From Frying Pan to Fire

The findings of a recent landmark study reveal that plan sponsors are susceptible to the same performance-chasing behavior that plagues individual investors, causing them to lose hundreds of billions of dollars in asset values, while paying dearly to do so.

“Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors” recently appeared in the November/December 2009 issue of the Financial Analysts Journal, the depth and scope of which is surely to impact the manner in which institutional investors make investment decisions.

The study, written by Stewart, Neumann, Knittel, and Heisler, is a comprehensive follow-up to the Sunil Wahal and Amit Goyal study titled “Selection and Termination of Investment Managers” study which is well-documented here.

“Absence of Value” analyzed a whopping 80,000 annual returns of institutional funds for the 22-year time period 1984-2007, focusing on 1, 3 and 5-year performance periods to answer the study’s inquiry: Do plan sponsor decisions regarding the allocation of assets to specific asset class fund managers or the withdrawal of assets from them add value for the ultimate beneficiaries on whose behalf the plan sponsors are acting?

The exhaustive study concluded that “much like individual investors who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions. In fact, the study estimates that over $170 billion was lost over the period examined,” and that is before transaction costs and consultant fees are considered!

The comprehensive study set out to document whether the efforts typically employed by institutional investors provide a reasonable expectation of payoff that would justify the time and expense associated with them. “Pension plans, endowments and foundations are typically staffed with professionals with years of experience and advanced degrees. Working on their own or with the aid of consultants, institutional sponsors devote considerable time and resources to selecting asset classes and products that are expected to perform well in the future,” cites the study. 

Using data from the PSN Investment Manager Database which includes only institutional products offered in separate accounts or pooled vehicles, and has no data on private equity, alternatives or hedge fund assets, the study analyzed the inflows and outflows of assets of specific fund products and their subsequent 1, 3 and 5-year returns. All performance information includes only gross returns of the products and the study estimates that an additional 1% of transaction costs should be factored into the returns.

The methodology of the study was to calculate asset flows for every product in the PSN database, collecting performance subsequent to inflows and outflows to determine whether products with significant inflows perform differently than products with significant outflows. Post-flow returns for a portfolio of products receiving the largest inflows were means tested against the returns for a portfolio of products experiencing the largest outflows. If different, the study examined the source of those differences. Similar analyses were conducted with account gains and losses.

The findings of this rigorous analysis showed that the funds which experienced especially poor results lose accounts in addition to assets. Interestingly, these products experienced especially strong performance subsequent to being fired. "The preceding analyses document that plan sponsors are not acting in their stakeholders’ best interests when they make rebalancing or reallocation decisions with plan assets. Portfolios of products to which they allocate money underperform relative to the products from which assets are withdrawn. Performance is lower over 1 and 3-year periods and shows no signs of reversal even after two more years,” the study concludes.

The chart below, “Value Gained or Lost When Moving Assets from One Manager to Another” quantifies the impact of their ill-timed decisions in favor of recent past performance.

(see the original study )

As the chart shows in only two years out of eighteen did plan sponsor decisions add value to the portfolio over the subsequent five years. In most cases, value was extracted from the impact of the transactions, with resulting 5-year weighted average impact, without compounding, resulting in a loss of value summing $170.2 billion for the full 18-year sample period, “a significant figure,” the study claims. This sum does not account for all of the money that is lost to the impact of active management fees and expenses. Assuming these costs add an additional 1%, this would mean that $100 billion of the $10 trillion in institutional assets is further eroded, and this does not even consider the high costs of consultants who detract from value, and as the study shows, facilitate the underperformance of returns.

The study’s data-rich findings provide further evidence of the random nature of stock prices and the futility of manager selection based on recent strong, but lucky performance.  This study states, “Clearly, plan sponsors could have saved hundreds of billions of dollars in assets if they had simply held course.”

The study questions “why plan sponsors appear to fail in their goal of increasing the value of plan assets. Heisler et al suggest that certain comfort can be found in the use of historical track records, despite the preponderance of evidence that shows such data to be a poor predictor of future positive results. “Perhaps investment officers, either because they believe it themselves, or their supervisors do, find comfort in extrapolating past performance when in fact excess performance is random or cyclical,” the study states.