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IPE special report May 2018

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Pension funds' fixation on past performance 'damaging wealth' – study

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Institutional investors are damaging their long-tern performance through the “bad habit” of chasing multi-year returns in asset classes and managers, research has shown.

A study sponsored by Rotman International Centre for Pension Management and conducted by academics at Columbia Business School, Universite de Lausanne and AQR Capital Management finds anecdotal and statistical evidence that pension fund asset allocations mirror past performance in asset classes at the expense of returns.

While pension funds rebalance asset allocations to target weights, the study – ‘Asset Allocation and Bad Habits’ – says evidence shows allocations drift relative to past asset class performance.

The study’s authors concede this could reflect buy-and-hold strategies, or a market-cap weighted approach.

However, the study focuses on return chasing, pointing out that financial markets often carry momentum over a number of months, which makes chasing “ideal”.

“Pension funds in the aggregate do not recognise the shift from momentum to reversal tendencies in asset returns beyond a one-year horizon,” the paper argues.

The study shows that funds tend to chase returns over several years.

Using data from CEM Benchmarking, an organisation that collates and benchmarks pension fund performance, the study analyses more than 570 US-based pension funds with approximately $10bn (€7.3bn) in assets on average.

It looks at returns and average weighted allocations from 1987 to 2011, using a three-year return horizon and its effect on future allocations.

It finds that weighted allocations, in general, are related to current returns, as well as returns for the previous three years, in each of the main asset classes.

Breaking down the asset classes produces weaker, and sometimes negative, correlations, such as in international equity and fixed income.

However, the evidence does indicate asset class policy is positively correlated with past returns of three years, with some evidence showing this is more the case in corporate pension funds than in public.

“Institutional investors are anecdotally known to chase returns – buy into recent and longer-term winners – whether asset classes or managers,” the report says.

“And many lack patience when facing a few years of underperformance, even if they are aware of the limited predictive ability in past performance and the high transition costs.”

Using equities and fixed income in a relatively basic example, the study demonstrates return-chasing beyond one year will have a negative impact by the end of three years.

“Ill-timed flows into and out of good investments can make the investor’s performance poor,” the study says.

“By contrasting evidence of multi-year, pro-cyclical institutional allocations, with findings of multi-year return reversals in many financial assets, we hope to make at least some investors remedy their bad habits.”

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