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Benefits and Pensions Monitor

Some Are More Equal Than Others

By: Jim Helik

Over the years, academics have noted the many differences between institutional investors and retail investors. Institutions, for example, typically seem to prefer liquid stocks with a higher market capitalization and lower volatility than do individual investors. However, there are far fewer studies about the differences between institutional investors such as pension funds and endowments.

One recent yet-to-be-published study by Josh Lerner and Wan Wong, of Harvard, and Antoinette Schoar, of MIT, Smart Institutions, Foolish Choices? The Limited Partner Performance Puzzle, shows there are great differences between institutional investors when it comes to investments in, for example, private equity funds.

They examined the returns of the private equity funds (including early stage venture capital funds, late stage venture capital funds, and buyout funds) that had received investments from six major categories of institutional investors:

• endowments
• public pension funds
• corporate pension funds
• advisors
• insurance companies
• commercial and investment banks

The results are startling. The funds that endowments invested in had the best overall performance with an average rate of return of 20 per cent. The funds that public and corporate pension plans invested in had more modest returns of eight per cent and five per cent respectively. The remaining groups did even worse with funds picked by banks having a negative three per cent return.

Next Question
Of course, the next question is whether these differences are determined by the time periods in which the investments were made (endowments have, on average, been investors in private equity for longer periods than have many pension funds). However, the results are the same. Performance of a fund is positively related to the number of endowments investing in the fund and negatively related to the number of banks investing. Controlling for risk factors – such as fund size, age, and investment focus – doesn’t materially change the results.

So if these results are true – and the authors are quick to point out that the results may not hold because of differences in risk profiles that cannot be observed – then what accounts for the superior decisions made by endowment funds?

Agency issues seem to be a likely explanation. University and foundation endowments are often viewed as being, on average, the most sophisticated investors. In the case of private equity, they have typically been at the business for far longer than other institutional investors and, presumably, have learned something about this asset class along the way. To test this, the authors looked at how reinvestment in private equity funds took place.

Higher Performance
Funds in which endowments, and to a lesser extent public pension funds, decide to re-invest show a much higher performance than those funds where endowments decided not to invest. This leads to the conclusion that endowments are able to proactively use the information they gain from being inside investors, whereas other institutional investors are less willing or able to learn from the information they get from being an existing fund investor.

The other part of this could result from historical accident. Through an endowment’s early experiences with a fund, it might have greater access to private equity groups that manage high performing funds. When the authors adjusted for age, there was still a performance premium for endowments and public pension funds, though it was much smaller. So while historical accident was not a key driver, there is some evidence that early access to superior funds has helped.

Dismal Performance
But what accounts for the dismal performance of the banks? Again returning to agency theory, the motivation for a bank’s investment activity is more complex than that of other institutional investors. It can be theorized that banks might not be seeking to maximize their returns on investments in order to maximize future banking income from the portfolio firms in which they invest. Banks can make substantial money from lending to, or advising, firms undergoing leveraged buyouts. They may invest in a buyout fund based less on the expectation of a high return and more on the expectation of banking fee generation.

Are endowments better than other institutional investors at choosing hedge funds or money managers? Is the private equity world just an anomaly? We don’t know yet. But for now, it’s worthwhile trying to understand what, possibly, makes endowments the better investor.

Jim Helik is co-author of ‘Energy Markets Risk Management,’a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto.

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