Pension funds exhibit herd mentality and fail to capture liquidity premiums, which destabilizes larger financial markets, according to a study.
The research studied UK private and public defined benefit (DB) funds’ asset allocation and performance from 1987 to 2012 and concluded their behaviors contradicted those expected from typical long-term investors.
“They have not made best use of a key comparative advantage as long-term investors,” said David Blake and Lucio Sarno of City University of London’s Cass Business School and Gabriele Zinna of Bank of Italy. “[They] failed to play a useful role in helping stabilize financial markets.”
According to the study, there was overwhelming evidence of “reputational herding” behavior from pension funds—more so than individual investors.
“[Pension funds] have not made best use of a key comparative advantage as long-term investors.” —Blake, Sarno, & Zinna
Pension funds are often evaluated and compared to each other in performance, the paper said, creating a “fear of relative underperformance” that lead to asset owners picking the same asset mix, managers, and even stocks.
Data showed herding was most evident at the asset class level, with pension funds following others out of equities and into bonds at the same time. They were also likely to herd around the average fund manager producing the median return—or a “closet index matcher.”
The authors also found short-term portfolio rebalancing as valuations of different asset classes changed, while also systemically moving from equities to bonds as their liabilities matured.
“There is little room for the average fund to react to changes in the expected returns and risks on the assets,” Blake, Sarno, and Zinna said. “The average pension fund’s investment behavior can be destabilizing, since it does not respond to the release of new information, with the risk that market prices can be moved away from their fundamental values.”
And lastly, pension funds failed to earn long-run liquidity premiums over the same period of 25 years, the paper said.
Moreover, funds that were more exposed to liquidity risk were unable to outperform others. The research also found these DB plans failed to “exploit the liquidity shortages of other investors,” in line with herding behavior and further unable to provide liquidity into the markets.
Read the full paper here.
Related Content: Identifying Behavioral Woes of Institutional Investors, IMF: Institutional Investors Create Volatility through Herding