The California Public Employees Retirement System (CalPERS) is the largest pension plan in the U.S., with assets in excess of $256 billion. It was an early adopter of index investing. More than half its assets are indexed.
In a stunning announcement, CalPERS said it is considering whether the active managers it is using achieve better returns than the index portion of its portfolio.
This assessment is based on the recommendation of a savvy consultant to the plan who found that only about one-quarter of the active managers used by the plan outperformed their benchmarks at any time. The issue is whether this outperformance is canceled out by the balance of the active managers who are underperforming. The consultant also noted that the outperforming managers change over time.
According to Janine Guillot, the chief operating investment officer, preliminary interviews with 12 board members, staff members, money management executives and consultants "showed a wide disparity of views as to whether active management is working for CalPERS."
Here's my memo to Ms. Guillot:
I am sure those who benefit from engaging in the process of trying to select outperforming actively managed funds will strongly resist your efforts to stop this charade. Their livelihood depends on the circular game of picking fund managers based on past performance, dumping them when their outperformance does not persist, and hiring new active fund managers to replace them.
All you need to know to make the right decision for the plan beneficiaries can be found in this study: Luck versus Skill in the Cross Section of Mutual Fund Returns, by Eugene F. Fama and Kenneth R. French. Fama and French are two of the most cited professors of finance in the world. They looked at the performance of actively managed funds that invest primarily in U.S. stocks from 1984-2006. They formed a portfolio of actively managed U.S. stock funds and weighted each fund every month by the assets under management. This fund represented the aggregate portfolio of wealth invested in active mutual funds. You could follow the same protocol (which is probably what your consultant has done) for that portion of your assets that are actively managed. Here's a summary of their findings, as they explained in this blog post:
- Before expenses, the overall portfolio of active funds showed "no evidence that active managers can enhance returns."
The study found most active fund managers did not perform better than what you might expect from random chance. It's almost impossible to determine whether outperformance was the result of skill or just luck. Even the top 3 percent of the active fund managers studied demonstrated only enough skill to cover their costs, which would hardly benefit investors in those funds. Fama and French expect the balance of 97 percent of actively managed funds to perform "worse than comparable efficiently managed passive funds."
As your consultant noted, the majority of the active managers you use underperform their benchmark. It's exceedingly difficult to predict which ones will outperform in the future. Even if you could do so, their outperformance will likely be more than offset by the balance of underperforming actively managed funds in your portfolio.
A far better option would be to invest in an all-indexed portfolio. You will give up the allure of excess returns, but adopting this strategy is likely to outperform using a bevy of active managers, all of whom claim to be able to "beat the markets," while relatively few are able to deliver on this promise.
- Where's your peer-reviewed data?
- Do you have an economic interest if we continue to use actively managed funds?
