Why It Pays to Invest Locally

A bias among US state pensions towards local stocks is no bad thing, according to a study—even if it is partly driven by political pressure.

The study—conducted by Jeffrey Brown, Joshua Pollet, and Scott Weisbenner of the University of Illinois at Urbana-Champaign—observed investment behaviors of 27 US state pension plans that manage their own equity portfolios from 1980 to 2008 and found a 76% bias towards in-state stocks.

This bias was largely charged by familiarity, informational bias, and political influences, the authors said. And despite the dangers of increasing the overall portfolio risk, the study found that state pension funds with such a bias outperformed those without a local tilt.

“Put simply, CalPERS appears to know which in-state small technology stocks to buy and which to avoid, and Texas Teachers’ knows which in-state small oil companies to buy and which to shun.” —Brown, Pollet, & WeisbenneLocal equities represented 9.7% of the entire portfolio on average, a significant bump from a 5.6% holding in the average market portfolio. Such a bias would theoretically lead to a more positive correlation between states’ economies and tax revenues and the performance of the pension plans’ portfolios, the authors argued, leading to increased overall portfolio risk.

Despite such consequences, the study found that state pension fund managers were able to deliver excess returns by investing in small, in-state stocks—especially those that are part of the state’s largest industries.

State pension plans might choose in-state equity because people have a tendency to invest in what they know, the authors wrote. They may also rely on having more knowledge about local companies and industries, which can help pension plan pick winners from losers.

“Put simply, the California Public Employees’ Retirement System appears to know which in-state small technology stocks to buy and which to avoid, and Teacher Retirement System of Texas knows which in-state small oil companies to buy and which to shun,” the authors said.

Among stocks outside the S&P 500 in a state’s largest industry, pension fund managers were able to outperform the out-of-state small firms in the same industry by nearly 6.5% per year, the paper said. 

Politics also played a hand in pension plans’ in-state equity bias, the authors said. State pension plans were more likely to be biased towards in-state companies, particularly towards those located in areas that gave large campaign contributions to the current governor. 

These politically-motivated equity portfolios were also likely to deliver excess returns, the study found. Holdings in firms based in politically-connected counties outperformed those from counties that were less so by nearly 46 basis points per month and returned some 5.7% higher annually.

Read the full paper here.

Related Content:  US State Pensions: Returns Improving, Underfunding Remains & Making a Local PE Investment? Think Twice.