March Madness For Investors

Pension funds have investment return assumptions which, if not realized, have negative consequences for their respective plans. Given this seemingly singular aim of the fund manager, most pension funds tend to buy assets whose expected returns in aggregate will achieve their return assumption. Accordingly, pension funds tend to be managed with outcome-based strategies.

For example, consider a pension fund manager with an 8% return target that largely allocates between stocks and bonds.

Given the current yields in the table above, and therefore expectations for returns on sovereign bonds of approximately 1%, the manager must instead invest in riskier fixed income products and equities to achieve the 8% return objective. Frequently, a pension fund manager has a mandate requiring that the fund hold a certain minimum amount of sovereign bonds.  The quandary then is, how much riskier “stuff” do they have to own in order to offset that return drag? In this instance, the manager is not allocating assets based on a value or risk/reward proposition but on a return goal.

To illustrate, the $308 billion California Public Employees Retirement System (CalPERS), the nation’s largest pension fund, has begun to shift more dramatically towards outcome-based management. In 2015, CalPERS announced that they would fire many of their active managers following repeatedly poor performance. Despite this adjustment, they still badly missed their 7.5% return target in 2015 and 2016. Desperate to right the ship, CalPERS maintains a plan to increase the amount of passive managers and index funds it uses to achieve its objectives.

In speaking about recent equity allocation changes, a CalPERS spokeswoman said “The goal is to eventually get the allocation to the right mix of assets, so that the portfolio will likely deliver a 10-year return of 6.2%.”

That sounds like an intelligent, well-informed comment but it is similar to saying “I want to be in Poughkeepsie in April 2027 because the forecast is sunny and 72 degrees.” The precision of the 10-year return objective down to the tenth of a percent is the dead giveaway that the folks at CalPERS might not know what they’re doing.

Outcome-based strategies sound good in theory and they are easy to implement, but the vast amount of pension funds that are grossly underfunded tells us that investment policies based on this process struggle over the long term. “The past is no guarantee of future results” is a typical investment disclaimer. However, it is this same outcome-based methodology and logic that many investors rely upon to allocate their assets.

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