Is It Too Late for Institutions To Be Contrarian?

Institutional investors are their own worst enemy due to systematic behavioral biases that rob them of potential alpha, according to Research Affiliates.

The firm’s co-founder Jason Hsu argued that there is strong evidence the equity market premium is countercyclical and predictable using valuation ratios. However, investors’ manager selection process and “trend-chasing allocation decisions” could contribute to persistent low returns and return gaps—and this could be hard to fix.

“The prognosis for improvement is unfortunately pessimistic,” Hsu said. “No longer can behavioral biases be overcome by the greater mastery of one’s emotional state or by attaining greater investment enlightenment.”

“Most investors might benefit from simply forgetting the ID and password to their trading account.”Specifically, investors often use short-term performance as the basis of evaluating manager skill, Hsu said, despite data that show underperforming managers tend to outperform in the future and vice versa.

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Though many investors attempt to time alpha, they “do so very poorly,” according to Hsu. “These investors earn negative dollar alpha, on a gross-of-fee basis, and thus provide a large reservoir of alpha to others,” he continued.

Furthermore, Research Affiliates said investors tend to fall victim to herd mentality and often blame others for “random bad outcomes.”

These behavioral biases have now become an organization problem, according to Hsu. Investment consultants are unlikely to recommend managers with poor recent performance, and pension CIOs tend to stay away from managers with a negative trailing three-year alpha.

“The investment ecosystem has conspired against the end investor,” Hsu said. “The path of least resistance is the path most often taken: buy recent performance.”

The solution is to become a contrarian—buying the out-of-favor styles and stocks that are trading below historical norms—and earning “a handsome ‘fear’ premium for taking the other side of the industry’s trades.”

However, this is easier said than done.

“Indeed, most investors might benefit from simply forgetting the ID and password to their trading account,” Hsu said.

But the sovereign wealth fund argues that many other ways of practically addressing environmental, social, and governance issues within a portfolio do work.

Exclusion and divestment do not boost investment performance, according to a white paper from the New Zealand Superannuation fund (NZ Super).

In the paper, the NZ$29.8 billion (US$19.4 billion) sovereign wealth fund outlined its approach to environmental, social, and governance (ESG) investing—and how that approach has proven financially beneficial.

The only cases of responsible investing where there was not significant outperformance, the fund found, were in socially responsible funds. These typically exclude whole sectors such as tobacco or armaments for ethical reasons, rather than reasons of risk and return.

“Overall, there is strong evidence that companies that do well on ESG metrics tend to perform better.”According to the paper, these funds neither outperformed nor underperformed the market on average, suggesting that divestment on its own is not sufficient for boosting performance.

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In contrast, factors such as governance, employee relations, safety, and environmental risks are “material to the long-term successful performance of any business.” By identifying and managing these factors, NZ Super said it has been able to “find new opportunities, steer our capital towards more attractive areas, and manage long-term investment risks.”

“We believe that responsible investing is good for the portfolio,” wrote CIO Matt Whineray. “It can be a source of opportunities and a way to control risk.”

The paper listed several ways the fund’s performance has improved through good ESG management, including more consumer support of businesses in which NZ Super invests, early detection of risks that could otherwise be overlooked, and investing in “more dynamic, innovative, and productive” companies.

Additionally, NZ Super said investing early in the life cycle of assets with ESG drivers creates more potential for returns, while also making better use of the fund’s long time horizon.

“Overall, there is strong evidence that companies that do well on ESG metrics tend to perform better,” NZ Super reported, citing lower costs of equity and borrowing, higher profitability, and higher stock prices.

NZ Super also highlighted that, within an ESG-driven process, it was an active and engaged asset owner, maintained a robust analytical and decision process, and benchmarked the fund’s performance against its own responsible investing standards.

“By identifying and managing these ESG factors, we are more confident in our ability to allocate capital toward more attractive areas, and better manage long-term investment risk,” the paper concluded.

Institutional investors are split on the benefits (or otherwise) of divestment. Dutch pension PFZW last week outlined plans to overhaul its investment portfolio, dumping carbon-producing companies, and the University of California has taken a similar approach to fossil fuels. In the UK, the London Pension Fund Authority recently rejected calls for it to exit such assets.