World Bank Report: Herding Prevalent Among Pension Funds

(July 5, 2011) — A recent research report by the World Bank concludes that pension funds herd more frequently in assets for which they have less market information and when risk increases.

The paper shows that pension funds — which, as sophisticated investors, have been expected to invest in a wide range of securities and provide liquidity to domestic capital markets — tend to herd. “This is consistent with pension funds copying each other in their investment strategies as a way to extract information, boost returns, and reduce risk,” the World Bank asserts.

According to the report, which computes measures of herding across asset classes (equities, government bonds, and private sector bonds) and at different pension fund industry levels, herding is more prevalent across funds that narrowly compete with each other. In other words, herding is more popular among funds of the same type across pension fund administrators. Furthermore, the herding pattern is consistent with incentives for managers to adhere to industry benchmarks, which might be driven by both market forces and regulation, the report claims.

In an Interrogation with aiCIO in its Spring Issue, Scott Kalb, the chief investment officer of the Korea Investment Corporation (KIC), South Korea’s government-owned investment management company, expressed “folly in benchmark hugging.” “Do your best to overcome the tyranny of the benchmark; we saw the consequences of following the benchmarks closely during the financial crisis,” he told aiCIO. “Benchmark investing doesn’t demand good technique. It’s not particularly strategic. Nor does it help much with risk management. We want to be anchored by our benchmarks, not be ruled by them.”

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“Herding might also be explained by managers following similar trading strategies like momentum…Managers might herd as a way to reduce risk,” the World Bank report states. “While traditional theories of asset allocation focus on the problem of an isolated investor whose goal is to maximize wealth or consumption at some point in time, several papers study the incentives schemes that arise in the context of financial intermediation. In particular, the conflicts of interest between fund managers and the underlying investors can affect manager risk-taking behavior.”

When asked about the increase in the study of behavioral finance following the financial downturn, Erik Knutzen, the chief investment officer of consulting firm NEPC, told aiCIO: “There are leaders within the institutional investor world, such as Yale’s David Swensen, and there are people who will group behind them.” Knutzen added that during the financial crisis, investors grouped around the Yale model which led to people having excess amounts of illiquidity at the wrong time.

“Usually leaders move onto the next step as others are crowding around,” he said, noting that tail-risk hedging also has been viewed as an example of herding behavior. “I think being contrarian is a productive way to approach the market. The challenge is that you can be contrarian and against the herd, but it can take a while till the contrarian positions take hold.”

To contact the aiCIO editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742

A group of 11 mortgage-bond investors have filed a challenge to Bank of America’s proposed $8.5 billion settlement with holders of its subprime mortgage securities.

(July 5, 2011) — A group of 11 mortgage-bond investors have challenged Bank of America’s proposed $8.5 billion deal with investors who bought subprime mortgages through the bank’s Countrywide Financial subsidiary, the Wall Street Journal has reported.

The group, calling themselves Walnut Place but at this point otherwise remaining anonymous, filed a challenge in New York County Supreme Court attacking the deal’s fairness.

The filing marks the first legal challenge against what would have been the banking industry’s largest single settlement stemming for the 2008 housing market collapse. Bank of America agreed on June 29 to a $14 billion settlement with embittered investors who purchased unsound subprime mortgages through the bank’s Countrywide Financial subsidiary. Walnut Place appeared to only have challenged the $8.5 billion allocated to a group of larger investors led by Pacific Investment Management Co. (PIMCO), BlackRock, and the Federal Reserve Bank of New York.

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The filing by Walnut Place highlighted three major objections to Bank of America’s proposed settlement. The first is over the size of the proposed deal. Although the $8.5 billion represents more than the bank has made in collective profits since the financial crisis, the group argues that the bank owes its investors much more. “[Bank of America’s subsidiary] Countrywide may be liable to repurchase loans with unpaid principal balances of as much as $242 billion. The $8.5 billion that Countrywide and Bank of America have agreed to pay is therefore only a small fraction of the potential liability that they would have faced in litigation on behalf of the trusts.”

Walnut Place’s second objection in the filing is that serious conflicts of interests marred the integrity of Bank of America’s deal. “[M]any of these 22 investors have substantial ongoing business relationships with Bank of America other than their ownership of certificates in Countrywide-sponsored trusts. For example, BlackRock Financial Management, Inc., is one of the 22 investors. During the time in which the Settlement Agreement was being negotiated, Bank of America owned up to 34 percent of BlackRock….Many other of the 22 investors also have substantial business dealings with Bank of America or its subsidiaries other than their ownership of certificates in Countrywide-sponsored trusts.”

The final objection is to the secretive, non-adversarial nature of the settlement negotiations. The group also singled out Bank of New York Mellon, the trustee for the Bank of America bondholders, for the most criticism.

“Walnut Place has serious concerns about the secret, non-adversarial, and conflicted way in which the proposed settlement was negotiated and about the fairness of the terms of the proposed settlement….In short, despite the fact that BNYM owes at least the same duties to Walnut Place that it owes to every other certificateholder in the 530 Countrywide-sponsored trusts, BNYM is asking this Court to approve a settlement that it negotiated in secret and that would release Walnut Place’s claims without its consent while it is in the middle of an active litigation…”

To contact the aiCIO editor of this story: Benjamin Ruffel at <a href='mailto:bruffel@assetinternational.com'>bruffel@assetinternational.com</a>