Swedroe: ‘Familiar’ Doesn’t Mean ‘Safe’

May 23, 2016

Behavioral finance is the study of human behavior and how that behavior leads to investment errors, including the mispricing of assets. Among the many behavioral biases well-documented in the literature is “local” bias—individual investors tend to invest more in stocks that are close to home.

There’s also evidence that local bias extends to the behavior of institutional investors. And what’s more, there is evidence that it affects not just public equity, but private equity.

One explanation for local bias is that investors believe they can exploit an informational advantage regarding geographically proximate firms. My own view is that the bias largely results from investors making the mistake I refer to as confusing what is familiar with what is safe—the same mistake that leads investors all over the world to possess home-country bias, in which they overweight by wide margins equities from their own countries in their portfolios.

Political Bias And Pension Funds
Daniel Bradley, Christos Pantzalis and Xiaojing Yuan, authors of the study “The Influence of Political Bias in State Pension Funds,” which appears in the January 2016 issue of the Journal of Financial Economics, contribute to the literature by examining factors that might contribute to local bias in state pension funds from a political viewpoint, and the impact politics can have on fund performance.

Their study covers 16 state pension plans and the period 1999 through 2009. Following is a summary of their findings:

  • State pension funds overweight local firms by 26% relative to the market portfolio (sacrificing diversification benefits).
  • State pension funds overweight local firms that make political contributions to local (state) politicians or that have significant lobbying expenditures by 23% and 17%, respectively.
  • Political bias is detrimental to fund performance. Using the three Fama-French factors (market beta, size and value) and the Carhart momentum factor to measure performance, a one-standard-deviation increase in local political bias results in about a 0.25-0.28% decline in quarterly equity performance. Given that the equity assets of state pension funds are, on average, $21 billion, this implies an annual decline in fund performance in the neighborhood of $225 million. This suggests that any informational advantage may be illusionary and is simply confusing the familiar with the safe. Note that familiarity could lead to overweighting but should not negatively impact returns.
  • State pension funds have longer holding durations for politically connected local firms and display strong disposition behavior (selling winners too soon and holding on to losers too long) in these positions. This disposition effect is not present for nonpolitically active stocks.
  • Political bias is positively related to the percentage of politically affiliated trustees on the pension fund’s board and their Congressional connections.
  • Politically connected trustees, perhaps under political pressure stemming from local and/or federal politicians, are more likely to favor investments in local firms that support home-state politicians. Such behavior is not in line with their fiduciary duty to represent the best interests of state employees or plan beneficiaries, who are more concerned about the performance of the fund.
  • Political bias is higher when state GDP growth rate is lower, suggesting state pension funds are more willing to support politically connected local firms when the local economy is poor.
  • Union influence (as measured by the percentage of nonagricultural employees who are union members) is positively correlated with local bias.
  • The more politically affiliated trustees on the pension fund’s board, the more the fund shifts toward risky asset allocations. Conversely, funds whose boards include more trustees with a finance background invest less in risky securities. In addition, states with higher integrity measures invest in less risky assets.
  • When a pension plan’s underfunded ratio is higher, the weight in risky assets is also higher. This suggests that state pension funds try to hide (or perhaps compensate for) their underfunding status by increasing the weight of risky assets.
  • States with greater reliance on government spending and more corporate tax revenue invest in riskier assets.
  • When state governance and regulatory mechanisms are more effective, less overweighting of politically connected local firms occurs. Local bias and political bias are lower in states with a higher conviction rate and more effective law enforcement.
  • Political bias is more prevalent in Democrat states.

No Net Benefits From Local Information
Bradley, Pantzalis and Yuan found their results imply “that any potential benefits to fund performance from superior local information are countered by the detrimental effects of political bias.”

They concluded: “Overall, our results imply that political bias is likely costly to taxpayers and pension beneficiaries.” They added: “Our evidence suggests that the extent of political bias in state pension funds is related to fund governance characteristics.”

This study not only adds to the research on local bias, but it expands on the developing literature focused on the interplay between politics and investment behavior.

For example, other research has shown that investors are more optimistic and willing to invest in riskier assets when the president belongs to the party they support, and that they become more conservative and tend to invest more in local stocks when the opposition party is in power.

The bottom line is that the evidence showing that politically influenced investment decisions by state pension fund managers are detrimental to fund performance suggests that at least some managers (trustees) are not upholding their fiduciary duty to act solely on behalf of the plan’s 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.

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