Even though institutional investors try to maximize returns, politics and localism still play big roles in their investment choices.
Two separate studies found similar patterns of parochialism at two different levels: sovereign wealth funds and public pension funds in the United States.
The first study—by Shai Bernstein of Stanford Graduate School of Business, Josh Lerner of Harvard Business School, and Antoinette Schoar of MIT Sloan School of Management— looked at the direct investments by sovereign wealth funds.
When politicians were involved in management, sovereign wealth funds were 41% more likely to invest in domestic companies. Not only that, the sovereign funds tended to buy into industries with inflated valuations that often deflated later. Put another way, many sovereign wealth funds engage in trend-chasing that hurts their long-term returns.
“Political pressures seem to force these sovereign wealth funds to use their funds to support underperforming local industries rather than build a savings buffer for the long run,” Bernstein and his coauthors write.
A second study, by Joshua D. Rauh of Stanford GSB and Yael V. Hochberg of Northwestern University’s Kellogg School of Management, finds that localism is alive and well in the United States, too.
Pension funds are plowing more money into alternative investments, hoping to generate higher returns. But those higher returns can be illusory, in part because many pension funds pour money into subpar local deals.
State pension funds generally reap lower returns on their in-state deals than on their out-of-state deals. Those diminished returns cost state pension funds about US$1.28 billion a year. Nationally, that’s less than 1% of annual pension contributions.
Because there are only a limited number of good deals, the study argues that some pension funds settle for low-quality, in-state transactions.
“They’re getting themselves drawn into the cult of alternative investments,” Rauh says. “If they don’t invest in these risky assets, they say, they won’t have any hope of making those returns. It’s kind of like saying that the only way to become a millionaire is to play the lottery.”