Bad Habits in Asset Allocation

When does return momentum succumb to mean-reversion? Sooner than most investors expect, according to Andrew Ang and two fellow researchers.

Recency bias—the inclination to believe what’s just happened will reoccur—has often been blamed for investors’ tendency to chase returns. Since market movements tend to have momentum month-to-month, a bias for betting on recent trajectories can be a profitable one. 

For institutions, however, “recent” returns can mean much longer spans than a few months—long enough that mean-reversion overrides the tendency for return momentum. Performance chasing remains common on these time horizons, according to researchers, but becomes a more costly habit. 

Columbia Business School’s Andrew Ang, along with Amit Goyal of Switzerland’s Université de Lausanne and AQR’s Antti Ilmanen analyzed 978 pension funds’ target allocations over a 22-year period for evidence of longer-term performance chasing and its costs. Their study, published in the Rotman International Journal of Pension Management this fall, found that “the typical pension fund keeps chasing returns over multi-year horizons, to the detriment of the institution’s long-run wealth.”

Corporate and public pension funds alike tended to increase exposure to asset classes with strong returns in both the short and longer term, the paper noted. Even performance three years prior influenced allocation patterns. While the study split out pension funds by size and plan sponsors, they found no statistically significant variance in behavior.

The researchers then turned to a data set provided by AQR, covering global equity, bond, and commodity markets since 1900. Based on more than a century of market activity, the study found momentum patterns on a one-year time horizon. Beyond that, the only statistically significant result showed that two years following a given return, performance was likely to have moved in the opposite direction.

“In the aggregate, pension funds do not recognize the shift from momentum to reversal tendencies in asset returns beyond a one-year horizon,” Ilmanen, Goyal, and Ang concluded. “We hope that this evidence will help at least some pension funds to reconsider their asset allocation practices.” 

Related Content: Chase Alpha, Not Returns; The Professors: Andrew Ang Profile