Smaller Mandates Generate Positive Alpha: Study

1092533_41672492Pension funds are a critical component of many people’s overall financial position and among the largest institutional investors in the US. However, remarkably little is known about their performance and cost structures. By contrast, the mutual fund and hedge fund sectors have been heavily scrutinized. The lack of pension fund performance studies can be largely attributed to an absence of sufficient data, which is a direct result of a lack of reporting guidelines. Mutual funds are required to report their performance and fees on a regular basis, whereas no such obligation exists for pension funds.

The main contribution of this paper is to employ the CEM pension fund database to provide a comprehensive overview of the performance and costs of domestic equity investments by US pension funds. The database, which does not suffer from reporting biases, covers approximately 40% of the US pension industry in terms of assets, representing a wide variety of fund sizes and equity mandates, and contains both defined benefit and defined contribution plans. Specifically, our database consists of 463 defined benefit pension funds for 1990–2006, and 248 defined contribution pension funds for 1997–2006.

We find that pension fund cost levels are substantially lower than mutual fund fees, largely as a result of scale advantages. The risk-adjusted net performance of total equity investments of the funds (after expenses and trading costs) tends to be positive and statistically significant, though relatively small after also benchmark-adjusting. However, small cap and smaller size mandates tend to generate positive alpha. For example, small cap mandates of defined benefit funds outperform their benchmarks by about 3% a year. These results contrast with the average underperformance of mutual funds. Read the full paper here.