U.S. equity, credit boost public pension plan returns

Double-digit returns were the norm for U.S. public pension plans for the year ended June 30, with smaller funds and those focused on domestic equities or taking opportunistic positions in credit achieving the best results.

The median return of the 42 plans analyzed by Pensions & Investments — all with assets of more than $1 billion — was 12.45%, slightly below the 12.61% median for public plans with more than $1 billion as reported by the Wilshire Trust Universe Comparison Service, administered by Wilshire Associates, Santa Monica, Calif.

Pension plans with higher allocations to public equity, especially U.S. equity, largely outperformed their peers. On the flip side, plans with higher allocations to traditional fixed income were hurt as bond returns barely broke even. While alternative investments — including private equity, hedge funds and real estate — produced returns on par with median overall returns, they still largely underperformed public equity.

“Basically, anybody who was overweight in U.S. stocks relative to most diversifying asset classes did better,” said Steve Charlton, partner and director of consulting services at NEPC LLC, Cambridge, Mass. “It doesn't surprise me that smaller investment programs, which are typically less diversified and typically have larger allocations to traditional stocks and bonds, would've done better in the last year relative to larger investment programs that tend to have a lot more in alternatives ... and dedicated emerging markets.”

For the 12 months ended June 30, the Russell 3000 returned 21.5%, and the Barclays Capital Aggregate Bond Index, -0.69%.

Among pension funds analyzed and reported on by Pensions & Investments, the $12.3 billion Oklahoma Teachers' Retirement System, Oklahoma City, was one of only five public plans with more than $1 billion in assets to outperform its benchmark by at least 300 basis points. Its 17.4% return, compared with the 14.4% benchmark, also blows away the TUCS median return.

The $7.06 billion San Bernardino County (Calif.) Employees' Retirement Association had the second best overall return and largest relative outperformance with a net 15.05% return against its 8.2% custom benchmark. The $5.4 billion Missouri Local Government Employees Retirement System, Jefferson City, was second at 14.5%, compared with a 9.1% benchmark.

See the complete table of the top-performing public pension funds

Oklahoma Teachers likely would be considered a midsize public pension plan, and that potentially could be an advantage, said James Wilbanks, executive director. “Just like our belief in smaller companies, smaller plans can grow faster, be more nimble and more committed,” he said.

Kelly Cliff, senior vice president and chief investment officer of public markets at Callan Associates Inc., San Francisco said smaller plans have more difficulty diversifying, which benefited them this past year as U.S. equities outperformed global portfolios.

“In general, it's harder for some smaller plans to adopt the diversification practice of larger plans,” Mr. Cliff said. “Building a global equity portfolio with less home bias is more challenging for small plans.”

Of the 12 largest public pension funds that reported June 30 returns, only four outperformed the Wilshire TUCS median for public plans with more than $1 billion in assets.

Among plans with $5 billion or more in assets, the $260.9 billion California Public Employees' Retirement System, Sacramento, returned 12.5%, just slightly ahead of the TUCS median of12.43%.

Eleven plans with more than $20 billion in assets posted returns of less than 12%, while the same number surpassed the mark. The top performers were the St. Paul-based $52.1 billion defined benefit plan of the Minnesota Board of Investment, with a 14.2% return compared to a 12.9% benchmark, and the $170 billion California State Teachers' Retirement System, West Sacramento, with a 13.8% return compared to a 13.3% benchmark. The two systems ranked sixth and 10th, respectively, of the 42 plans reported by P&I. Seven of the 10 lowest overall returns came from plans with more than $20 billion in assets.

Stephen L. Nesbitt, CEO of Cliffwater LLC, a Marina del Rey, Calif., alternatives investment consultant, said there is “no performance advantage to size” over the long term, adding that it's likely that smaller plans had a higher allocation to equity and lower allocations to alternatives that helped boost returns.

Despite a wide range of return numbers, the vast majority of plans outperformed their policy benchmarks. Only two plans reported returns of more than 100 basis points below the benchmark for the year ended June 30. The $3.8 billion Houston Police Officers' Pension System returned 7.67% compared to a 12.11% benchmark, while the $40.6 billion Colorado Public Employees Retirement AssociationDenver, returned 10.6% against an 11.7% benchmark.

Public equity was the main driver for returns, but some of the top performers saw enhanced overall returns from non-traditional investments. Mr. Nesbitt said hedge funds and real estate mostly kept pace with overall returns, but not all strategies were equal. Risk-on credit and direct-lending strategies provided additional value to pension plans in the past year. He added it was too early to discuss private equity returns as performance generally lags at least one quarter.

“Overall it was a good year for alternatives, (but) nothing compares to the S&P 500,” Mr. Nesbitt said.

He said riskier hedge funds like equity long/short and event-driven performed well, while global macro and CTA strategies that were popular with pension funds a year ago were relatively flat. Commodity strategies were widely negative for the year as well, and real return produced tepid, if not negative, performance. Teacher Retirement System of Texas, Austin, lost nearly 30% in its commodity portfolio from gold exposure, but still managed 154 basis points of relative outperformance despite registering the third lowest overall return at 10.21%.

Mr. Nesbitt predicted alternatives will return a combined 10% for the year ended June 30, with traditional investments in the 7%-8% range.

Within traditional investments, strategies with a dedicated or partial exposure to emerging markets equity took a hit despite emerging markets being one of the more popular asset classes for institutional investors over the last several years. The MSCI Emerging Markets index returned just 3.2% for the year, compared to 19.4% for the MSCI EAFE and 20.6% for the S&P 500.

“The decoupling of equity markets abroad and domestically was a little unexpected,” Callan's Mr. Cliff said. He expects subdued global growth this year and believes central banks will continue to be accommodating. Equity markets should cool off but still “look like the tallest person in the room,” he added.

Oklahoma Teachers was able to get the best of both worlds in the past year. The pension plan had the highest domestic equity return reported by P&I — 25.5% — and one of the highest international equity returns — 19.8% , the plan had the highest domestic equity returns reported by P&I and one of the highest international equity returns at 19.8%. But the fund also received a large boost from master limited partnerships, which make up about 6.3% of the total plan and returned an astounding 39.7%. The fund adopted MLPs as a separate asset class in February 2011.

“We made the decision that was an attractive space,” Mr. Wilbanks said. “It's not well understood or covered in the public fund world.” He added the prospects for MLPs continue to look good even though valuations are now higher.

In the domestic equity area, Mr. Wilbanks attributed the outperformance to dedicated portfolios in midcap and small caps that returned 27.7% and 29%, respectively. “Unlike other funds, we have a dedicated allocation to the midcap space ... it has served us very well,” he said.

Bucking the equity trend, San Bernardino County's income-focused strategy enabled the pension plan to have the greatest level of outperformance of the funds relative to the benchmark studied by P&I The alpha generated over the year was 11.7%. Only the fifth percentile of all pension funds with assets of $1 billion or more earned at least 6.9%, while the median was 3.8%.

“Generally speaking, we are more income-focused. Collectively, between high yield, international credit and emerging market debt, we have close to 30% in credit,” said Don Pierce, CIO. Top performers in San Bernardino's portfolio were European credit and volatility strategies.

“The board was investing in this area of the market when many pundits were calling for a collapse of the eurozone,” Mr. Pierce wrote in a memo to the board. “Needless to say, pessimism often increases the gains one can receive. We believe we have further gains in store.”

In June, the board bumped up its allocation to international credit to 10% from the 8% adopted the year before. “We felt a lot of bad news (was already) priced into the European market in 2011 and 2012.”

The fund was well rewarded for European credit, earning 18.75% in that investment for the fiscal year.

The $2.4 billion Nashville (Tenn.) & Davidson County Metropolitan Government Employee Benefit Trust Fund returned 14.22%, compared to a 10.99% benchmark. Alternative fixed income was the top-performing asset class for the fund, at 27.23%.

CIO Fadi BouSamra said the asset class is mainly made up of investments in distressed corporate debt, asset-backed securities and private lending. “These types of investments come from looking at the landscape for the best investment opportunities on a risk-adjusted basis,” Mr. BouSamra said.

The plan is increasing its target allocation to alternative fixed income to 15% from 10% and a 9% actual allocation. The initial 10% was drawn down from traditional fixed income, and the additional 5% will come from equity, Mr. BouSamra said. “We are trying to move the fund into less equity and less equity volatility to more opportunistic investing and high-conviction investing,” Mr. BouSamra said.

Arleen Jacobius contributed to this story.