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Can Large Pension Funds Beat the Market? Asset Allocation, Market Timing, Security Selection, and the Limits of Liquidity

Aleksandar Andonov, Rob M. M. J. Bauer and K. J. Martijn Cremers

We assess and analyze the three components of active management (asset allocation, market timing and security selection) in the performance of pension funds. Security selection explains most of the differences in pension fund returns. Large pension funds in our sample on average provide value to their clients after accounting for all investment-related costs, both before and after risk-adjusting: we find an annual alpha of 17 basis points from changes in asset allocation, 27 basis points from market timing, and 45 basis points from security selection. All three active management components exhibit significant liquidity limitations, which are important in all asset classes, including equity and fixed income. Security selection outperformance is largely driven by momentum trading. Accounting for momentum reduces the security selection alpha by about 72 basis points and offsets most of the positive risk-adjusted returns from market timing and asset allocation changes. Larger funds realize economies of scale in their relatively small allocation to private asset classes, like private equity and real estate. However, in equity and fixed income markets they experience substantial liquidity-related diseconomies of scale.

JEL Classifications: G11; G23.