Arthur Frankenstein did not go on his way to create a monster. He had the best scientific intentions. He hoped to create a living creature, well, body parts. While the story of Mary Shelley takes place, we learn that Frankenstein’s experiment was poorly ended.
A much less creepy experiment started in Massachusetts in 1911. That is where the first entire pension fund was created in the United States. It turned out to be a much more successful experiment, but not without his own unforeseen consequences.
Nowadays, all 50 states maintain at least one pension plan for the entire state. All plans for the entire state. And then there are all the plans of the city and the province. Jurisdictions with multiple pension schemes are the subject of this message.
Diversity is a main principle of the management of Prudent Pension Fund. The principle is written everywhere in Fiducian law. Public plan managers have been meticulous in their efforts to diversify investments. They always prepare an asset plan for diversification between activa classes. They hire multiple investment managers. They use index funds. Their return held to broad market indexes. My studies, for example, indicate that the return of large public funds on average one R2 of 98% with that of the market. Public pension funds are diversified into the NDE degree.
Diversification has gone Hooidwire
Here things are getting sticky. Large public funds use more than 150 asset managers on average.[1] A prescription of efficient portfolio management is that the investor doesn’t Use active managers for diversification, which can be done much cheaper with index funds. Hiring scads from managers is expensive. I estimate that public pension funds, with their average allocation of 35% of expensive alternative investments and 20% or less in index funds, make investment costs of 100 to 150 BP per year. And they perform under the market indexes with a similar amount. Trustees get their diversification, yes – but with sad inefficiency.[2]
The monster we built
It gets worse if there are several pension funds in one jurisdiction. This results in redundancy in the amount of de facto consolidation of all individual funds, because that is the Bottom-line impact on taxpayers. Consider a taxpayer in Los Angeles. Their tax is influenced by the implementation of three city pension funds, one provincial fund and three over the entire state of funds. The consolidated fund contains more than 1000 actively managed portfolios with countless individual positions. The losers of one portfolio compensate for the winners of another; Investment betting by hundreds of cancellation cancel each other. The result is an unholy index fund, patched together without intention and give rise to a sample of inefficient diversification.
There are $ 5 trillion on publicly defined baten activa in the United States. I estimate that public plans waste $ 50 billion a year through inefficient diversification. The waste contributes to the already enormous burden of financing public pension plans, which ultimately fall on taxpayers.
What is the solution? Some states, such as Minnesota, have an investment council. Although Minnesota has different pension schemes over the entire state, their assets are merged for investments. This is a step in the right direction. But as noted, individual pension funds are usually inefficiently diversified, so there is no certainty that it will simply achieve the desired result of plan assets. And state boards usually omit local funds.
A more certain alternative is to index public pension assets in reality. Jumbo format, pension funds run by the government that are active in a political goldfish bowl, miss comparative benefits as investors. Passive investing against almost no costs transforms the game into a game in which public funds can be consistent winners.
Important collection restaurants
Public pension plans can use index funds or seem to follow market benchmarks, but in reality:
- Still employ hundreds of active managers
- Take expensive alternative investments
- End with total portfolios that reflect the market, but at much higher costs
[1] See Aubry, JP and K. Wandrei. 2020. “Internal versus external management for state and local pension schemes.” Center for Retirement Research, Boston College.
[2] See Ennis, RM 2025. “The downfall of alternative investments.” The Journal of Portfolio Management (coming). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5163511.
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