søndag 18. oktober 2009

Evaluation of government speculators: the Dutch ABP fund also struggels with active management

(Note: this blog post is about a Dutch government pension fund. In order for the fund, or anyone else, to be able to respond should they want to, the post is written in English.)

In my review of how different government run funds around the world is doing when it comes to active management, the turn has come to the Dutch fund ABP. ABP is the pension fund for government employees in the Netherlands and is one of the largest pension funds in the world. At the end of 2008 the fund had assets of around 170 billion euro. I won't describe the fund in any more detail, but interested readers can find a good introduction to ABP on Wikipedia and more information can also be found on the fund's home page.

What is ABP's experience with active management? For 2008 the fund reported, in it's annual report (page 69), that it underperformed its benchmark by 4.8%. However, the fund also notes in the report that:
"It should be noted, however, that the balance of the actual return and the return on the norm portfolio [i.e. the benchmark] for 2008, together with the outperformance achieved in the past five years, is still positive."
4.8% underperformance in one year is quite massive, so if the fund is still in positive territory for the last five years, then outperformance in preceding years must be significant. Hence, I decided to check older annual reports from ABP and in the 2007 report (page 51) I found some useful number which said that excess return for 2003-2007 was 6.7% and that this in euro terms meant an excess return of 11.1 billion euro.

I then emailed the fund and asked how much the 4.8% underperformance in 2008 was in euro terms, and got a reply back saying this was 9.6 billion euro. It could then seem that the fund indeed has generated a positive return from its active management in the last six years (2003-2008). A positive 11.1 billion euro excess return in 2003-07 and a negative 9.6 billion euro excess return in 2008 would give a total positive excess return for the period of 1.5 billion euro.

However, in the email I sent the fund, I also asked whether these numbers were before or after costs. The fund replied back that the reported numbers for excess return were before costs. What is relevant for the fund's stakeholders (i.e. the government employees) is, of course, excess return after cost. At least those costs which are attributable to the active management.

So I decided to add in the costs to see if this altered the results. For years from 2003 to 2008, the fund had costs around 0.26% of assets under management per year. As the ABP is a big fund, the total costs for the period was no less than 2.3 billion euro. Given its size, the fund should be able to run its operations at a cost of around 0.05% per year if it had chosen a passive index strategy instead of active management. I hence attribute around 80% of the cost, or 2.3 billion euro, to the active management.

The gross (before costs) excess return for the period 2003-08 is 1.5 billion euro (11.1-9.6). However, if we deduct costs associated with the active management, the net excess return for ABP for the period 2003-08 is -0.8 billion euro (11.1-9.6-2.3).

The ABP writes in its 2008-report that it has a positive result in its active management in the last 5-year period. Can this then be true? Due to the availability of reports, I have looked at the 6-year period from 2003-08, and not the last 5-year period (2004-08). Could it be that the results for the 5-year period is positive, while the results for the 6-year period is negative? That depends, of course, on the results of 2003. Were they positive, the results for the 5-year period would be worse than the 6-year period, and, hence, necessarily negative. Were they negative, the results for the 5-year period would be better than the 6-year period, and potentially positive.

I have not managed to find ABP's annual report for 2003, the fund's website only have available reports since 2005. However, this quarterly report (thanks to Google) states that the excess return in 2003 was positive. Hence, the results for the period 2004-08 are worse than the results for the period 2003-08. Active management in the last five year period has thus yielded negative results.

So it is simply not true when the ABP writes in its report that:
"the outperformance achieved in the past five years, is still positive"

Calculated in the only correct way, i.e. after costs, the outperformance for the last five years is negative, not positive.

What can we learn from ABP? First of all, even though a fund succeeds in producing positive excess returns for several years in a row, that does not necessarily indicate any real skill. It could just be that the fund manager is making bets whose true outcome only will be known after several years. What kind of bets ABP has made, I do not know. All I know is that they were costly to make and that they they have ended up with a loss for government employees in the Netherlands.

We can also learn that it is important to factor in costs when the results of active management are measured. Ignoring costs is, of course, a convenient trick to use for mediocre managers like the ones in ABP. However, pension plan owners, and boards, should insist that all returns, absolute and excess, are measured after costs.

Why does the ABP engage in active management? Given that it is very costly (2.3 billion euro over the last six years) and that it has yielded only a loss, it is certainly not because it can be expected to benefit pension plan owners, i.e. government employees. The other two possible explanations are that the people running ABP are either incompetent or cynically greedy. Although it is conceivable that they are incompetent, I believe it is more likely they are cynically greedy. In either case, Dutch pensioners would be better off if they fired the managers at ABP and instead mandated that the fund be managed passively according to an index strategy.

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