Top 200 pension funds actively moving to passive strategies

Active management in traditional asset classes took a back seat to passive strategies, according to the latest survey by Pensions & Investments of the nation's 200 largest retirement plans.

Defined benefit plan assets in traditional equity strategies decreased more than 10% overall, with active portfolios taking the brunt of the decline, both domestically and abroad, in the 12 months ended Sept. 30.

U.S. equities overall decreased 10.7%, with active portfolios down 13.1% and passive assets down 9.3%.

This compares with a 10.2% drop in overall international equities for the period, with active international dropping 16.6% and international passive strategies, a mere 0.9%. Adjusting for market returns, international active assets fell 8.5% while international passive grew 8.7%.

Developed markets investments saw the biggest spread between active and passive, with active strategies down 14.7%, or a market-adjusted -6.4%, while passive developed market assets saw an increase of 14%, or 25% on a market-adjusted basis.

Emerging markets equity assets fell on an absolute basis for both active and passive, but grew 1.48% and 8.1%, respectively, when adjusted for market returns.

(For the 12 months, the Russell 3000 index returned 0.54%, the MSCI Europe Australasia Far East index, -8.87%; the MSCI World, -3.81%; and the MSCI Emerging Markets index, -16.08%.)

It was a similar story for fixed income, where overall assets decreased 5.6%, and U.S. investments dropped 6.5% for the year ended Sept. 30. Passive U.S. bonds fell 2.1% and active, 8.8%.

The Florida State Board of Administration, Tallahassee, had the largest shift to passive U.S. bonds from active among funds reporting that data. Active domestic bonds at the $120.8 billion Florida board decreased to $10.6 billion from $20.4 billion with a corresponding shift in passive, to $16.7 billion from $6.2 billion, during the survey period.

“Strategically, we view our fixed-income asset class as our anchor to windward,” said Dennis MacKee, director of communications for the Florida board. “A more passive fixed-income approach will help us to better weather future major market disturbances and provide us with a source of liquidity for rebalancing needs, capital calls and benefit payments.”

Global bonds were a different story: Actively managed assets by survey respondents increased 15.5% to $66.8 billion while passive fell 60% to $2.1 billion. The big winner was active strategies for global developed markets, which increased 53%.

Terry Dennison, Los Angeles-based senior partner and U.S. director of consulting at Mercer LLC, said it is more difficult now for active domestic fixed-income managers to add value in the current environment. Skill at interest-rate anticipation is no longer important, with the government controlling interest rates and corporations with strong balance sheets paying down debt make credit analysis less important, he said.

“Opportunity to add value, unless going to exotic strategies, has been pretty limited,” Mr. Dennison said.

Russell Ivinjack, Chicago-based partner and chair of Hewitt EnnisKnupp's U.S. investment committee, said that among his firm's clients, “we've seen a very large shift to liability-driven investing.” He added that custom liability-hedging plans have been popular in the past two years to match liability profiles with fixed-income structures. “It's a major material move and will continue over the next several years.”

Mr. Ivinjack also said clients were disappointed during the 2008 downturn that active equity managers did not provide downside protection and produce better returns than indexes. Clients are now turning to passive equity strategies, which provide cheap beta with similar returns, he said.

“We've definitely seen over the last several years more money moved into index and passive investments in the U.S. and non-U.S.” portfolios, said Mr. Ivinjack.

The two main drivers in the equity shift have been dissatisfaction with underperformance from active managers and portfolio management shifting toward increased allocations in alternatives, mainly hedge funds and private equity, he said. “They (plan executives) have active risk in alternatives and are dialing back active management from a long-only equity standpoint. As institutional investors spend complexity points, less of these complexity points are going to public markets and more into alternatives.”

Mr. Ivinjack said Hewitt EnnisKnupp sees the move to alternatives as a “truly evolutionary” long-term trend.

Indeed, P&I's data show an overall increase to alternatives, including private equity and real estate, among defined benefit funds in the Top 200, to 21.1% as of Sept. 30, 2011, from 17% a year earlier. These increases were across the board by plan sponsor type: corporate plans, to 21.2% from 15.9%; public plans, to 21.4% from 17.6%; and unions, to 16.4% from 14.7% allocations.

Lynn Blake, senior managing director and chief investment officer of global equity beta solutions at State Street Global Advisors, Boston, said the shift to alternatives and passive equity is not as much a move to reduce risk, as was seen in 2008 and 2009, but more related to performance and costs. “Why pay for active if they can't deliver?” she said.

The Florida SBA decreased its U.S. equity investments 30% to $27.6 billion while increasing international equity 13% to more than $33 billion. U.S. active strategies decreased 31.8% to $3.6 billion while passive decreased 27% to $22.3 billion. Active international equity increased 5.6% to $18.7 billion while passive saw the largest inflow, increasing 42% to $8.3 billion.

Mr. MacKee said the board decided to go passive in the more efficient developed markets and place active risk more in alternatives and emerging markets equity. Passive developed markets equity at the Florida SBA increased 41.9% in the 12 months ended Sept. 30.

Ms. Blake said it is not clear if the recent trend of shifting assets to passive is cyclical or secular. SSgA indexed assets under management increased 24.8% to $1.4 trillion for the year ended June 30, according to P&I data.

“Prices were impacted more by global macroeconomic concerns than fundamentals,” Ms. Blake said. “It's a tough environment for stock pickers.”

Mercer's Mr. Dennison said the shift to passive in U.S. equity markets is likely a secular trend because of market efficiency, but he believes the fixed-income shift is more cyclical and will change with an eventual easing of interest rates.

Mr. Dennison noted that markets have always moved up and down with business cycles, but “existential threats” like the European debt crisis are generating huge uncertainty now. This is causing investors to take what the market gives them instead of trying to find the managers “with the best crystal ball.”

“The uncertainty level that drives volatility is much higher,” he said. “We're now in a period where our vision of the future is not very long. We can't see very far ahead.”

Several of the largest U.S. pension plans had significant shifts in their equity portfolios. The $8 billion IAM National Pension Fund, Washington, decreased its active domestic portfolio 21% to $1.2 billion while passive domestic equity increased 46% to $870 million.

“Like most investors, we've found it more compelling to search for alpha elsewhere than large-cap equity,” said CIO Monte Tarbox. “As time goes by, passive makes more and more sense. Although there are no plans now, it would not be surprising if we decide to further increase allocations to passive equity.”

Mr. Tarbox said market uncertainty is the reason passive strategies “have a permanent role and are increasingly valuable.” He doubts the pension fund will backtrack to more active strategies in the future.

Hewitt EnnisKnupp's Mr. Ivinjack said domestic equities allocations were hit harder because of the desire of larger pension funds to reduce home-country bias.

The $75.3 billion North Carolina Retirement Systems, Raleigh, decreased its overall domestic equity portfolio by 39% to $13.2 billion while increasing its international 12% to $13.2 billion. Active domestic equity decreased by 46% while passive decreased 23%. In its international portfolio, active strategies decreased 4% while passive increased 73% to $4.3 billion. North Carolina also boosted its assets in global equity portfolios to 45%, or $2.46 billion as of Sept. 30, of which $984 million is passive.

“As the opportunity for global diversification presents itself, we have looked to reduce home-country focus and thus reduce some concentration risk,” said Julia Vail, deputy director of communications for the North Carolina Department of State Treasurer, in an e-mail.

SSgA's Ms. Blake said the U.S. market efficiency has made it difficult for equity managers to deliver on active strategies, causing investors to look overseas and into emerging markets for better active returns. Active assets made up 40.7% of domestic equity investments, compared with 62% in the international equity arena, P&I data show.

“It's dogma in some ways in that it's a zero-sum game in U.S. large caps to add value,” Ms. Blake said. “That's been an accepted idea for quite a while.”

Among other pension funds reporting sizable moves to passive equities:

• Dallas-based AT&T Inc. increased its passive international equity nearly 6,800%, to $1.65 billion from $24 million even while slashing its overall domestic and international equity portfolios about 23% each. Passive domestic equity dropped 50% for the $43.9 billion defined benefit plan.
  


• The $9.6 billion Maine Public Employees Retirement System, Augusta, completely exited active equity strategies, dropping its $247.7 million domestic and $120 million international equity portfolios.


• The $133.8 billion New York State Common Retirement Fund, Albany, decreased its active international equity portfolio by 38.5% to $10.2 billion and increased passive investments 68% to $6.4 billion. Active domestic equity decreased nearly 18% to $6.1 billion while passive increased 4% to $42.2 billion. “The movement toward more passive investments in our international equity portfolio is in line with our global equity strategic plan,” said Eric Sumberg, spokesman for state Comptroller Thomas P. DiNapoli, in an e-mail.


• The $22.2 billion National Railroad Retirement Investment Trust, Washington, decreased its active domestic assets by 27.1% to $3.9 billion while passive increased 42% to $2.5 billion. It was the opposite on the international side as active allocations increased 40% to $3.5 billion and passive decreased 57% to $1.7 billion.