US Public Pension Funds Break Cardinal Rule of Investing

Research shows that institutional investors rely on past performance to gauge future returns.

While securities laws require investment literature to clearly state that past performance is no guarantee of future returns, there is no law saying institutional investors have to believe this mantra—and apparently they don’t.

According to a research paper from Stanford Business School, US public pension fund managers regularly break the cardinal rule of investing, and are, in fact, using past performance to gauge what their future returns will be.

“There is a robust relationship between past overall pension fund returns and the assumption about future performance in public equity, where fund performance is not persistent,” said the paper, which was authored by Aleksandar Andonov and Joshua Rauh.

“Even in private equity, the extrapolation of past performance is driven by old instead of recent investments and cannot be reconciled with a rational extrapolation of skill in selecting and retaining better managers,” Andonov and Rauh wrote. “Therefore, our paper provides suggestive evidence that pension plans excessively extrapolate past performance when formulating return expectations.”

The research also found that pension fund past performance affects real return assumptions across all “risky asset classes,” which it defines as assets such as public equity, real assets, private equity, and hedge funds.

And to make matters worse, struggling public pensions are even more likely to rely on historical data to determine performance expectations, according to the findings.

“State and local governments that are more fiscally stressed by higher unfunded pension liabilities assume higher portfolio returns,” said the paper, “and are more likely to do so through higher inflation assumptions than higher real returns.”

The research drew upon data on allocations and return expectations by asset class, which was collected from required disclosures of all US public pension funds, which in aggregate manage approximately $4 trillion in assets.

“While the relationship between beliefs and past experience has been clearly demonstrated for retail investors,” said the paper, “our study is the first that we are aware of to make this determination for institutional investors.”

US governmental accounting standards rules require pension plans to report long-term expected rates of return by asset class as part of a justification of the plan’s overall long-term rate of return assumption.

“This disclosure separately reveals institutional investor expectations about returns in individual asset classes such as public equity, fixed income, private equity, hedge funds, and other asset classes,” said the paper. “It is the only setting of which we are aware in which a large sample of institutional investors expresses their expected returns by asset class, alongside their targeted asset allocation.”

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