Questions arise around public funds' ease in topping benchmarks

U.S. public pension funds have largely reported negative returns for the latest fiscal year ended June 30. But that hasn't stopped most plans from easily outperforming their benchmarks, drawing criticism from one investment consulting pioneer on the methods used to compare portfolios.

Richard M. Ennis, who co-founded the Chicago-based firm that would become Ennis Knupp & Associates, said in a widely reported blog post in March that a sample of 24 public funds underperformed passive investment during a recent decade by an annual average by 1.4 percentage points, while during the same period they outperformed their policy benchmarks by 30 basis points.

Among the 55 pension funds tracked by Pensions & Investments for the most recent fiscal year, 52 provided benchmark information and 41 reported exceeding those benchmarks. Only six plans reported positive returns for the year.

A P&I analysis of prior fiscal-year benchmarking by U.S. public pension funds shows plans choose benchmarks based on preferences and classifications guided by their investment goals and portfolio construction, which makes it harder to compare plan performances.

For example, some funds include emerging markets and global equities within the same broad non-U.S. equity category, but only report overall non-U.S. equity returns and choose broad non-U.S. equity benchmarks to represent all; some funds report emerging markets and global equities separately and choose EM or global equity benchmarks that better reflect their strategies.

Fixed income is even more complicated because it depends on how plans treat high yield, loans, private credit and other subsectors. Private markets benchmarks, meanwhile, can vary extremely.

Nashville (Tenn.) & Davidson County Metropolitan Government Employee Benefit Trust Fund recently reported a net return of -1% for its fiscal year, above a benchmark return of -11.2%.

Much of that disparity from the policy benchmark came from its private equity portfolio returning a net 13.1% for the period, and benchmarking it to the Russell 2000 index, which returned -25.2% for the period.

Fadi BouSamra, Nashville's CIO, could not be immediately reached for comment.

It is not uncommon for public funds to benchmark private markets to public market indexes and add a premium, performance reports show.

Mr. Ennis said in an email that the $40.1 billion Iowa Public Employees' Retirement System has "one of the cleanest benchmarks I came across."

The Des Moines-based pension fund reported a net return of -3.9% for the fiscal year ended June 30, 15 basis points above its policy benchmark return of -4.05% for the period. For the three, five and 10 years ended June 30, IPERS returned an annualized net 8.8%, 8.6% and 8.6%, respectively, compared to the respective benchmarks of 8.7%, 8.5% and 8.6%.

Sriram "Sri" Lakshminarayanan, IPERS chief investment officer, said in a phone interview that for one thing, "private markets tends to have these real long investment horizons and it doesn't do anybody any favors by trying to measure the value of a private market investment or the performance on a monthly basis and daily basis. It's a different time horizon and needs to be measured differently."

Mr. Lakshminarayanan said they do not use external benchmarks for their private markets. Their solution is that the pension fund benchmarks its private markets investments and the asset allocations to its own past performance "to make sure that the noise of private market benchmarking doesn't affect us on a day-to-day basis and lead us to bad decisions in rebalancing the portfolio."

IPERS also has separate allocations to core-plus fixed income, which is benchmarked to the Bloomberg U.S. Universal Bond index, and public credit, which has its own custom benchmark of 67% Bloomberg U.S. High Yield 2% Issuer Capped index and 33% J.P. Morgan EMBI Global index.

Mr. Lakshminarayanan said the distinction helps the pension fund avoid the issue of really wanting to hire a "high octane credit manager," but having to place it in a portfolio with the wrong benchmark.

When the pension fund implemented factor-type portfolios, investment staff created a new asset class "global smart beta equities" with its own custom benchmarks and carved out traditional domestic and international equity asset classes.

"We felt these factor premiums manifest themselves over decades," Mr. Lakshminarayanan said. "It takes 20 years before you can realize whether these things can add value or not."

Valerie Ge contributed to this report.