(January 7, 2013) – Home-country bias is a real and hazardous force in institutional investing, one study out of Northwestern University argues.
Two researchers at the Kellogg School of Management, Yael Hochberg and Joshua Rauh, recently published their article, “Local Overweighting and Underperformance: Evidence from Limited Partner Private Equity Investments,” in the Review of Financial Studies. “Our analysis suggests that institutional investors of all types (endowments, foundations, public and corporate pension funds) exhibit substantial home-state bias in their PE portfolios,” the authors wrote. They found that institutional PE portfolios held an extra 8.1% of in-state investments on average, beyond what would be predicted statistically. For public pension funds, however, this over-allocation to in-state investment funds is even larger, at 9.7%.
Public pension systems’ in-state investments underperform by 2% to 4%, compared with private equity investments in other states, according to the study.
“The overweighting of public pension LPs [limited partners] in poorly performing local investments is particularly striking when one considers that risk management incentives should give public pension LPs a strong motivation against local concentration,” Hochberg and Raug wrote. “If the performance of local investments is correlated with local economic conditions, then declines in the value of these local investments will come exactly at times when state revenues have declined and raising revenue for pension funding is most costly.”
The authors estimate that overweight allocations to underperforming local investments cost public pensions in the US roughly $1.2 billion every year. (In other words, if in-state private equity investments had performed as well as out-of-state investments for all US public pensions, the funds would have reaped an additional $1.28 billion.)
California and Massachusetts are the two most extreme examples of home-state bias: Hochberg and Raug estimate they are responsible for over $750 million of the annual cost of the phenomenon. Indeed, California recently committed to investing $800 million in local infrastructure projects over the next three years.
The authors note that their analysis does not suggest public pension funds would be better off diverting assets away from private equity. The sector has outperformed public equities over the last several years, as well as outpacing the fixed-income market (albeit with substantially more risk and less liquidity).
Finally, the authors suggest that “further research that analyzes the extent of any potentially positive effects of local private equity investments on overall welfare would be useful.”
Related video: “Mercer Warns of Home-Country Bias”