KCFR Funded Research 2023

Portfolio Design Issues for Institutional Investors: Asset Allocation in Public and Private Markets, Active Management, and Portfolio Concentration

Profs Keith Brown, University of Texas, and Christian Tiu, University at Buffalo)

The authors analyze and document how the disparities in the investment problems faced by different asset owner types—defined-benefit pension plans and university endowment funds—lead to different outcomes regarding portfolio design judgments. The mixture of public and private market asset allocations in the average endowment and the average pension fund has converged over the years, although endowment funds were the leader in the public-to-private migration trend. For both pensions and endowments, the benchmark allocation decision is the most important variable in explaining a fund’s return variation over time, with the alpha return decision being the most important factor in the cross-section of funds at a given point in time. For both pensions and endowments, active investment decisions are positive marginal contributors to the production of total returns while passive allocation decisions are negative marginal contributors. Generally, endowment funds have adopted an optimal mixture of passive and active risks; conversely, depending on the way in which the investor’s objective function is defined, pension funds could benefit from taking additional active risk.

Choosing Pension Fund Investment Consultants

(Aleksander Andonov, University of Amsterdam, Matteo Bonetti, De Nederlandsche Bank, and Irina Stefanescu, Federal Reserve Board)

Nearly all pension funds employ a general investment consultant, collectively advising $19 trillion of US public and private pension assets. The authors examine what role consultants have, and examines the value of the services through the lens of data on the hiring and firing of consultants. They find that pension funds hire consultants for various reasons, including shielding, access to certain investments but not because of superior investments skills. They also find that consultants have an impact on investment allocations.The concentration of consultants has implications for investment flows and performance.

The Rise of Alternatives

(Juliane Begenau, Stanford GSB, Pauline Liang, Stanford GSB) and Emil Siriwardane (Harvard Business School)

The aggregate alternative and alternative-to-risky portfolio share in pension funds has risen in the US since the 2000’s, but in a heterogenous way over pension funds. The authors examine various reasons as to why this is the case. Modern portfolio theory suggests two potential answers – a shift in beliefs that returns will be greater without additional risk (more alpha, but heterogenous beliefs over alpha) or alternatively a desire to take on more risk. Their data work suggests the first offers a simpler explanation, but leads to further questions regarding the rationality of these beliefs.

A copy of the paper at SSRN