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Pension funds more tolerant of underperformance


In the past, institutional investors have been accused of being too trigger happy when it comes to manager underperformance. But a new study has found they actually find it hard to let go.

A team of researchers surveyed 218 global institutional investors representing US$4.1 trillion in assets under management through data gathered by the Institutional Investor, a US-based financial publication and research, to “primarily learn about their patience and fortitude with respect to external asset managers”. Respondents hailed from North America, Europe, and the “Rest-of-the-World.”

What the researchers found was that while underperformance is the dominant reason for termination of a manager, there is also a surprising latitude for that underperformance; 66 per cent, 56 per cent, and 50 per cent of respondents report a willingness to tolerate underperformance for three years or longer in public equity, fixed income, and hedge funds respectively.

“We find that across all three asset classes, the tolerance to underperformance is negatively related to the use of a multi-factor benchmark suggesting that greater precision in performance measurement allows investors to be less forgiving of poor performance,” the report says. “Tracking error tolerance is positively related to tolerance for underperformance, but only for equity mandates.

However, only 42 per cent of respondents reporting holding periods of longer than five years in hedge funds. But the research still runs counter to previous reports that found that institutional investors were trigger happy, with “ruthless firing rules” that caused them to perform much worse than “loyal long-term asset owners.” Prior research suggested that the largest asset allocators focused heavily on a three-year window that harmed realised returns.

“Interestingly, the locus of control is unrelated to tolerance to underperformance…. We would expect variables that proxy for the locus of control (external consultant or internal experts) to be important to forbearance because of differences in agency costs,” the report says. “However, we find that the coefficients on the variables that proxy for the locus of control are statistically indistinguishable from zero.

“This implies that, controlling for other regressors, whether the decision makers are internal or external, or the nature of their expertise, has no influence forbearance.”

On the other hand, hiring decisions are made based on the prior performance of the asset manager, the personal connections between personnel at the institution and asset manager, and the recommendations of investment consultants. But the things that plenty of institutions now claim underpin their decisions don’t seem to matter at all.

“Institutions are relatively “hard-nosed” in their selection decisions, focusing primarily on performance, the details of the investment strategy, and competitive differences across investment managers,” the report says.

“Despite the widespread marketing jargon with respect to culture, it plays the least important role in manager selection. Even more interesting and surprising is the lack of sensitivity to fees: it is the second least-important reason in selection decisions, perhaps because competition between asset managers within an investment style is intense.”

The survey encompassed private retirement systems, public retirement systems, endowments, foundations, insurance companies, financial institutions, healthcare organizations, family offices, sovereign wealth funds, and central bank reserve funds.

Among the respondents, the nebulously-defined “financial institutions” were least tolerant of underperformance, while North American institutions were much more tolerant than institutions from other domiciles, belying beliefs that the North Americans were more trigger-happy than their peers.

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