The Performance of U.S. Pension Funds: New Insights into the Agency Cost Debate
By: Rob Bauer, Rik Frehen, Hubert Lum and Roger Otten
Published: February 22, 2007
Think back to before the Wii, before X-Box, and even before “Grand Theft Auto” – when kids did puzzles like connect-the-dots or spot-the-difference. Well, a study released last month tries to “spot the difference” between mutual funds and comparable pension funds with the same mandates. All in all, researchers were successful – spotting several differences that set mutual funds apart from very similar pension funds, including one big one that starts with “under-” and ends with “-performance“.
Alphaphiles will note that performance differences between two funds with the same (beta) benchmark must be chalked up to differences in alpha. And with alpha a scarce commodity in long-only funds of all stripes, it doesn’t take much to jeopardize the whole enterprise of active investing.
While $6 trillion is invested in U.S. pension funds, very little is known about their performance. Research on pension fund performance over the past 30 years has been a real dog’s breakfast with some studies showing pensions beat the market and some showing they lagged it. The problem is that these studies have been conducted over various time frames, using various definitions of “pension fund” and using various benchmarks to measure success.
But the researchers in the study managed to wangle previously unavailable performance data on nearly 1,000 pension funds from a private-sector benchmarking firm for their work (note: to compare apples to apples, when they say “pension fund”, they mean the overall pension fund, not just one or more of the managed accounts traded by their money managers). Their conclusion: mutual funds underperformed their comparable pension brethren by 200 basis points a year.
Why? Well, the researchers downplay any skill difference between mutual fund managers and pension fund managers since the return streams of the two track very closely (in addition, they point out, many of the comparable funds are managed by the same fund manager. So unless he’s managing the pension in the morning, then getting drunk at lunch and managing the mutual fund in the afternoon, skill should be moot). Perhaps surprisingly, the researchers also discount fee differences as the source of the delta.
Instead, the study suggests that mutual fund managers face agency costs that are reflected by their returns. Apparently the pension/mutual fund performance delta is small for passively managed funds (about 30 bps per annum) and largest for actively managed funds. Say the researchers:
“Since passively managed portfolios are less vulnerable to hidden agency costs, we interpret our findings as indirect evidence of the presence of agency costs in the mutual fund business.”
“Often, pension fund assets are managed on separate accounts. The accounts are thoroughly scrutinized by the pension fund. This monitoring power enables pension funds to detect possible hidden costs. As a result, pension funds are less vulnerable to soft dollar, pay-to-play and late pricing agreements between mutual funds and brokerage firms.”
It makes intuitive sense that institutional investors might pay closer attention to their managers than does Stan from across the street. After all, they have staff dedicated to this very monitoring. And it seems that these staff are paying for themselves.
The study also confirms another piece of intuition: pension funds use their size to their advantage. They can spread the relatively fixed costs of running the fund across a wider base – reducing the cost as a percentage of assets.
No matter how you slice the data, pension funds come out on top – marginally trailing or beating their benchmarks vs. a significant underperformance for mutual funds. So roughly half the pensions added value and half subtracted value. Which begs the question: can’t you just pick the winners? Unfortunately no. As in the mutual fund and hedge fund industries performance “persistence” is weak.
So where does this leave us? By attributing higher returns of pension plans to the “power to scrutinize a managed account”, this study lays out a financial case for independent oversight of mutual funds. Does someone have a calculator? What’s 200 basis points times $10 trillion. $200 billion? No bad (although one might argue that pensions are meeting their benchmark after costs at the expense of mutual fund investors. Since we can’t all win, higher mutual fund performance might lead to a drop in pension fund performance).
In any case, next time you’re on a long road trip and your kids want to play a game, just give them a copy of this study on mutual funds and pensions and ask them if they can spot the difference (and ask them to find Waldo while they’re at it).