Does active management work for institutional investors?

It is increasingly well-understood that low-cost index funds will, on average, beat actively managed mutual funds for average investors. I think that there is still a perception that large institutions like pension funds and endowments, with access to the supposedly best money managers are able to outperform.

Fortunately there are some good sources of information that we can turn to to see if this is true.

It has been well documented that fees can vary substantially depending on who is investing. Retail investors typically pay much higher fees in terms of percentage of their assets than institutions. Institutions are also able to access asset classes, like real estate, private equity, and hedge funds, that might not be readily available to a retail investor. A proponent of active fund management might argue that these factors should be conducive to market beating performance for institutional investors.

A 2017 report from Standard and Poors looked at the net and gross of fee performance for institutional investment accounts with the intention of seeing if fees were the sole cause of underperformance for retail active managers. The data in the report show that the overwhelming majority of actively managed institutional accounts underperformed their benchmark over 10 years, before fees. The underperformance was only exacerbated after fees. Well that answers that. While it may help, the lower fees that institutional investors are able to negotiate do not mean that active management will work for them.

Every year, the National Association of College and University Business Officers (NACUBO) releases their report on the performance of college endowment funds. With people like the legendary David Swensen at the reins of the Yale endowment, endowment funds have often been looked to as thought leaders for the investment world. Taking advantage of their exceptionally long time horizons, endowment asset allocations will often allow for less liquid asset classes like private equity and hedge funds. These asset classes do also tend to be more expensive to invest in and require more staff on hand to manage. It’s all worth it if the returns are great.

The 2017 NACUBO report shows that the 10-year average return for all 809 institutions that they track has been 4.6%. A simple 60% stock and 40% bond index fund portfolio has returned a little more over the same period, for a tiny fraction of the costs and far less complexity. Endowments have not generated the stellar performance that we might expect.

In the great financial crisis, Harvard’s massive endowment was famously left with no cash to cover their margin calls, and had to go into debt to stay afloat. Much of their capital was tied up in illiquid private equity and real estate. They lost nearly 30% in 2009, about the same as a 60/40 index fund portfolio.

Some pension funds have gotten the message. Steve Edmundson, who manages the Nevada State pension fund, a 35 billion dollar fund nearly the same size as Harvard’s endowment, does nothing but invest in low-cost index funds. It’s also worth mentioning that the Nevada State Pension fund has consistently outperformed Harvard’s complex and expensive endowment fund.

In a 2013 report, the Maryland Public Policy Institute wrote that:

“State pension funds, including Maryland, have succumbed for years to a popular Wall Street sales pitch: “active money management beats the market.” as a result, almost all state pension funds use outside managers to select, buy and sell investments for the pension funds for a fee. the actual result — a typical Wall Street manager underperforms relative to passive indexing — is costly to both taxpayers and public sector employees.”

The report continues:

“Getting pension fund administrators to support the policy and to educate legislators about indexing will be an uphill battle. By agreeing to the policy, administrators essentially admit they made mistakes by betting heavily on active managers. Who wants to admit an error? Investment consultants and Wall Street money managers will vigorously oppose such a policy.”

With their ability to negotiate lower fees and gain exposure to more exotic asset classes, it might be expected that large institutional investors could beat the simple low-cost strategy of index investing. That data do not support this assertion. What we do know is that complexity increase costs, and costs decrease average returns. Even the largest and most sophisticated investors cannot escape this truth.