How Pension Funds Can Improve

Anyone who invested in equities in 2024 with a strong focus on Switzerland and Europe is likely to have achieved returns of around 14% – well above the long-term average of about 8%. This may be pleasing, but there is still a question: Are 14% returns good or bad?

Anyone comparing the performance with the SPI, the Swiss stock market, which generated returns of 6.2% last year, will pat themselves on the back. The outperformance amounts to an outstanding 7.8 percentage points. However, if the MSCI World global market index (reference currency Swiss franc) is used as a benchmark, the picture becomes rapidly bleaker. It achieved outstanding returns of 29% in 2024. This shows the pitfalls of benchmark comparisons in asset management. Depending on which benchmark is used for comparison, the investor or money manager sees themselves as either a high-flyer or a failure.

Now, it can be argued that in both cases, apples and oranges are being compared. In the professional pension fund business, the benchmark comparison is therefore carried out in such a way that the investments in the portfolio are comparable with the benchmark. Swiss equities are compared with the SPI (the Swiss stock market), German equities with the DAX and American equities with the S&P 500. Finally, mandated consultants define a benchmark against which the performance of the entrusted asset managers is measured.

As a result, most managers invest close to the benchmark in order to minimise the risk of failure. This practice offers those responsible for a pension fund security, as close monitoring of the advisors and a clearly defined tracking error (a measure that determines how much an asset manager may deviate from the benchmark) ensure that accidents can be avoided for the most part. However, pension funds do not buy these advantages without paying a price.

Passive investing and managers “mimicking” the benchmark results in cluster risks. For example, the US S&P 500, which produced 2024 returns of 35.2% in the Swiss franc reference currency, has a weighting of over 70% in the global index. The US tech giants alone, the so-called Magnificent Seven, account for around a third of this. Adherents of passive investing should consequently invest with this weighting in the USA, otherwise they are not passive.

In the boom of the late 1980s, Japan had a weighting of 50% in the world index. Investors mirroring the index suffered greatly during the subsequent stock market crash in the land of the rising sun. The difficult year 2022, when the American tech giants drifted lower, also revealed the high risks of passive investing – many pension funds suffered losses of 15% or more.

There are also cluster risks on the Swiss stock market. Those who invest passively held an over 17% stake in Nestlé at the beginning of 2024 and suffered from the sharp fall in the share price. Despite all the sympathy for this high-quality equity, the cluster risks of index-linked investing can be easily eliminated with a simple equal weighting of equities.

It is scientifically undisputed that the equal weighting of equities performs significantly better in the long term than the usual capitalisation weighting. In part, this is due to the fact that the former has a countercyclical effect. Equities experiencing weakness are added to, while gains from upward spikes in well-performing ones are harvested by selling. In contrast, the index-linked benchmarking practice has a procyclical effect. Equities that have performed well are systematically increased in weight. This is how you bring cluster risks into your portfolio.

If “benchmark cuddlers” imagine that by buying index products they are passive investors, they are deluding themselves. The most important decision for investors is to determine the investment structure, which is responsible for 80 to 90% of performance. This decision is a very active one for every investor.

How high should the equity component be? Should you invest in high-yield bonds, and how do you deal with currency risks? Does it make sense to invest in alternative investments? Pension funds and their advisors rightly refer to the efficiency of the capital markets and the fact that most experts do not manage to beat the benchmark in the long term.

If that is the case, then it raises the following question: Given this premise, how can pension funds be justified in investing in particularly actively managed emerging markets, private equity, infrastructure and hedge funds? Somehow that doesn’t fit together. If no systematic outperformance is achieved in the listed equities segment, it is difficult to understand why it should exist in often overpriced, illiquid and non-transparent investments.

There are now around 1,900 exchange-traded funds (ETFs) on a wide variety of indices in Switzerland. In comparison, only around 200 companies are listed. Which indices are ultimately selected for the benchmark is an active and often arbitrary decision.

It is therefore not surprising that, contrary to all empirical evidence, the majority of money managers claim to have outperformed their benchmark in the long term. This can probably only be explained by the fact that, given the large number of indices, any “desired” benchmark can be compiled in order to gloss over the respective performance.

Passive indexing and benchmarking inherently cause pension fund managers to switch off their brains. As many advisors also provide risk-averse advice for their own protection, this often leads to a suboptimal definition of the pension fund strategy. The focus is on measuring the outperformance or underperformance of a benchmark of any kind on a monthly basis, which in efficient markets is largely due to chance.

However, the determination of the optimal long-term strategy should not be left to chance. On average, a Swiss pension fund holds around 30% of its portfolio in equities. This is not enough and can only be explained to a limited extent by the legal framework. The Norwegian sovereign wealth fund serves as a beacon of a successful long-term investment structure. Its gigantic total assets of around 1.6 trillion francs are invested by capitalisation weight, and it reported returns of 13% in 2024.

72% of the assets are invested in equities, 26% in bonds and 2% in real estate. The long-term returns are around 50% higher than that of the average Swiss pension fund. The managers of the extremely successful sovereign wealth fund, who are convinced that alternative investments are not the way to go, probably don’t care much whether or not they outperform a benchmark of any kind in individual years. Those who are optimally positioned do not need to beat a benchmark, because the implementation of the strategy then corresponds exactly to the benchmark.