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.”

“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.”