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Can large pension funds beat the market?

A recent study on large pension plans provided some favorable evidence that they can generate alpha, or returns above an appropriate benchmark. However, a closer look at the study shows that the data may not be as favorable as it seems.

Before we launch into our discussion, let's review why it seems logical to believe pension plans of large companies could beat the market:

-- Their huge asset bases give them access to the best portfolio managers with outstanding track records.
-- The majority of the pension plans hire professional consultants such as Frank Russell, SEI and Goldman Sachs to help them perform due diligence.
-- The fees they pay for active management are much lower than for mutual funds.

With these advantages in mind, the study "Can Large Pension Funds Beat the Market?" examined large U.S. and Canadian pension plans and found the following.

Study findings

Pension funds show skill with respect to setting asset allocation target weights (0.17 percent annual alpha), the timing of asset allocation decisions (0.27 percent alpha), and derive an even larger positive alpha resulting from security selection decisions (0.45 percent alpha).

For U.S. funds, the positive alpha from security selection was 0.28 percent (only marginally significant with a 1.70 z-statistic, with determines if the difference between two population means is statistically significant). However, the "alpha" was completely driven by momentum, which captures the difference in returns between a portfolio of stocks with high prior one-year returns (winners) and a portfolio of stock with low prior returns (losers). (Note that momentum can be captured by passive strategies.)

Adding the momentum factor to the risk-adjusting model, U.S. funds security selection performance turns negative at -1.07 percent.

Canadian funds exhibit a security selection alpha of 0.83 percent per year. However, all of that could be attributed to what they called the "Nortel" effect. Nortel once made up such a large percentage of the Canadian stock market that its performance dominated returns. The effect meant your performance could be explained by simply looking at whether you overweighted or underweighted Nortel. Adjusting for this effect, the security selection component of Canadian funds equals -0.04 percent per year or -0.21 percent controlling for the momentum factor, though neither is significant.

There's some evidence that asset allocation performance is best achieved using passive rather than active management, which is related to liquidity as well, as passive investing generally means more liquidity.

Pension funds' returns in hedge funds are volatile and negative on average: -1.82 percent (z-statistic of -1.85) in the U.S. and -2.27 percent (z-statistic of -1.89) in Canada.

U.S. and Canadian funds aren't able to generate alphas from active management within fixed income assets. Larger pension funds experience diseconomies of scale in equity and fixed income (mainly due to liquidity limitations).

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.

Funds belonging to the best performing quintile this year are more likely to remain among the best performers in the following year.


The data doesn't seem to be all that impressive. First, once we adjust for momentum, there's no alpha on stocks. In fact, it becomes negative. Second, there's no evidence of ability to generate alpha on fixed income investments. Third, as noted in the summary above, they found that asset allocation performance is best achieved using passive rather than active management.

And importantly, there are also concerns about the methodology, giving reason for caution about the results.

First, there might be biases lurking in self-reported databases. For example, it's possible that only the better/cheaper funds are included the dataset of CEM Benchmarking of Toronto, which provided the data used in the study. Those funds obviously care more about being competitive than firms than don't use CEM.

Second, the paper finds that pensions have had positive asset allocation and market timing returns. However, overall trends toward riskier asset classes, such as emerging market stocks, is an alternative explanation for this result. This would indicate a passive shift, rather than an active market bet.

One last note on security selection, which is particularly sensitive to the choice of benchmark. There's potential that the returns are inflated if there's benchmark gaming. For example, the vast majority of Canadian funds uses the S&P/TSE300 as the equity benchmark and isn't able to distinguish size and/or value styles.

The bottom line is that once we account for these issues, there doesn't seem to be much there.