Small Caps Deliver Outsized Returns for U.S. Pension Funds

New Haven, Conn., May 19, 2010 — Small is beautiful for U.S. pensions funds. In a new study of pension fund performance and costs, researchers at the Yale School of Management, Maastricht University, and Tilburg University find funds earn their best domestic equity returns from their small cap mandates, and smaller fund and mandate size is linked to better performance.

According to the findings, U.S. pension funds' domestic equity investments tend to generate slightly positive returns after expenses and trading costs, outperforming their benchmarks by 45 basis points a year. The authors contrast this to the performance of mutual funds, which, on average, underperform their benchmarks. Small cap and smaller size mandates deliver even better performance. For example, small cap mandates of defined benefit funds outperform their benchmarks by about 3% a year.

The results show that fund size and liquidity, as well as their interaction, drive pension fund performance. "Pension fund size and performance are strongly negatively associated," said study co-author Martijn Cremers, associate professor of finance at the Yale School of Management. "While larger pension funds have cost advantages due to economies of scale, their size becomes a disadvantage in equity performance. Liquidity limitations seem to allow only smaller funds, and especially small cap mandates, to outperform their benchmarks."

Unlike mutual funds and hedge funds, little has been known about pension fund costs and performance due to a lack of required reporting and resulting data. In the study, Cremers and co-authors Rob Bauer of Maastricht University School of Business and Economics and Rik Frehen of Tilburg University analyzed data from the recently available CEM Benchmarking pension fund database, which covers approximately 40% of U.S. pension industry assets. The study sample included 463 defined benefit pension funds for 1990-2006 and 248 defined contribution pension funds for 1997-2006.

The researchers also find that pension fund costs are substantially lower than typical mutual fund fees, with a median annual cost of 27 basis points for defined benefit funds and 51 basis points for defined contribution funds, compared to typical mutual fund fees of about 150 basis points.