A nearly universally accepted assumption is that, unlike most individual investors, large institutional investors can beat the market. In pursuit of this objective, some U.S. states employ more than 100 investment staff members to invest the capital of public employee retirement funds. Top universities claim to employ the brightest individuals to manage their endowments. And blue chip companies pay large sums to investment consultants and OCIOs to gain an edge.

But what if this assumption is wrong? What if, in the long-run, their costly efforts are unlikely to produce better returns than those delivered by financial markets? The evidence overwhelmingly shows that the faith that trustees have in their advisors is misplaced.

Regular readers of IFA articles will already be aware of the ongoing SPIVA analysis provided by S&P Dow Jones Indices. It's an ongoing scorecard showing the performance of actively managed funds, not just in the U.S. but all around the world. What it shows us, again and again, is that most funds underperform for most of the time. Over periods of 15 and 20 years or more, only a very small proportion of active funds have succeeded in beating the appropriate benchmark on a proper cost- and risk- adjusted basis. Even over shorter periods, active funds have struggled to survive, let alone outperform the market.

As you can see form the chart below, in every single category SPIVA looked at, the vast majority of actively managed equity funds underperformed the relevant benchmark over the ten-year period to the end of December 2023. Even in the sector where active funds had most success — namely mid-cap equity funds — only 19.62% of funds available to investors at the start of January 2014 were able to beat the index.

Institutional Funds Have Performed Almost As Badly

Fund managers generally offer institutional investors different versions of the funds that retail (or individual) investors use. These typically have lower expense ratios and either reduced sales loads or none at all, which makes them more cost-efficient.

This does give institutional funds an advantage over retail funds. But how much difference does it make to the proportion of funds that outperform?

Well, in recent years, SPIVA researchers have begun to chart the performance of these institutional funds. The answer is, not much difference at all. Here, for example, is the Year-End 2023 edition of its institutional scorecard. More than 70% of funds across equity vehicles underperformed their respective benchmarks over the ten-year period ending December 31, 2023. After deducting fees, underperformance rates increased to approximately 81%.

Over the same period, 65% of fixed income accounts underperformed comparable indices on a net-of fees basis, although fees made a more significant difference across the fixed income categories analyzed.

The findings come as no surprise to us at IFA. They are not only consistent with the findings of previous institutional scorecards, but are also consistent with numerous academic studies. For example, Jean-Pierre Aubry and Yimeng Yin from the Centre for Retirement Research at Boston College recently produced a short paper called How Do Public Pension Plan Returns Compare to Simple Index Investing? It showed that public pension plans have been shifting toward more complex investments in the past two decades, making more use of alternative assets, and expanding their reliance on external managers. Yet, since the Global Financial Crisis, their relative performance has substantially deteriorated.

Most Trustees Are Effectively Gambling

Mark Higgins, senior vice president for IFA Institutional, says institutional investment plan trustees need to take a long, hard look at the returns their achieving. "Unless trustees have a provable, stable, and sustainable competitive advantage," he says, "they should invest in low-cost index funds. If they refuse, they should at least use a more fitting label to describe their strategy. It is not investing; it is gambling."

"It is also an especially unprincipled form of gambling because it is highly unlikely to pay off, and it is done with other people's money. But trustees are also victims because they are surrounded by consultants, OCIOs, and staff that encourage this behavior. In fact, these advisors are much like the servers who supply free drinks on the casino floor. And much like the servers, most know or should know that they are encouraging bad behavior."

I would encourage any trustees who would like to learn more about the way that complex and expensive active strategies are failing institutions and their beneficiaries, to watch this video recording of a webinar that Mark Higgins recently delivered.

In it Mark explains:

• the structural decision-making challenges for fund trustees (at 3:55)

• the tricks that investment consultants commonly employ to make their performance look better than it is (8:45)

• the evidence from independent studies of how poorly pension plans have performed (12:30)

• the structural headwinds that active managers and alternative investments face (16:37)

• the conflicts of interest at the heart of the investment consultancy business model (33:22)

• the rationale for using an indexed OCIO like IFA (41:55)

 

---

HOW CAN WE HELP YOU?

Do you have any questions about this subject, or any other issue related to investing? If you do, we would love to address them in future content.

Simply email your question to [email protected] and we'll do our best to answer it.

---

ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

---

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.  Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarangee of any particular financial product, service, or advisor. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.