfolios among 8-12 asset classes. This approach typically involves using more than 100 investment managers at a cost of 1-2% of asset value annually. Sometimes referred to as the Endowment Model, the approach has failed to provide a diversification benefit and has proven to be a serious drag on performance. The vast majority of institutional investors would be better off managing their funds passively at next to no cost in the configuration that best accords with their risk tolerance and other preferences.

Endowment Performance

Endowment Performance
Dec 01, 2020 by Richard M. Ennis
Endowment funds in the U.S., large and small, significantly underperform passive investment. Moreover, an analysis of the performance of 43 of the largest individual endowments over the 11 years ended June 30, 2019, reveals that none outperformed with statistical significance, while one in four underperformed with statistical significance. Alternative asset classes have failed to deliver diversification benefits and have had an adverse effect on endowment performance. Given prevailing diversification patterns and costs of 1 to 2% of assets, it is likely that the great majority of endowment funds will continue to underperform in the years ahead.

A Bad Year for Institutional Investors

Sep 04, 2020 by Richard M. Ennis
Most public pension funds and educational endowments report their annual investment results on a June 30 fiscal year basis. The year just ended was a bad one. These investors, in the aggregate, underperformed passively investable benchmarks by nearly 300 bps for the year, which is a wide margin by historical standards.