Pension funds should ditch alpha and cut fees

May 13, 2009

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own —

If anyone has reason to pray that the current equity rally holds, it is the world’s active fund managers who need investors to return to the folly of betting on outperforming the markets rather than the uninspiring but reliable business of cutting costs.

Pension funds, particularly those where the employer bears most of the risk of making good on promised payouts, are hurting after more than a decade of poor market returns.

In Britain, for example, pension funds which promise to pay a fixed percentage of workers’ final salaries are woefully underfunded. If you use a more conservative government bond yield to value the funds, the top 200 firms in Britain needed a whopping 120 billion pounds to be considered fully funded, according to consultants Aon Corporation.

This is not the result of some unforeseeable economic storm but instead the fruit of two related delusions; that a prudently managed portfolio can expect to get a return of 8 percent a year or so over the long run, and that individual funds can maximize their returns by choosing the right active fund manager who will outperform even that optimistic benchmark.

And as is so often the case when we are kidding ourselves, these assumptions allowed employers and savers to avoid doing something unpleasant; in this case putting away the cash required to actually fund retirements. Workers felt as if they were “earning” more because their take home pay was larger than it would have been if they were saving sufficiently and businesses could often take contribution holidays or avoid chucking in extra to make good the shortfalls. Win-win, right?

Well, actually no. It was more lose-lose-win, with the two losers being the savers and employers, and the sole winner the financial services industry.

Now it is essentially impossible to know what rate of return capital in aggregate can demand over a long period, but given the way debt goosed the economy and asset markets, and given the way a long, and for investors benign, period of disinflation in the past 25 years affected returns, I’d be willing to bet that the 8 percent benchmark will prove too high.

So that leaves the question of how pension funds and other retirement savers should best invest and on one point there seems little doubt: paying the extra for active fund management is not a good bet.

Active funds create drag on returns in a number of ways; the managers themselves must be paid, as must the investment banks and brokers who advise them and executive the trades they make in order to try to beat the market.

While it is always possible that market returns will more than make up for this, there is no doubt whatever about who bears whatever costs are generated.


Andrew Clare, Keith Cuthbertson and Dirt Nitzsche of London’s Cass Business School have published an analysis of decades of performance data for 734 British pooled pension funds with more than 400 billion pounds under management.

As about 40 percent of UK institutional money is in pooled funds and there is data going back more than 20 years, this is a pretty fair sample.

The result, according to the authors, is that there is “little evidence” of positive performance persistence, i.e. that managers can outperform over time. Further, there is “virtually no evidence” that active fund mangers can time the market.

For example, over a 20 year period ending in 2004, only 3 of 42 pooled funds showed statistically significant outperformance, while 2 showed statistically significant underperformance. All 42 did, however, charge statistically significant fees.

“With increasing numbers of UK fund mangers purporting to be able to provide ‘high alpha’ products to the UK’s beleaguered pensions industry, our results do not give us great confidence that the solution to the widespread deficits lies in the hands of the UK’s active institutional investment managers,” the authors wrote.

About 20 percent of the UK’s institutional money is now in passive strategies, with most of the growth happening in the past 10 years.

The response of the fund management industry to this has been to offer ever more complex fund structures, often with more freedom to short stocks or employ leverage and almost always at a higher cost to the ultimate consumer.

Who knows, perhaps some of these will work. Perhaps all that was wrong with the old fashioned funds was that they couldn’t bet against things, or use borrowed money to amplify returns.

My guess however, is that the best solution is a simple one: go passive and cut fees. It is money in the bank, as it were, from day one.

Employers and employees have a common cause here and should not let an evanescent rally blind them to the steady bleed that fees represent.

— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —


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Mr. Saft, what you say is true. There is no guarantee that active funds can outperform the market over time. However, there are active fund managers that have. But it is also true that no buy & hold strategy or any one asset can outperform the market over time either. Therefore, we are all market timers unless we want to accept a return of closer to 3-percent per annum rather than closer to 8-percent. The 8-percent annual return is one part historic in nature and is not predictive of the future. And in part it reflects re-invested dividends that we have seen dramatically reduced ironically as the perceived risk of owning equity was reduced by long-term historic returns. Again not a predictor of the future. By if long-term GDP growth is in the area of 3-percent, and real interest rates not greater than say 3-percent per year, then any investor hoping to buy & hold and get 8-percent returns is just fooling themselves. Okay, they may not have to pay an active fund manager to fool themselves, but they are not going to get better than 3-percent in a passive fund either. I may not be able to call the tops and the bottoms, but I can pull my money out of bubbles, and save my capital to play another day. And researchers will never be able to accurately track money that was never invested publicly. Call it luck, but to quit when you’re ahead is savvy investing.

Posted by MrBill, Eurasia | Report as abusive

Quote ‘All 42 did, however, charge statistically significant fees’.

It is not just the fees but their utter incompetence which is astonishing. In the last two housing bubbles in the UK, when it was quite obvious that house prices were too high, pension providors were buying estate agency chains. They had to sell these at massive losses.

I would love to have these so called ‘professionals’ hauled in front of an informative live TV audience to explain their investment decisions.

Professional investment providers, CNBC stock pumpers etc etc should be ignored. For every 50 you hear or read, maybe one is relatively competent. This whole area is one which the retail investor should be very careful of. They only care about their own interests and certainly not yours.

Posted by D Rumsfeld | Report as abusive

U.S. economic growth has been upon the back of mortgage backed securities. The bubble in housing prices made the profits in these vehicles look to good to be true. Everyone took the bait. Essentially GDP had grown on inflated land values as the economies durable goods production and manufacturing base has declined over the last several decades.

The canceling of Bretton Woods and the repeal of Glass/Steagall was not incompetence. Our Congressmen bowed to the pressure of large financial interests. Their financial support was needed by incumbents seeking reelection. Campaign contributions from business’ and corporations is in my estimation nothing more than legal bribery.

Rolling banking, securities and insurance all into one company is fraught with conflict of interest and the potential for fraud. Produce mortgages sell it to Fanny May. Package said mortgages into securities. Sell derivatives as insurance in case the securities fail. These were the very reasons given in 1933 for enacting Glass/Steagall. Certainly no one believes even the most competent fund manager could produce sustainable results with con artists running rampant through corporate America?

Posted by Anubis | Report as abusive

I feel the natural dynamics have eroded. There is a fundamental difference between froth-feeders and bottom-feeders.

We rely on bottom-feeders to return to the market and provide stability. They tend to focus on the fundamentals. By nature they are slightly paranoid, skeptical and prone to get nervous from sharp, sudden movements up or down in the market. They need huge discounts to justify the risk.

Froth-feeders in contrast love sharp, sudden movements up and down. They buy into rallies and sell into crashes. They trade even on small price differentials and force the market into a sustained equillibrium. We are expecting froth-feeding behaviour in a bottom-feeding environment.

I just don’t think that the people who used to be there are still there. They are not waiting to jump into the market. So a lot of hype is irrelevant whether boom or bust. They are gone. These are people near the top of the food chain along with creatures that eat wild grass. The predators will eventually starve without them. Then when the predator population gets decimated, the number of feeders return to normal.

I’m a bottom feeder. I get nervous when people keep telling me that things are improving or worsening. Bush was right on that aircraft carrier telling people that the Iraq War was over. Interest rates are 0 percent. I don’t care about official unemployment stats. I just check with my neighbours to see things are. The government and securities industry is full of idiots. These are not normal conditions.

However what exactly happens to the markets don’t matter. All of the cash is spoken for. While froth-feeders are in it for short-term gain, bottom-feeders fully intend to eventually take their money out at some future time. That would be now.

Posted by Don | Report as abusive

Thank you for the information James.

The situation in the UK is dire as the proportion of retired population is increasing yearly. (Hence the government proposal to increase the retirement age).

The increasing level of liquid funds required by insurance companies to maintain pension payouts means that the suckers looking for the next “bull market” will be contributing nicely to keeping these payments running as insurance companies liquidate investments to fund the payments.

The only way insurance companies can increase the value of their investment holdings is if their contributions from members and growth in investment portfolio value exceeds their payouts and the recession will bar this from happening.

It seems to me that whoever coined the “green shoots” recovery theory may have been smoking the “green shoots” that you mentioned could save us from the credit crunch if the industry was legalised.

Posted by Greg | Report as abusive

One good thing has come out of the current crisis; it has exposed the vast majority of active fund managers as fee driven mediocrities with little or no real investment competence. Many of them will now dissappear and the ridiculous number of funds available on a global basis will be dramatically thinned out.

What is left may be sufficiently attractive to convince small retail investors like me to return to the equity markets. Until this clean up takes place I suspect that many of us will stay in cash.

Posted by anton kleinschmidt | Report as abusive

This is all, of course, the result of misplaced value. Rather than being valued as a medium of exchange, money is valued as a medium of control.

No longer is the idea of living within your means good enough. That type of thinking doesn’t generate enough “growth” for our industry. So those who own the “stuff we need”, sold us the idea of credit as a necessity. And like the foolish sheep we are raised to be, many working folks were lured in by the apparent life of luxury that living on credit can “afford” one.

How is this possible? If you’re a lower middle class working stiff, your day is pretty draining. Most of the time you come home tired and you really just don’t feel like dealing with anyone’s crap. You don’t feel like you’ve done anything of any particular value. Usually you feel like your time is finally your own when you get off the clock. So why shouldn’t someone who lives every day in this way, have a little something to show for it?

Big business knows there’s an emotional niche to exploit. And so they do. Look at all the rent-to-own and pay-day-loans popping up all over the place. People who work hard feel entitled to a portion of what they work to produce. And in a “free market” , you can have what you want for a price. As if your labor and self alienation weren’t enough.

Take out a home equity line of credit. Go get yourself some rent to own stuff. And now that your collective employers have robbed you of your time to produce this stuff, the financial leeches will explain how good an idea it would be to have all that nice shiny new stuff you want right now. And you can do it by just taking out a loan against your house. But not to worry, your home will go up in value and you could use that extra value to help you pay off this loan. Sounds reasonable right?

SURE IT DOES!!! And so the American worker develops the “keep up with the Jones’ mentality”. And are then bled dry by the financial instruments sold to them as a means to achieve some “financial security” or “freedom”.

And still we look at this issue from the perspective that we somehow need to suffer great pain if the money isn’t there.
We still accept that families can be kicked out of their homes for lack of money as being acceptable. But reality will hit when you find yourself on the loosing end of this game wondering why it is that you should have to give up your community roots and your home just because some bank is strapped for cash.

The money is only the problem because we are being forced to serve it.

Posted by Benny Acosta | Report as abusive

I’ll buck the trend of long-winded posts. Leveraging and short selling are the worst active managers can do. Leveraging is the reason we are in the current economic mess. Worse yet, this is used most commonly in commodities. Which have huge levels of volatility- right back to market timing problems. Short selling is about to be blown up by regulation. Both are horrible strategies and why this field is dying…

Posted by Matt T | Report as abusive

The finance industry has sucked the money out of our society and made a gang of self entitled and immoral frauds rich. The Obama administration is trying to turn the corner on this but the change is just too large to accomplish, so now we have this dummy recovery and silly assertions about returning to “expansion” in the 3rd quarter. That model is over, housing is tapped out, derivatives unmasked, just like Bernie “Chairman of the NASDAQ” Madoff. We need an entirely new model. Banks must be made boring and marginally profitable again. Withdrawing equity from homes was not a sustainable strategy for wealth and now we are left with grossly overvalued assets, whose decline will be painful every step of the way. It all started when Reagan/Thatcher took housing out of the measure of inflation – the home ownership society was a scam. Many have seen their propery grow in value by 10 times since the 90’s, think how that may unwind. Many made more money from their houses than they have ever earned, and were helped to believe that was just and acceptable. Now their children and grandchildren are left to clean up after the boomers magnificent adventure.

Posted by Bilbo Baggins | Report as abusive

Hmmmm…writer is on the trail…and commenter Anubis too…gentlemen, we must ask ourselves, can the center hold much longer, or, as V.I. Lenin once said, “What is to be done…?” before he took action. How long can the folk be deluded and sidetracked in this 3-card Monty? We must address it all aggressively: derivitives, MBS’s, credit defult swaps, the walls down betw investment banking, insurance, securities; campaign financing and legal bribery, Bretton Woods…and most of all, the U.S. Federal Reserve…look at the history and follow the money…the cat will soon be out of the bag.

Posted by Pax Americana | Report as abusive

“…paying the extra for active fund management is not a good bet.”

An occasional gambling man myself, I love the way the word “bet” kinda rolls off the tongue there.

Would-be pension recipients of the future – have been relegated to punters at an infernal derby with its totalizer system on the blink, none of its last ten or so races having ended anywhere near photo-finish, favorites all succumbing to the trots – might be entitled to redress from those having cajoled them into gambling their very livelihood on this staggering washout. If only they still had the busfare home.

Instead they’re being told they can’t leave, somebody having economized on fire exits. Oh well, let’s see what’s on the telly…

Big nags foaming at the mouth, track officials diligently respirating and injecting yet more dope into the cadavers of declared winners – signs are, this sport of kings has run its course. Wiser, more educational and possibly entertaining to have invested in government glue factories all aong.

The following may be viewed as the core of your article –
“Active funds create drag on returns in a number of ways; the managers themselves must be paid, as must the investment banks and brokers who advise them and executive the trades they make in order to try to beat the market.”
Disambiguated, this might read –
“If Active Funds were to manifestly produce and sustain accountable returns exceeding passive market indices, then those who manage and advise on the procurement of such certifiable returns may expect to be compensated accordingly.”

That would be all right, really, but unluckily, nothing like what’s been happening. At some point, studies are liable to show better returns playing Vegas Rules roulette, then Find The Lady Thatcher. Then what?

There is no basis in logic or civil law why most Active Fund managers et al. should qualify for anything better than early retirement without pension. I’ll wager they’d like that better than Debtor’s Prison.

“…there is no doubt whatever about who bears whatever costs are generated.”

I’m betting it’s Would-Be Pension Recipients Of The Future, Jim! They were gamed. What do I win?

Now, will whoever still believes this system can self-regulate please raise your hand, there’s a bunch of zombies at the door seeking alms … and legs.

Posted by The Bell | Report as abusive