Here is the anti-breeding portfolio of public pensions

It is time for public pension funds to abandon active management and alternative investments and adopt a single portfolio.

In a new article, Richard Ennis, founder of consultancy EnnisKnupp, says America’s public pension plans have failed to leverage the $6 trillion in assets they hold to become what he calls the producers of the cheapest returns on investment. Instead, they locked themselves into an expensive portfolio model, which includes a huge allocation to alternative investments and failed to deliver good risk-adjusted returns.

Public pensions now have an average equity exposure of around 70% in highly diversified portfolios. It’s not bad in itself. But their herd behavior has also resulted in “over a trillion dollars [in] alternative investments after alts stopped adding value to institutional portfolios more than 10 years ago,” Ennis wrote in the article, titled “A Universal Investment Portfolio for Public Pension Funds: Leveraging the best of our herding methods”.

“And yet, the heavy reliance on active management, and alts in particular, has cost funds dearly. Managers of public funds must understand that their strength is not in the active management of money. Rather, it is their potential to become the cheapest return on investment producers on the planet,” Ennis continued.

Ennis outlines the benefits to public pensions of implementing a standard, universal investment portfolio, attributing many of the current model’s weaknesses to well-known behavioral biases and wishful thinking. Institutions, after all, are always run by humans.

“It helps if we can learn to live with what we can reasonably expect from the markets, and not harbor hopes for something more when it’s not in the cards. Smart institutional investing also requires us to recognize our strengths and weaknesses,” Ennis wrote.

In the 13 years ending June 30, 2021, 59 U.S. public pension funds have significantly underperformed a global benchmark — an average of 1.21% per year. In fact, the underperformance essentially matched the fund’s average expense ratios, which hit 1.2%, according to the newspaper.

Additionally, Ennis determined that only one of the funds created significant alpha, or risk-adjusted returns above the benchmark, often a measure of investment talent. Thirty-four of them generated negative alpha. “The analysis points to a systemic problem rather than just a series of bad luck,” the document claims.

Digging deeper, Ennis finds that public pensions are not benefiting from their large allocations to alternatives. The performance of these portfolios is entirely explained by equities and bonds. The effort and manpower required for alts is essentially wasted. “The conclusion that the correlation between a fund composite with an average exposure to alts of 30% and a benchmark of tradable securities is nearly perfect goes against the popular notion that the return properties of alts differ significantly from those of stocks and bonds.

Given the failures, Ennis is hiring an asset manager to create and market what he calls a universal investment portfolio for public pension funds. The passive model would mirror how pension funds as a whole are allocated, with expenses decreasing as assets under management increase. Ennis predicts that the model, which would have 28.6% U.S. bonds, 51.8% U.S. equities, 7% international equities with currency hedging and 12.6% non-U.S. equities, could potentially rank in the top quartile of funds due to its low costs. And it could be profitable for an asset manager. “When the UIP fund reaches one trillion in assets under management, a one basis point fee would produce $100 million in revenue. I think a manager with deep passive capabilities could make a nice profit on a fee like this for managing a single portfolio,” Ennis wrote.

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