When it comes to investment performance for pension and sovereign funds, there’s a nagging question whether it pays to be small and nimble or big and powerful. For example, in Sweden the decision was taken to create a handful of small(ish) pension reserve funds that would compete with one another and maintain dynamism. Other countries, however, have preferred to go after the economies of scale that come with size; the Korea Investment Corporation has indicated, for example, that they are looking to grow rapidly in order to “snap up opportunities in deal sourcing”. What’s better?
I can see both sides. Indeed, I happen to know some large funds that miss out on fantastic deals that are “too small to move their return needle” because, given that internal resources necessary to source and vett a smallish deal are similar to a large deal, these funds focus on the large deals even though the small deals offer considerable upside. Conversely, many large funds have the ability to manage assets in house, make direct investments in real assets, and impose a sort of monopsonistic leverage in their negotiations with potential asset managers, all of which offers considerable return potential. So, this begs the question as to which is actually the more profitable position to be in. In short, can large funds beat the market?
The short answer is “yes”, according to a new paper by Aleksandar Andonov, Rob Bauer, and Martijn Cremers entitled “Can Large Pension Funds Beat the Market? Asset Allocation, Market Timing, Security Selection and the Limits of Liquidity.”
“… we document that pension funds are, on average, able to beat the market or their self-declared benchmarks, both before or after risk-adjusting for equity market, size, value, liquidity and fixed income market factors. Interestingly, they can do so in all three components of active management. Pension funds show skill with respect to setting asset allocation target weights (17 basis point annual alpha), the timing of asset allocation decisions (27 b.p. annual alpha), and derive an even larger positive alpha resulting from security selection decisions (45 b.p. per year).”
So, the authors find that large pension funds can and do beat the market. Does this mean that governments should look to super size all their funds? Not exactly. As you can imagine, there’s quite a bit of nuance to the authors’ arguments:
“The relation between size and performance is not uniform and depends on the asset class and investment style.”
“Larger pension funds experience diseconomies of scale in equity and fixed income (mainly due to liquidity limitations), but they realize their economies of scale in alternative asset classes, especially in real estate. Larger funds can assert more negotiation power in alternative asset classes, which enables them to access better investment opportunities at lower costs.”
“Our results also show that funds that manage most of their assets internally improve their performance compared to peers with mostly external mandates, potentially due to fewer agency conflicts and lower investment costs.”
My crude conclusion from this paper: If you’re really big, it pays to invest in (the ability to invest in) illiquid assets through internal teams. That’s how big funds can beat the market. If you’re small, you don’t have the resources to throw at internal teams, so you’re better off focusing your internal resources on selecting managers that can beat the market for you.
This post originally appeared on the Oxford SWF Project