1. The Return Expectations of Public Pension Funds, 2022, Review of Financial Studies, 35(8), pp. 3777–3822 (with Joshua D. Rauh).Earlier Version: The Return Expectations of Institutional Investors
The return expectations of public pension funds are positively related to cross-sectional differences in past performance. This positive relation operates through the expected risk premium, rather than the expected risk-free rate or inflation rate. Pension funds act on their beliefs and adjust their portfolio composition accordingly. Persistent investment skills, risk-taking, efforts to reduce costly rebalancing, and fiscal incentives from unfunded liabilities cannot fully explain the reliance of expectations on past performance. The results are consistent with extrapolative expectations, as the dependence on past returns is greater when executives have personally experienced longer performance histories with the fund.
2. Delegated Investment Management in Alternative Assets, 2022, Review of Corporate Finance Studies, forthcoming.
Institutional investors can be segmented into investors that hold simple portfolios of traditional equities and bonds, and investors that manage complex strategies in public and private markets. Investors implementing active portfolio management and holding diversified portfolios of equities and bonds are more likely to invest in alternative asset classes. The performance of institutional investors in alternative assets is significantly lower than in equities, suggesting that investors accept lower returns in exchange for diversification benefits. Institutions delegate 90% of their alternative investments to external managers and funds-of-funds. These intermediaries capture large part of the potential diversification benefits through higher fees and lower returns.
3. Institutional Investors and Infrastructure Investing, 2021, Review of Financial Studies, 34(8), pp. 3880-3934 (with Roman Kraussl and Joshua D. Rauh).Earlier Version: The Subsidy to Infrastructure as an Asset Class
Institutional investors expect infrastructure to deliver long-term stable returns but gain exposure to infrastructure predominantly through finite-horizon closed private funds. The cash flows delivered by infrastructure funds display similar volatility and cyclicality as other private equity investments, and their performance depends similarly on quick deal exits. Despite weak risk-adjusted performance and failure to match the supposed characteristics of infrastructure assets, closed funds have received more commitments over time, particularly from public investors. Public institutional investors perform worse than private institutional investors, and ESG preferences and regulations explain 25-40% of their increased allocation to infrastructure and 30% of their underperformance.
4. Political Representation and Governance: Evidence from the Investment Decisions of Public Pension Funds, 2018, Journal of Finance, 73(5), pp. 2041-2086 (with Yael V. Hochberg and Joshua D. Rauh).
Representation on pension fund boards by state officials—often determined by statute decades past—is negatively related to the performance of private equity investments made by the pension fund, despite state officials’ relatively strong financial education and experience. Their underperformance appears to be partly driven by poor investment decisions consistent with political expediency, and is also positively related to political contributions from the finance industry. Boards dominated by elected rank‐and‐file plan participants also underperform, but to a smaller extent and due to these trustees’ lesser financial experience.
5. Pension Fund Asset Allocation and Liability Discount Rates, 2017, Review of Financial Studies, 30(8), pp. 2555-2595 (with Rob Bauer and Martijn Cremers).
The unique regulation of U.S. public pension funds links their liability discount rate to the expected return on assets, which gives them incentives to invest more in risky assets in order to report a better funding status. Comparing public and private pension funds in the U.S., Canada, and Europe, we find that U.S. public pension funds act on their regulatory incentives. U.S. public pension funds with a higher level of underfunding per participant, as well as funds with more politicians and elected plan participants serving on the board, take more risk and use higher discount rates. The increased risk-taking by U.S. public funds is negatively related to their performance.
6. Intermediated Investment Management in Private Markets: Evidence From Pension Fund Investments in Real Estate, 2015, Journal of Financial Markets, 22, pp. 73-103 (with Piet Eichholtz and Nils Kok).
We evaluate the economics of financial intermediation in alternative assets by investigating the allocation and performance of pension fund investments in real estate, the most significant alternative asset class for institutional investors. We document substantial heterogeneity in real estate investment cost and performance, determined by two main factors: mandate size and investment approach. Larger pension funds are more likely to invest in real estate internally, have lower costs, and higher net returns. Smaller pension funds invest primarily in direct real estate through external managers and fund-of-funds, and disregard listed property companies. Overall, we find that delegating real estate investment management to financial intermediaries increases costs and disproportionally reduces returns.
7. A Global Perspective on Pension Fund Investments in Real Estate, 2013, Journal of Portfolio Management, 39(5), pp. 32-42 (with Piet Eichholtz and Nils Kok).JPM link
8. TIPS, Inflation Expectations, and the Financial Crisis, 2010, Financial Analysts Journal, 66(6), pp. 27-39 (with Florian Bardong and Thorsten Lehnert).
The authors show that inefficiencies in the U.S. market for inflation-linked bonds can be exploited by informed traders who include survey estimates or inflation model forecasts in trades on breakeven inflation. The Treasury Inflation-Protected Securities market has yet to fulfill investors’ expectations as a low-risk, efficient, and liquid financial instrument.
1. Financing the Energy Transition in Electricity Generation, 2022 (with Joshua D. Rauh).
We collect ownership data of U.S. power plants accounting for 99% of the electricity generation over the 2008-2020 period. Domestic listed corporations have reduced their ownership from 68% to 54%, while private equity, institutional investors, private firms, and foreign corporations have increased their ownership stakes from 8% to 23%. Private equity, private firms, and foreign corporations increase their ownership largely through the creation of new power plants. Private equity plays a large role in the creation of new solar and wind farms, especially in states where the public is highly concerned about climate change, and it especially creates new natural gas plants in states with deregulated electricity markets. We find limited support for the hypothesis that domestic listed corporations sell older polluting power plants to private owners (the “leakage channel”). Domestic listed corporations have the highest probability of decommissioning a power plant conditional on plant age and capacity, and private equity is the second most likely ownership structure to retire power plants. Institutional investors and foreign corporations maintain very low exposure to plants subject to decommissioning. The new ownership structure does not appear to change the capacity utilization of power plants, but the new owners do adjust the contractual terms and electricity pricing. Private equity firms sell electricity for $4.6 higher average price per MWh, and they establish wholesale contracts with more volatile prices for electricity generated by fossil fuels. Specifically, private equity sells electricity generated by fossil fuel power plants under contracts with shorter duration, shorter increment pricing, and peak term periods. In wind and solar assets, private equity also obtains higher average prices than domestic listed corporations, but with similar contractual terms.
2. Choosing Pension Fund Investment Consultants, 2022 (with Matteo Bonetti and Irina Stefanescu).
Public pension funds rely on the advisory services of investment consultants for asset allocation decisions, manager selection, and performance benchmarking. While prior research finds that consultants generally do not add value, pension funds have increased the number of consultants over time. We explore the factors underlying the hiring and firing of consultants and examine whether these decisions are made in the best interests of participants. We find that consultants are more likely to be hired by funds with high allocations to alternative assets and by funds with political boards. Pension funds are also more likely to hire consultants that have a discretionary asset management services arm, despite potential agency conflicts. Both hiring and firing depend on past performance, although we find weak evidence that performance improves subsequent to a consultant turnover. Overall, our evidence is consistent with pension funds hiring consultants to shift responsibility rather than improve performance.
3. Overlapping Factors, 2022 (with Esther Eiling and Thu Nguyen).
Characteristic-based factors, such as value, momentum, and low volatility, are constructed from the same universe of stocks. As such, they can contain some of the same stocks. Although the degree of overlap among these factors is not excessive, the overlap matters. We find that the subset of stocks that are included simultaneously in the same leg across multiple factors drive nearly all factor performance. Their average return is 66 basis points per month. In sharp contrast, pure factor stocks that are included in a single factor earn on average 5 basis points despite similar characteristic values, size, industry composition, institutional ownership, and portfolio turnover. Further, the portfolio of overlapping stocks is priced in the cross-section of stock returns, while the portfolio of all pure factor stocks is not. Exposures to sources of macro-economic or liquidity risk cannot explain the return difference between overlapping and pure factor stocks. Only in the short leg, we find that overlapping stocks are more exposed to investor sentiment and they have a higher short interest than pure factor stocks.
4. Financial Sophistication and Conflicts of Interest in 401(k) Investment Menus, 2022 (with Mike Qinghao Mao).
Defined contribution pension plans transfer the risks and responsibility for retirement outcomes to plan participants, while exposing participants to agency conflicts in the design of investment options. We analyze the role financial sophistication of participants and plan governance in reducing conflicts of interest in 401(k) plans. Pension plans of finance firms with an external independent trustee invest less in sponsoring company equity and options affiliated with the trustee than pension plans of non-finance firms and of finance firms that serve as own trustees. The changes in options on the investment menu offered by finance firms with an external trustee are more sensitive to past performance and their participants benefit from the removal of underperforming mutual funds. The evidence implies that greater financial sophistication among plan participants can improve the investment allocations, but only when it is accompanied with an independent governance structure.
5. Can Large Pension Funds Beat the Market? Asset Allocation, Market Timing, Security Selection and the Limits of Liquidity, 2012 (with Rob Bauer and Martijn Cremers).
We analyze the three components of active management (asset allocation, market timing and security selection) in the net performance of U.S. pension funds and relate these to fund size and the liquidity of the investments. On average, the funds in our sample have an annual net alpha of 89 basis points that is evenly distributed across the asset allocation, market timing, and security selection components. Stock momentum fully explains the positive alpha in security selection, whereas “time series momentum” drives market timing. While larger pension funds have lower investment costs, this does not lead to better net performance. Rather, all three components of active management exhibit substantial diseconomies of scale directly related to illiquidity. Our results suggest that especially the larger pension funds would have done better if they invested more in passive mandates without frequent rebalancing across asset classes.