Why Bigger Is Better

New papers show why large DB pension funds outperform.

March 8, 2012

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big and smallIn the restaurant business, a quirky little boîte can quickly lose its fashionable edge as it becomes popular. Once the whole world learns about it, well, it has to cater to the tastes of the whole world. Or as Yogi Berra is reputed to have said: ”nobody goes there anymore – it’s too crowded.”

And so it is a truism in the investment world that once a fund gets to a certain size, the attractive returns it achieved before it became popular are harder to repeat. Assets swamp alpha. The fund comes to resemble the market.

But researchers Alexander Dyck and Lukasz Pomorski at  the University of Toronto’s Rotman International Centre for Pension Management, winners of the 2011 Canadian Investment Research Award sponsored by the Toronto CFA Society and Hillsdale Investment Management, suggest something very different may be going on with large pension funds.

In the ordinary view, they write, “Market forces constantly push firms toward operating at an appropriate scale. Where such forces are absent, firms can destroy value by operating at a non-optimal scale for extended periods of time. Defined benefit pension plans are a perfect example where such inefficiencies might occur. Their scale is driven largely by the size and age of the workforce and by contractual commitments to the workers. Plan beneficiaries unhappy about performance cannot vote with their feet and move their funds to appropriately scaled plans. Moreover, beneficiaries often have weak incentives to act, as it is unclear whether they will be required to make up for performance losses, or whether losses will be borne by employers or the public more generally.”

In the mutual fund industry, they note, “a well-known stylized fact in the fund literature is that there are diseconomies of scale arising from more severe price impact of trades, increased capital inflows leading managers to pursue poorer investment ideas, and/or growing hierarchies in an organization that slow down decision making and dampen incentives. These factors predict pension plans should face downward sloping or at best flat returns as a function of their size.”

But, they argue, pension plans as asset allocators have two roads open to escape the drag of scale diseconomy. “We predict one avenue available to larger plans is to seek cost savings from negotiating power with external managers or from the ability to replace expensive external management with more cost effective  internal management (that  may be close  enough in the ability to generate returns). We further predict that  larger plans will exploit their power over resource allocation to shift assets from areas where diseconomies are more likely to areas where they are minimal or where there may even be scale-related benefits in returns. Larger plans, for example, may get preferential access to private equity or real estate deals with attractive return-risk relationships.”

As it turns out, using data from CEM Benchmarking Inc., a Toronto firm with 842 global pension plans reporting, they find that size matters. “Bigger is better when it comes to pension plans. Larger plans outperform smaller plans by 43-50 basis points per year in terms of their net abnormal returns,

which we define as gross returns minus actual costs minus  plan-specific benchmarks for each detailed asset class.  This gain is similar in magnitude to the reported benefits of passive management in US equities.”

They cite a number of reasons for the outperformance. One is that larger plans tend to reduce active external asset management. They have more passively managed assets, and more assets managed in-house.

The costs savings from reduced external active management account for almost half the performance difference. Beyond that, larger plans are more likely to turn to alternative asset classes, such as private equity and real estate, where their size gives them bargaining power over fees – and access to co-investments.

It is interesting to compare these results against those obtained by Aleksandar Andonov, and Rob M.M.J. Bauer, both at Maastricht University and K. J. Martijn Cremers atYale University. In their paper, Can Large Pension Funds Beat the Market? Asset Allocation, Market Timing, Security Selection and the Limits of Liquidity

They indicate, using the same CEM database that “[l]arger funds realize economies of scale in their relatively small allocation to alternative asset classes, like private equity and real estate. However, in equity and fixed income markets they experience substantial liquidity-related diseconomies of scale.”

But, pension plan sponsors do have an advantage over retail mutual funds, they add.

“The largest defined benefit pension funds are relatively unconstrained, and are able and willing to invest across many different public asset classes (such as equities and fixed income) and private assets (like real estate, private equity and hedge funds), using both active and passive strategies and employing both internal and external investment managers. The long-term liability structure enables pension funds to also invest in the domain of longer-term illiquid assets, in which their vast average size provides significant bargaining power. This makes pension fund performance a particularly rich environment for research, allowing an in-depth analysis of all three components of (strategic) portfolio management and of the extent to which all three contribute to performance: asset allocation, market timing and security selection.”

The upshot? “[P]ension funds are, on average, able to beat the market or their self-declared benchmarks, both before and after risk-adjusting for equity market, size, value, liquidity and fixed income market factors. Interestingly, they can do so in all three components of active management. Pension funds show skill with respect to setting asset allocation target weights (17 basis point annual alpha), the timing of asset allocation decisions (27 b.p. annual alpha), and derive an even larger positive alpha resulting from security selection decisions (45 b.p. per year). “

But these results do not happen across the board, they note. “The relationship between asset size and performance is not uniform and depends on the asset class and investment style. Larger funds realize economies of scale in alternative asset classes, especially real estate, but experience diseconomies of scale in public equity and fixed income markets.”

That seems to indicate a different dimension to alpha: negotiating power.

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I believe an important bias is not mentioned. It is embedded in the definiton given by the authors to "net abnormal returns", which is defined as "gross returns minus actual costs minus plan-specific benchmarks for each detailed asset class". This means that net alpha (which is what we are talking about here) is calculated from each plan-specific benchmark. It is therefore very likely that the same asset class is measured against a different benchmark, which would make the conclusion much less robust. Such a situation is very common, particularly for private asset classes such as real estate, private equity, farmland and infrastructures. One needs to compare apples with apples. My experience tells me that it is impossible to compare alpha from different players if we do not know the benchmarks they use. The only way to go over this is to normalize the returns by using one benchmark for everyone, and measuring the results of each player against that "universal" benchmark.

Contex Group