Identifying Behavioral Woes of Institutional Investors

Nordic strategists and managers say institutional investors’ tendencies to herd, chase past performances, and second-guess decisions have contributed to underperformance.

(October 29, 2013) — Various investors’ behaviors such as herding, performance chasing, and complex committee structures could cause poor manager selection and underperformance, according to attendees at the Opalesque Nordic Roundtable.

A group of five Nordic investment managers, consultants, and strategists identified the three factors as the “three maladies of institutional investing” and might contribute to the less than stellar performance by larger funds.

Peter Seippel, head of quantitative analysis at Optimized Portfolio Management, said this was emphasized particularly with a growing demand for hedge funds by investors.

“From the beginning of the year, fixed income has given negative returns and that is of course a problem for investors relying heavily on bonds,” he said. “That has pushed some clients to reallocate and start increasing allocations towards hedge funds again.”

As more pensions turn to alternatives and absolute return strategies, a concern for “herding into ideas” escalates, according to Mikael Stenbom, CEO of Risk and Portfolio Management. Because large corporations have a difficult time performing their own analyses of managers and strategies, investors follow the steps of their peers that are making similar investments.

“It seems many of those investors tend to go in the same direction: they typically choose the same managers or the same providers, probably because it feels safer and is perceived as less politically controversial and risky,” Stenbom said.

Innovation, in both strategy and manager selection, was more prevalent among smaller organizations, family offices, or independent asset managers. Nordic investment consultancy Wassum’s Karl Trollborg said these smaller investors were able to perform appropriate due diligence on managers and various funds: “They also tend to be very active investors, keen on following through and deploying their money smartly.”

Another behavioral hindrance was investors’ tendencies to select their investments largely based on performance chasing. Opalesque suggested investors most often invest with a certain manager to chase past rates of return, lacking display of “proper know-how and procedures to invest rationally.”

“You have to do your analytics,” Stenbom said. “You have to visit the managers, you have to do the due diligence, you have to have the experience and the skill, you have to do all the work, and most importantly, you have to understand the manager.”

Understanding the manager is a complex idea—it constitutes understanding why a manager is making or losing money, explaining drawdowns, and being able to formulate “methods and courage to act anti-cyclical,” according to Stenbom.

Complex investment committee structures made up the third malaise. Extensive “second-guessing” by investment teams could cause stress and uncertainty, Stenbom said.

“The frightening thing is that the result that the group comes up with typically underperforms the average of the individual decisions, which is probably not a good case for committee decision making,” said Martin Estlander, founder of Finland-based Estlander & Partners.

Looking ahead, the roundtable concluded there would be increased volatility among a relatively positive outlook for global economies. Estlander projected improvements in both Chinese and US markets, followed by good opportunities for investments.

However, he asserted the difficulty of making accurate projections for asset and risk management.

“Our job is not to forecast the future, rather to respond to what’s happening,” Estlander said. “We just have to face reality from the point of view that when the s**t hits the fan, it’s going to hit all over the place and on every single position and gear our exposure accordingly.”

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