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US public pension funds are losing out on billions of dollars in gains each year to speculators who front-run their periodic trades to rebalance stock and bond portfolios, according to a new study.
The research by three US finance experts found that some traders take advantage of the funds’ “predictable” moves to realign allocations by making similar trades in advance, thereby worsening the price retirement funds get.
The lost value each year amounts to at least $16bn — one per cent of annual investment gains or about $200 per retiree — the research found. Pension funds are aware of the problem but have been slow to get their investment committees to fine-tune the rebalancing practices.
The front-running is not considered illegal because the trades do not rely on inside information.
The lost upside from rebalancing has posed a fresh challenge to US pensions, which are already struggling with anaemic returns and trillions of unfunded liabilities.
“Many people are losing a couple of weeks of contribution to their pension because of this and if you look over many years then you are talking about losing a year or two of contributions,” said Campbell Harvey, a professor at Duke University and a co-author of the study. “This is a really big deal.”
Most public pension plans follow similar rebalancing rules where they buy or sell securities on given dates. Traders who anticipate the moves and trade ahead of them have driven up prices by an additional eight basis points per trade, according to the study.
Paul O’Brien, a trustee at the $11.2bn Wyoming Retirement System, said it is worth shining a light on the problem as a lot of pension plans “might not have been aware of the issue”.
Still, he said the losses were minimal and therefore may not be a priority for pension funds. “Given all the other moving parts in an institutional portfolio,” said O’Brien, “it is not clear to me that is the first place I would look to improve returns.”
Harvey presented his findings in a meeting last year with 20 major pension plans overseeing a combined $2tn in assets. The study suggested making rebalancing dates less predictable.
“If you’re saying, ‘we will rebalance at the end of the quarter,’ you are just inviting people to front-run you,” Harvey said.
Still, the timing of many pensions’ rebalancing trades are dictated by mandate when allocations become mismatched to their targets, and changing policies often requires approval from investment committees.
“Pension funds should create value for pensioners, and our paper points out that they could do better,” Harvey said. “Maybe the problem can never totally go away. But we can reduce the magnitude of it, which is shockingly high.”
