Nationally, teacher pension funds have amassed more than a trillion dollars in assets. But those funds cannot just sit in a bank somewhere; that money needs to grow. It needs to earn high returns so that pension funds can pay down debts and meet burgeoning financial obligations to their members. In fact, states often base how much they need to save today on ambitious assumptions about the expected rate of return they’ll get on their investments.
Most pension funds engage in a strategy that’s called active investing. Under this approach, money managers make decisions about which company’s stock should be bought and sold, and when. With smart people making such decisions, the idea is that active investing will produce greater financial gains than a “passive” approach of regularly buying an index of equal amounts of all companies in the market.
The evidence, however, tells a different story.
As Ben Carlson, the author of A Wealth of Common Sense, pointed out in a tweet earlier this fall, over the last 15 years “passive” index funds overwhelmingly outperformed traditional, “actively” managed mutual funds. Among the different types of funds analyzed, index funds outperformed the actively managed mutual funds at least 80 percent of the time. In many cases, index funds performed even more strongly. For example, small-cap growth funds were outperformed by their benchmark 99.35 percent of the time.
These data suggest that passive investing could provide a safer and, over the long-term, a more productive investment, for teacher pension funds. Passive investing, such as through an index fund, spreads investments widely. This produces a highly diversified portfolio that covers the entire market, rather than trying to make guesses about which particular companies or sectors will do well at a given time. This strategy insulates investors from more dramatic swings of volatility in individual stocks and, as shown above, can often produce returns that outperform managed accounts.
Taking a more passive investing approach could benefit teacher pension funds in other ways as well. Passive investing also typically incurs lower fees, meaning teacher pension funds can pay less for these returns on their investments. Furthermore, electing to passively invest will severely reduce the need for pension fund employees to pick the right money managers, who in turn will pick the right investments. Studies of this practice suggest that it’s a lose-lose situation, that investors tend to chase after positive performance rather than capturing it themselves, and that states might be better off making passive investments with a leaner team.
As an added bonus, passive investing would help to eliminate some of the politics around pension funds. As my colleague Chad Aldeman previously noted, the American Federation of Teachers (AFT) black-listed certain money managers who ran afoul of the union’s priorities. Or conversely, some unions will attempt to make socially conscious investments such as avoiding weapons manufacturers. Passive investing allows pension funds to avoid these political issues.
To be sure, passive funds are not fool-proof. They follow the market, and if the market tanks so will they. A passive investment also won’t produce dramatic returns like someone who bought Amazon stock in the mid-1990s, or Bitcoin in more recent years. But index funds produce a greater than average return when the market is doing well, and can limit losses during a downturn. It is precisely this kind of investing strategy that pension funds need to grow their assets and meet their members’ financial needs.