The Smart Money Isn’t So Smart– The Expensive Failures of Institutional Money Management

For many years, institutional money management, as exemplified by the endowment model (sometimes referred to as the “Yale Model”), was acclaimed for its ability to generate significant returns, year after year, in all market conditions.

While most individual investors could not directly access this kind of “sophisticated” money management, many retail solutions boasted of their “institutional” approach, the success of these institutional money managers was used to defend the value of active money management. After all, many managers seemed to be able to outguess the market again and again.

But since the Great Recession of 2008, public employee pension funds, endowment funds and other nonprofit institutional investors have—on average—experienced consistently poor performance.

As a new paper, How to Improve Institutional Fund Performance by Richard Ennis, argues, this underperformance is not an accident. Rather is an inherent, structural feature of how institutions manage money, since the high number of managers most institutions use ends up making their overall portfolios look like expensive index funds.

For this reason, Ennis believes, “investors across the board would be better off investing purely passively.”

Pension funds control more than $4.5 trillion, making them the largest type of institutional investor in America. 26 million Americans count of the funds to help provide them with a secure retirement income. Yet, according to Ennis’s research, over the last 12 years (through June 2020) pension funds as a whole have underperformed a passive benchmark by 155 basis points a year. This translates to a loss every year of nearly $70 billion in potential returns.

Ennis notes that large pension funds use an average of 182 investment managers, commingled funds and partnerships, with a typical allocation to alternative investments of approximately 30% of assets. The net effect of all these managers, despite the significant allocation to alternatives, is a portfolio that looks 99% identical to an index fund. Unlike an index fund, the portfolio has substantially higher expenses of 110 basis points annually vs. the 5 or so basis points an index provider would charge

Large endowments have experienced similar performance challenges, with the 100 largest experiencing a risk-adjusted return alpha of -1.87% over the last twelve years, which is close to what the endowments are paying in expenses every year. Again, they are working with dozens and dozens of expensive managers.

Ennis believes that the solution for pension funds and most endowments is to invest passively, and if they are going to have an active component in their portfolios, use just a handful of managers so any potential outperformance is not drowned by dozens of underperforming managers.

As he notes, “the very nature of public pension funds and small endowments is such that beating the market is not a realistic expectation. Both types underperform passive investment by the full margin of their cost, and they do so with remarkable consistency. Trustees of these funds should put an end to the waste of precious resources and invest passively at next to no cost. Private institutions with large endowments would, in the main, be better off investing passively.”

This advice is just as applicable for individual investors. Trying to beat the market is almost impossible to do consistently and predictably. Investing in passive, index funds represent a much better, cheaper—and smarter--alternative.

In our experience, an even better approach is an Evidence-Based investment approach which combines the best of active and passive management, and uses decades of data and academic research to put science on the side of investors—without guesswork or speculation. This is how the real smart money invests.

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Diversification seeks to reduce volatility by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market.