Individual investors have long known that it’s possible to make more money in low-cost, low-maintenance index funds than in actively managed investments. But what about institutional investors—should they index, too?
According to research by Chicago Booth’s Joseph Gerakos and Juhani Linnainmaa, and Adair Morse of the University of California, Berkeley, institutional money should stick with active managers—or possibly do the same work in-house.
While retail investors typically put money in mutual funds, institutional investors often bypass similar institution-focused funds and instead invest in actively managed, strategy-specific funds. Of the $64 trillion held by institutional assets in 2012, $43 trillion was designated to managed funds, according to the research.
The researchers obtained data about $25 trillion of those assets, from a global consultant advising pension funds, endowments, and other institutional investors. The database had information for 22,289 funds offered by 3,272 asset manager firms between 2000 and 2012. The sample, according to the researchers, “represents close to the universe of funds that were open to new investors during this period.”
The institutions paid asset managers average annual fees of $172 billion, approximately twice the aggregate fees paid by retail mutual-fund investors over the same period, according to the data.
Investors got some return for their fees. On average, managed accounts for institutions outperformed their benchmarks by 96 basis points per year before fees, and by 49 basis points after fees, the researchers find. In aggregate, institutional asset managers generated $432 billion per year in returns, sending $260 billion to investing institutions.
The outperformance, the research suggests, came largely from smart beta strategies. Smart beta describes a wide variety of investing plans that balance portfolios using dividends, volatility, momentum, or any metric other than the traditional market capitalization based indexes. The returns imply “that asset managers provide institutional clients with profitable systematic deviations from benchmarks,” the researchers write.
By using historical data to construct portfolios, the researchers conclude that institutions could have achieved similar performance by adopting a long-only, mean-variance efficient portfolio if the cost of managing the assets in house—including trading and administrative costs—came to less than 73.1 basis points. Given the rise of low-cost liquid exchange-traded funds, the comparative advantage of institutional asset managers is likely eroding.