A report, which says their investments have underperformed since the 2008 financial crisis and are costly, suggests officials should switch to purely passive investing.

Public employee pension funds, endowment funds and other nonprofit institutional investors in the U.S. have underperformed properly constructed, passively investable benchmarks by a wide margin since the global financial crisis of 2008, contends Richard Ennis, an early pioneer of quant investing and co-founder of U.S. investment consultancy EnnisKnupp, in a research paper.

A composite of 46 large public funds underperformed a passively investable benchmark by 155 basis points (bps) per year for the 12 years ended June 30, 2020. The composite underperformed the benchmark in 11 years out of 12, according to his findings.

With public defined benefit (DB) pension plans’ holdings of $4.5 trillion (according to public plans data from the Center for Retirement Research [CRR] at Boston College), Ennis figures that underperformance of 155 bps per year costs stakeholders nearly $70 billion a year.

Ennis notes that a number of public pension fund officials might disagree with his findings and point out that their funds have outperformed their benchmarks or at least matched them. However, Ennis refers to public pensions’ benchmarks as “reporting benchmarks”—i.e., performance benchmarks of the funds’ own devising that they employ in their annual reports. He argues that his comparisons of returns of the reporting benchmarks of 24 of the largest U.S. public funds over the decade ended June 30, 2020, with the returns of “properly constructed,” passively investable benchmarks tailored for each of those funds found evidence of a sizable downward bias in the returns of custom benchmarks.

Ennis says the “extreme diversification” of public pension funds makes them more costly, “with poor prospects for keeping up with a passively investable benchmark over time.” Citing data from the CRR and Greenwich Associates, Ennis says large public funds use an average of 182 investment managers, commingled funds and partnerships; they index about 22% of their assets; and their typical allocation to alternative investments is approximately 28% of assets.

In the paper, Ennis makes some similar points about endowments’ investing. He notes that both public pensions and small endowments underperform by the amount of their cost. The solution, he says, is for fund trustees to invest purely passively at next-to-no-cost.

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