Can Pensions Beat a 60-40 Portfolio?

Julie Segal of Institutional investor reports, Not One Ivy League Endowment Beat a Simple U.S. 60-40 Portfolio Over Ten Years:

The performance of Ivy League endowments has trailed a passive portfolio of 60 percent U.S. stocks and 40 percent bonds over the past ten years — and has been more volatile to boot, according to a new report from research and analytics provider Markov Processes International.

MPI says this is the first time in the 16 years that it has been collecting data on all the Ivies that Yale, Harvard and the other elite colleges have lagged the indexed portfolio when looked at over a decade. The firm looked at performance for the period between July 1, 2008 and June 30, 2018.

What’s more, MPI found that the volatility of the endowment model — which includes large allocations to private equity, real estate, infrastructure and other illiquid investments — is significantly higher than that of a simple mix of stocks and bonds.

The performance of Ivy League and other college endowments is closely watched by the industry, as other institutional investors have been adopting some version of the portfolio allocation model — often referred to as the Yale Model, pioneered by Yale CIO David Swensen — since the early 2000s. The perennial question has been whether the addition of expensive alternative investments, including hedge funds, is worth the trouble, given the cost, illiquidity, and underperformance of many of these funds.

“There’s a tug of war going on in endowments, as well as in asset management,” said Jeff Schwartz, president of MPI, in a phone interview. “A lot of people are hoping that there is no point in investing in these complex alternatives. Then you have devotees of the Yale model who want to show there is a payoff for putting so much of the portfolio into private equity, VC, and all the things we think of as sophisticated and expensive. This report shows that the reality is much more complex than either narrative.”

Over the most recent decade, Columbia and Princeton led the pack, both delivering 8 percent annually, according to MPI. Harvard turned in returns of 4.5 percent over the period, with Cornell at 4.8 percent. The 60-40 portfolio returned 8.1 percent.

The news wasn’t all bad for the Ivy endowments. Though the endowments didn’t beat a plain-vanilla portfolio over ten years, they did outpace it when looked at over the most recent 15-year period on an annualized basis. Results varied widely, however. On the low end, Cornell earned 8.01 percent annually during the time period, while Yale generated an 11.18 percent return, coming out on top.

And while the ten-year period measured by MPI wasn’t stellar for the schools, fiscal year 2018 was a good one. Every endowment, except Columbia University, had double-digit returns, and all outperformed the 60-40 portfolio. According to MPI’s returns-based analysis, private equity and venture capital investments were the primary drivers behind most endowments’ gains.

The returns this year were similar to 2017, with Harvard’s performance still far behind its peers, at 10 percent. Harvard has spent seven years at or near the bottom of this group. Princeton was the best performer in fiscal 2018, with returns of 14.2 percent. Columbia generated a 9 percent return, falling to the bottom from No. 3 last year.

Although MPI only has data for four schools going back 20 years, all of those — including Harvard — beat the 60-40 benchmark, MPI found.

The Ivy League endowments’ investments in alternative funds have remained high, according to MPI. Many are increasing their allocations, with Brown upping private equity investments faster than other endowments.

“We observe that the high endowment returns are accompanied by high risk. Ivy risks are noticeably higher than a 60-40 portfolio, with private equity and real estate contributing the most across the board,” wrote the report’s authors. “In fact, equity (public and private) and real estate risk are the two dominant sources of risk across the Ivies, indicating their portfolios are not as diversified as many believe them to be,” they continued.

The endowment returns were measured against a U.S. portfolio, which has generated extraordinary returns over the past ten years. Though this is the standard benchmark for all endowments, according to the report, investors that had any international holdings would have lagged a U.S-.only portfolio over the past decade.

This article generated a lot of discussion last week and gave ammunition to those who think pension funds following the Yale model are only wasting their time and money, they're better off indexing their portfolio to the US 60-40 benchmark.

Now, I shared this article with three pension heavyweights, Leo de Bever, Wayne Kozun and Andrew Claerhout. They all had senior roles at the Ontario Teachers' Pension Plan and Leo is the former CEO of AIMCo.

Let me begin with Leo's insights:

Any particular ten year timeframe for return and annual volatility is not necessarily indicative for how things will play out in the next ten years.

The Ivy League model has had its 10-year issues, i.e. getting squeezed in 2008 by over-committing to new funds assuming the old ones would pay out when they did not. We all make mistakes.

As the article observed, international diversification did not pay off over the last ten years for US equity investors. Again, that may not last.

The last decade in the US listed market was not kind to long term value investing, which is what private equity is supposed to be. The question is whether the value put on some of the growth stocks makes sense, and whether low corporate taxes are sustainable.

The private equity model may need to change as well: reasonably priced brownfield investments are harder to come by. Persistence of private equity managers is falling.

That may be because the participants have become too attached to what worked well for so long. Financial engineering alone may not be as powerful in a world where technological change is accelerating.

Next, Wayne Kozun, OTPP's former SVP Public Equities, shared this:

This is somewhat Monday morning quarterbacking as over the last decade US equity has done much better than the equity markets of any other country, fixed income has done very well, and the US dollar has gotten stronger. So a US 60-40 portfolio looks great as it has no foreign exposure, but no one know this ten years ago. In hindsight you can always find "simple" portfolios that will have done better than "sophisticated" portfolios. But that doesn't help unless you know for certain what the future holds.

This paper was done by MPI and the volatility numbers that they quote are based on their own proprietary technique of estimating the "true" volatility of private assets. I don't know if there methodology is good or bad, but they likely have a bias which may be coming through in this analysis. While I do believe that private assets are much riskier than what the annual volatility is measured at, there is some value to being able to smooth asset returns for entities like endowments and pension plans. So you can say that the "true" volatility of private equity is higher than public equities, but that is ignoring the value in being able to smooth returns.

Wayne's insights prompted this reply from Leo de Bever:

I did not say so explicitly but the grossing up of private asset volatility to equate it to listed assets is backwards.

A long term investor should not care what monthly or annual volatility is, even if you accept volatility as a measure of risk instead of using some measure of downside.

Long term investors would want to look at their long term volatility relative to the long term volatility of listed markets.

Long term investments are not a sequence of short term investments. They attempt to exploit the existence of superior long term returns not accessible to managers that do not control how long they have access to invested capital.

And Andrew Claerhout, OTPP's former senior managing director Infrastructure and Natural Resources,shared these insights:

I don’t disagree with anything either of you (Leo and Wayne) have said.

The US markets have done remarkably well since the GFC but what I find interesting is that few stock pickers in US public equities have been able to beat the index and as a result there is a greater and greater shift towards indexing by many institutional investors.

Private assets provide diversification benefits but unequivocally some of this is overstated due to a lagging and conservative (in good times) and aggressive (in bad times) mark to market process.

What will determine the quality of an investment program is how it performs through a variety of economic and financial market cycles. We’ve been spoiled in the last ten years as a rising tide raises all boats... some more than others... but let’s see what happens when the tide recedes.

Indeed, we have been spoiled and this reminds me of a famous quote from John Kenneth Galbraith: "In a bull market, everyone is a financial genius."

The last ten years were unbelievably strong for US stocks and bonds following the 2008 crisis, and we can all thank the Fed and other central banks for goosing up the financial system through their multi-trillion dollar balance sheet operations.

Moreover, while volatility is underestimated in private markets, as Leo de Bever states, a long-term investor shouldn't care about monthly or annual volatility (until it impacts their career risk).

On the question of how MPI calculated volatility, however, Richard J. Tomlinson, Deputy CIO at LPP, shared this on LinkedIn: 

I’m curious how they estimated volatility - not a simple task when you have a large weighting to illiquids. There’s also the point of volatility of capital value vs volatility of income, different institutions have different preferences depending on liability profile, contributions etc

What else? I remember Mark Wiseman and his successor Mark Machin telling me their portfolios are structured in a way that when there is a roaring bull market they will under-perform but outperform considerably during a bear market or when public equities are lackluster. "Over time, the benefits of diversifying into private markets all over the world are there and they add up as we have handily beat CPPIB's Reference portfolio over the long run."

"Bullocks! Just index their portfolios so we don't have to pay these guys outrageous compensation each year!"

Well, it's not that simple. First, you pay for performance, and you need to pay if you're hiring people with a particular skill set in private equity, real estate, infrastructure, private debt and natural resources. You also need to pay people competitively if you stand a chance to beat the S&P 500.

Second, indexing has worked extremely well over the last ten years but there are no guarantees it will continue to do so over the next ten years.

Moreover, the popularity of indexing has generated a whole set of issues. Last week, Vanguard's Jack Bogle, the father of indexing, sounded a warning on index funds:

There no longer can be any doubt that the creation of the first index mutual fund was the most successful innovation—especially for investors—in modern financial history. The question we need to ask ourselves now is: What happens if it becomes too successful for its own good?

The First Index Investment Trust, which tracks the returns of the S&P 500 and is now known as the Vanguard 500 Index Fund, was founded on December 31, 1975. It was the first “product,” as it were, of a new mutual fund manager, The Vanguard Group, the company I had founded only one year earlier.

The fund’s August 1976 initial public offering may have been the worst underwriting in Wall Street history. Despite the leadership of the Street’s four largest retail brokers, the IPO fell far short of its original $250 million target. The initial assets of 500 Index Fund totaled but $11.3 million—falling a mere 95% short of its goal.

The fund’s struggle for the attention (and dollars) of investors was epic. Known as “Bogle’s folly,” the fund’s novel strategy of simply tracking a broad market index was almost totally rejected by Wall Street. The head of Fidelity, then by far the fund industry’s largest firm, put the kiss of death on his tiny rival: “I can’t believe that the great mass of investors are [sic] going to be satisfied with just receiving average returns. The name of the game is to be the best.”

Almost a decade passed before a second S&P 500 index fund was formed, by Wells Fargo in 1984. During that period, Vanguard’s index fund attracted cash inflow averaging only $16 million per year.

Now let’s advance the clock to 2018. What a difference 42 years makes! Equity index fund assets now total some $4.6 trillion, while total index fund assets have surpassed $6 trillion. Of this total, about 70% is invested in broad market index funds modeled on the original Vanguard fund.

Yes, U.S. index mutual funds have grown to huge size, with their holdings doubling from 4.5% of total U.S. stock-market value in 2002 to 9% in 2009, and then almost doubling again to more than 17% in 2018. Even that penetration understates the role of mutual fund managers, as they also offer actively managed funds, and their combined assets amount to more than 35% of the shares of U.S. corporations.

If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era.

Three index fund managers dominate the field with a collective 81% share of index fund assets: Vanguard has a 51% share; BlackRock, 21%; and State Street Global, 9%. Such domination exists primarily because the indexing field attracts few new major entrants.

Why? Partly because of two high barriers to entry: the huge scale enjoyed by the big indexers would be difficult to replicate by new entrants; and index fund prices (their expense ratios, or fees) have been driven to commodity-like levels, even to zero. If Fidelity’s 2018 offering of two zero-cost index funds has established a new “price point” for index funds, the enthusiasm of additional firms to create new index funds will diminish even further. So we can’t rely on new competitors to reduce today’s concentration.

Most observers expect that the share of corporate ownership by index funds will continue to grow over the next decade. It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the “Big Three” might own 30% or more of the U.S. stock market—effective control. I do not believe that such concentration would serve the national interest.

My concerns are shared by many academic observers. In a draft paper released in September, Prof. John C. Coates of Harvard Law School wrote that indexing is reshaping corporate governance, and warned that we are tipping toward a point where the voting power will be “controlled by a small number of individuals” who can exercise “practical power over the majority of U.S. public companies.” Professor Coates does not like what he sees, and offers tentative policy options—some necessary, often painful to contemplate. His conclusion—“The issue is not likely to go away”—is unarguable.

Solutions to resolve the issues connected with the concentration of corporate ownership are not self-evident, but a number of tentative possibilities have already been advanced:

• More competition from new entrants to the index field. For the reasons noted above, this eventuality seems highly unlikely.
• Force giant index funds to spin off their assets into a number of separate entities, each independently managed. Such a drastic step would—and should—face near-insurmountable obstacles, for it would create havoc for index investors and managers alike.
• Require index funds to hold just one company in any industry. Leaving aside the dubious ability of either academia or federal bureaucrats to define precisely what constitutes a given industry, such a drastic change would lead to the destruction of today’s S&P 500 index fund, by common agreement, the most beneficial innovation for investors of the modern age.
• Timely and full public disclosure by index funds of their voting policies and public documentation of each engagement with corporate managers. This would take today’s transparent and constructive governance practices several steps further.
• Require index funds to retain an independent supervisory board with full responsibility for all decisions regarding corporate governance. The problem with this idea is that it is not clear how such a board could add to the present scrutiny of the fund’s independent directors.
• Limit the voting power of corporate shares held by index managers. But such a step would, in substance, transfer voting rights from corporate stock owners, who care about the long-term, to corporate stock renters, who do not... an absurd outcome.
• Enact federal legislation making it clear that directors of index funds and other large money managers have a fiduciary duty to vote solely in the interest of the funds’ shareholders. While I believe that such a fiduciary duty is implicit today, making it explicit, with appropriate penalties for violations, would be a constructive step.

It is time for public officials to consider the pros and cons of these issues with indexers, the financial community, academia, and active managers alike—and develop national policies that support high standards of corporate governance. It will require their working together constructively and cooperatively.

But one thing seems crystal clear. Even if present trends continue (sometimes they don’t), the enormous value of index funds should not be ignored. First, index funds provide investors with the most effective stock-market strategy of all time: buy American business and hold it forever, and do so at rock-bottom cost. Second, index funds are among the few truly long-term owners of stocks—for all practical purposes, permanent owners of capital—an enormously valuable asset to society. The long-term focus of index funds is a much needed counterweight to the short-termism favored by so many market participants.

Prof. Coates agrees that nothing should jeopardize the existence of today’s index funds.

“Indexing has created real and large social benefits in the form of lower expenses and greater long-term returns for millions of individuals investing directly or indirectly for retirement,” he writes. “A ban on indexing would clearly not be a good idea.” I can only say, “Amen” to those words.

Take the time to read John Coates' paper here (h/t, Wayne Kozun).

Indexing in public markets is here to stay. There will be setbacks during bear markets and I too worry about what happens if it becomes even more popular than it already is (the great economist Paul Samuelson once praised Burton Malkiel's book, A Random Walk Down Wall Street, but also worried about what happens when everyone adopts this indexing approach).

Funny thing about markets, when everyone is doing the same thing, two things happen, great bubbles and great dislocations. The rise in indexing presents opportunities and risks.

But if indexing is here to stay, so are alternative investments at pension funds, endowment funds, sovereign wealth funds and other large asset allocators looking to diversify away from public markets into private markets.

Below,Vanguard Group Founder Jack Bogle discusses how the indexing business has changed over the years and the problem with index funds (June 2018). Here he discusses a different problem.

Also, Bogle explains why "if you hold the stock market, you will grow with America" and how we could avoid the financial crisis from 10 years ago. Great discussions, love hearing his wise insights.