Although a single study cannot itself be conclusive — and may not squarely address the risk management aspect of these popular strategies — the Ennis report is a wake-up call to public pension trustees, staff and consultants.
Ennis’ independent study of 54 prominent public plans’ portfolio data, from fiscal 2008 to 2023 as collected by the Center for Retirement Research at Boston College, documents pension trustees’ increasing adoption of nontraditional strategies as their new paradigm. Collectively they almost doubled their exposure to alternative investments, increasing it from 18 percent of their portfolio totals to 34 percent. Private equity commitments surged from 7 percent to 13 percent, hedge fund allocations tripled, and the funds’ real estate investments also grew measurably.
Undoubtedly some of this shift was attributable to this period’s pathetically low yields on long-term bonds, with benchmark U.S. Treasury rates stuck in the mid-2 percent range much of that time. That made Treasuries — and the traditional 60/40 stock-bond mix — unattractive to pension trustees who were fixated on 7-plus percent actuarial assumptions during what was called the “ZIRP” era, after central banks’ zero interest rate policies. In order to offset stock market risk while seeking materially higher returns than government bonds, it became increasingly popular to turn to alternative investments inside a broader portfolio mix.
The industrywide paradigm shift included a concoction of hedge funds that were assumed to have lower volatility, with their ability to sell short to profit from weak stocks and market downturns; real estate and commodities to provide a hedge against inflation; and private equity to provide juicier long-term returns. But a good number of private funds keep coming up short of fully transparent, real-time fair market valuation, which can misleadingly paper over their investors’ actual losses of economic value in adverse periods and thereby the inherent volatility of their actual financial worth. It’s been called “phony happiness” and “volatility laundering.”
Part of the problem is how consultants’ portfolio construction analytics are structured. The so-called illiquidity premium — the additional expected return on private assets that can't be sold for an extended period — is treated as a free bonus, promising reliable upside premised on the lure of extraordinary returns. The reason is “performance smoothing”: These funds exhibit negligible volatility from market price fluctuations because there is little or no ongoing market trading of their portfolio holdings. Private equity, credit and real estate partnerships have been treated analytically by many as if they were cost-free, high-yielding, long-term bank CDs that rarely experience major price fluctuations along the way.
Now throw all this into the pension consultants’ magic portfolio blender and — voila! — the models spit out a richer allocation to these alternative investments. Presumably that helps mitigate a portfolio’s downside risk of market cycles and economic recessions, at least on paper. But what if that’s been empirically misleading in practice, and there’s actually less performance improvement and more downside from the resulting portfolio mixes?
To make matters worse, mature, older public pension systems are now cash-flow negative in aggregate, paying out nearly $100 billion more in benefits annually than they receive in payroll contributions, and thus increasingly dependent on investment returns. Facing negative cash flows, an illiquidity-premium strategy can backfire in down markets despite its illusory price stability. The needed cash has to come from someplace else, and that can impair overall returns.
Statistical Underperformance
The Ennis findings suggest that, on average, the full cost of the fees and profits paid to the outside managers in this market space is about 1 percent of assets for the entire portfolio and thereby a huge detractor from actual investment returns.
Without going through all the statistical assumptions and inferences of the Ennis report, the bottom line of his analysis is that fees and hidden costs accounted for much of the underperformance and that this was directly related to the percentage of the portfolio invested in alternatives. The study’s equal-weighted average 28 percent commitment to alternatives investments correlated with portfolios’ total investment underperformance of about 1 percent annually. For the plans with 40 percent invested in alternatives, the drag on annual portfolio performance overall was estimated at 1.5 percent.
These are statistical inferences and correlations from a limited but reasonably representative sample. A different multiyear period could yield different results, so a grain of salt is appropriate. Some could claim, for example, that the 2008-2023 period was nothing more than a rare “bear market in diversification” — a nonrecurring statistical fluke. The study’s bookend calendar years of 2008 and 2022 both involved a stock market downturn. Nobody can predict that actual results in the next decade will mirror those of the past 15 years. For perspective on that, the Public Funds Survey reports issued annually by the National Association of State Retirement Administrators are worth reviewing as well, to provide context over a broader time period for reference.
There is also a contrary technical argument that profits from these selected pension funds’ increasingly exotic allocations have not yet been harvested — that the bigger returns from some of their newer investment vintages have not yet been realized and distributed. The industry adage is that “the lemons ripen first” and that it usually takes five or even 10 years to harvest the sweeter fruits of private partnerships. A period of expanding use of alternatives could accentuate such an investment return “J curve.”
Perhaps. But in the latest 12 months following the study period, pensions have suffered an even-larger bumper crop of lemons in their alternatives portfolios. The number of down-rounds in venture capital has hit a multiyear high and the commercial real estate market today is infested with very sour lemons.
Worse yet, a plagued crop of private equity funds are now zombies unable to pay out expected profits, forcing some pension managers to sell off their interests at a loss and even borrow money against their other assets to pay their retirees. Although the stock market performed quite well in the last year and indeed over the latest 15, many of these other illiquid strategies lagged far behind. Their performance contribution has gone from bad to worse.
Transparency and Fee Reforms
Pension accountants, actuaries and auditors now need to double-check the veracity of the private funds’ latest financial statements’ valuations in light of chatter that 99 percent of recent private equity secondary sales — those in which one investor purchases an asset from another — are underwater and that fraud is popping up in commercial real estate. Likewise, consultants might best revisit their asset allocation models and underlying assumptions for a reality check.
Informatively, the nation’s premiere association of financial analysts has weighed in with its own new report calling for frequent and accurate portfolio valuations along with timely quarterly reports of fees, expenses and performance. These corrective disclosure principles are overwhelmingly supported by a strong majority of surveyed professionals, not just a few cranky pension critics and industry gadflies.
Ultimately, however, the problem here is more than just disclosures. The entire industry structure of carried interest — tax-advantaged payments of an undeservedly hefty percentage of profits to managers in private partnerships — needs a complete overhaul by the pension industry. Returns that must be surpassed before a fund manager can claim any carried interest (“hard hurdles” in industry parlance) ought to approximate the returns now expected for competing investments, such as 7.5 percent for common stock and 5 percent for corporate bonds. On top of their already lofty management fees, managers should thence enjoy profit sharing only for producing results that exceed those thresholds. Unjustifiable fees likely account for about a third of the performance drag that the Ennis study reveals, all at the expense of voiceless public employers and their taxpayers.
The public pension community owes itself — and its stakeholders — a hard-headed self-examination of the issue of fee drag on performance, how fees and carried interest are structured and reported in public, and the debatable assumptions of consultants and actuaries. The Ennis evidence tells us that with alternative investments and their costly fees, less is more.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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