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US Public Pension Funds Breaking The Most Important Rule of Investing

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It is a cardinal rule of investing that past performance does not dictate future returns. Nevertheless, it appears that a majority of public pension fund managers have forgotten this axiom in favor of speculative forecasting.

According to a research paper from the Standford Business School, it has been discovered that US public pension fund managers routinely break this rule. Instead, they regularly make it a habit of basing future returns based on past gains, despite differing investment or market environments.

“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, 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 discovered that the tendency for a public pension to future base returns on past performance was consistent through all asset classes including public equity, real assets, private equity and hedge funds. Furthermore, the expectations that are placed on these asset classes by public pension fund managers are also based on past performance.

The research drew upon data collected from the allocations and expected returns of all US public pensions. The aggregate amount managed totals $4 trillion.

“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.”

“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.

That is not it; the paper concludes the following:

Our findings are more consistent with extrapolation that is not justified by persistence. Pension fund past performance affects real return assumptions across all risky asset classes, including in public equity where fund performance is known not to be persistent. Even in private equity, the extrapolation of past performance is
driven by old instead of recent investments, and pension plans that have made fewer past private equity investments make more aggressive assumptions. Additionally, state and local governments that are more fiscally stressed by higher unfunded pension liabilities assume higher portfolio returns, and are more likely to do so through higher inflation assumptions than higher real returns.

Andonov, Aleksandar and Bauer, Rob and Cremers, Martijn, Pension Fund Asset Allocation and Liability Discount Rates (February 21, 2017). Available at SSRN: https://ssrn.com/abstract=2070054 or http://dx.doi.org/10.2139/ssrn.2070054

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