UK pension funds have not taking advantage of their comparative advantage as long-term investors and have not earned a positive long-run liquidity premium on their investments, according to a paper from the Cass Business School that examines UK pension funds’ monthly allocations to major asset classes over the period 1987-2012.
The authors – David Blake, Lucio Sarno and Gabriele Zinna – identify that the combination of herding behaviour of these investors and short-term automatic rebalancing towards a long-term optimal asset allocation, driven by their liabilities rather than by expected returns, can be obstacles to asset prices reaching their equilibrium values.
Published by the Pensions Institute at the Cass Business School at the City University London, the paper, The market for Lemmings:Is the Investment Behavior of Pension Funds Stabilizing or Destabilizing, finds that although UK pension funds are long-term investors they have not earned a positive long-run liquidity premium on their investments because their investment behavior is driven by different incentives.
“Pension fund managers fear relative underperformance against their peer-group, which encourages them in the very short term to herd around the average fund manager who turns out to be a closet index matcher,” the paper says.
“Further, their short-term objective is to rebalance their portfolios when valuation changes across different asset classes cause portfolio weights to violate investment mandate restrictions, while their long-term objective is to systematically switch from equities to bonds as their liabilities mature. Overall, our results show that pension fund investment behavior might be less stabilizing than previously believed.”
Analysis of the data by the authors finds that pension funds herd and, in particular, they herd in subgroups defined by size and sector type, consistent with reputational herding.
Pension funds also rebalance their portfolios in a way that is consistent with meeting their mandate restrictions in the short term and with maintaining a long-term strategic asset allocation that matches the development (in particular the maturity) of their liabilities.
This mechanical rebalancing could also be destabilizing if it has the effect of driving prices away rather than towards equilibrium values.
The paper, The market for Lemmings:Is the Investment Behavior of Pension Funds Stabilizing or Destabilizing, can be found here
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