Investor herding instinct

We then address more directly the question whether pension fund investment behaviour is stabilising or destabilising for asset prices. A common view in the financial markets is that pension fund investment behaviour is destabilising only to the extent that it moves market prices away from, rather than towards, their equilibrium values. So if pension funds were momentum traders, but better informed than other investors, then their trading might still be stabilising. A fundamental question therefore is whether the trading of the average pension fund reflects its superior information.

The answer to this question is no, since we find that the systematic changes in the strategic asset allocation of the average fund reflects its changing liability structure, rather than changes in the expected returns or risks on the assets (which are the signals to which informed active managers would respond).

We also find that the short-term rebalancing of the average fund largely corrects for deviations from the long-term strategic allocation caused by relative valuation changes in the different asset classes. As a result, the average pension fund’s investment behaviour can be destabilising, since it does not respond to the release of new information, with the risk that market prices can be moved away from their fundamental values.

We also investigate the market exposure of the average pension fund in our sample. We find that the peer-group benchmark returns match very closely the returns on the relevant external asset class market index (for example in equities and bonds). This result, coupled with the evidence on herding, supports anecdotal evidence that pension fund managers herd around the average fund manager who generates the peer-group average return and who is, in turn, a “closet index matcher”.

Finally, although we find evidence of pension fund herding, pension funds might differ in their ability to earn a liquidity premium by deviating from the peer-group allocation. Individual funds, for example, differ in the maturity structure of their liabilities and in the strength of their sponsor covenant. Another important factor is fund size. On the one hand, smaller funds might be able to earn a larger liquidity premium, since they are able to react more quickly to liquidity shocks than larger funds where “size is the anchor to performance”.

On the other hand, larger funds might have the scale not enjoyed by smaller funds to invest in illiquid assets such as property and infrastructure. We find no evidence of a liquidity premium being earned by pension funds. Indeed, funds that are less exposed to illiquidity generate a higher return than more exposed funds.