Allocations by institutional investors to alternative investment classes have risen substantially during recent decades. By 2010, the 1,000 largest sponsors of public pension funds allocated on average more than 17% of their assets to alternatives, including 9% to venture capital and buyout funds and 6% to real estate. At the average university endowment, alternatives in 2010 made up more than a quarter of the portfolio, approximately half of which was venture capital, buyout and real estate.
Yael Hochberg and Joshua Rauh—the authors of the study “Local Overweighting and Underperformance: Evidence from Limited Partner Private Equity Investments,” which appeared in the February 2013 edition of The Review of Financial Studies—contributed to the literature by examining the allocation to, and performance of, investments by institutional investors serving as limited partners (LPs) in buyout funds, venture capital funds and real estate private equity funds, a class collectively referred to as private equity (PE).
It’s been well-documented that investors, both individual and institutional, exhibit “local” bias, meaning they invest more in stocks close to home. It’s also been shown that state pension plans overweight local companies in their holdings of public equity—and that bias negatively impacts returns.
Given the home-state preference, and the increasing allocation to PE by public pension funds, an important question is whether local bias impacts performance. Hochberg and Rauh examine institutional investor allocations to home-state and out-of-state PE funds, as well as their performance on those investments.
The authors’ study covered the period 1980 through 2009 and included 19,092 investments by 632 unique LPs investing in 3,199 PE funds. They found:
- Public pension funds in the sample overweight home-state investments by 16.3 percentage points relative to the overall state share of investments and 16.5 percentage points relative to the state’s share of all out-of-state investments, both statistically significant at the 1% level.
- Average overweighting by private pension LPs is approximately 8 percentage points.
- Average overweighting by endowments is also about 8 percentage points.
- Average overweighting by foundations is 9.6 percentage points.
- Public pension funds most overweight in-state venture capital investments and real estate investments. They overweight in-state investments in the “other” category and in buyout funds to a lesser extent.
Hochberg and Rauh note: “The overweighting of public pension LPs in local investments is particularly striking when one considers that risk management incentives should give public pension LPs a strong motivation against local concentration. If the performance of local investments is correlated with local economic conditions, then declines in the value of these local investments will come at times when state revenues have declined and raising revenue for pension funding is most costly.”
No Information Edge
The explanation they offer for this overweighting is that public pension funds may believe they are able to exercise local connections, networks and political access to gain better information on the prospects of funds located in their home states than out-of-state investors, or to gain access to better funds in their home state. An information advantage would be expected to be especially strong in the realm of PE, a setting characterized by substantial asymmetric information.
Unfortunately, the authors found evidence to the contrary:
- Public pension funds’ PE investments underperform on their in-state investments by 3.7 percentage points relative to other investments in the same state and vintage, and by 2.6 percentage points relative to investments in the same state, vintage and narrowly defined investment type. The results were highly statistically significant.
- The magnitude of the underperformance is greatest for venture capital, but there is clear underperformance of in-state versus out-of-state investments across all the categories.
- Local PE investments by public pension funds perform worse than both their own out-of-state investments and investments by out-of-state LPs in the pension fund’s state.
- Other types of institutional investors do not display significant performance differences between in-state and out-of-state investments.
- Local bias has negative implications when it comes to returns. If each public pension LP had performed as well on its in-state investments as out-of-state public pension LPs performed on investments in the same state, the public pension LPs would have reaped $1.25 billion annually in additional returns.
- Endowments were the top-performing class of institutional investor. Their funds returned a mean (median) net IRR of 12.0% (6.1%). Public-sector pension funds were the worst-performing institutional investor class. Their investments returned a mean (median) IRR of 5.9% (5.1%).
A logical explanation for the underperformance of local investments by state pension plans is that they’re subject to political pressures to invest in their home state. Consistent with other research, the authors found that local overweighting by public pension funds is higher in states with more political misconduct convictions per capita (a measure of corruption), in less prosperous states and for more underfunded pension systems. Interestingly, they found that in-state investments in states with higher levels of education actually perform worse.
Local bias exhibited by public pension plans in their PE investments may provide the answer to the question of why endowments earn much higher returns on their PE investments than public pension plans.
Bias Costs Investors
Summarizing their findings, the authors conclude: “Any informational advantages are overwhelmed by factors that induce local public pension LPs to select in-state investments that perform worse. Our results are consistent with home-state overweighting by public pensions that may be related to poor managerial talent, mismanagement, or political pressures to invest in state.”
The implications of this research are striking. There quite clearly doesn’t appear to be any informational advantage gained through local “connections.” And if there is any connection, the effects are swamped by other biases. The bottom line is that pressure exerted on public pension funds to invest locally has a negative impact on returns.
These findings are entirely consistent with those of a recent study by Daniel Bradley, Christos Pantzalis and Xiaojing Yuan, “The Influence of Political Bias in State Pension Funds,” which appears in the January 2016 issue of the Journal of Financial Economics.
They write that their results imply “any potential benefits to fund performance from superior local information are countered by the detrimental effects of political bias.” Finding that local bias may cost state pension plans $225 million annually, they concluded: “Overall, our results imply that political bias is likely costly to taxpayers and pension beneficiaries.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.