State public pension funds love buying shares in local companies, but it is not so much a matter of “buying what you know” as “buying shares of companies with political clout.”
A new study of equity holdings of self-managed state public pension funds finds that they have not only a bias towards in-state companies, but in particular towards those with political connections and influence.
What’s more, these investments aren’t winners; this bias towards in-state politically connected firms costs the typical state pension fund about $225 million in annual decline in fund performance, according to estimates in the study, which is slated to be published in an upcoming Journal of Financial Economics.
“We find that state pension funds overweight these politically active firms and doing so is detrimental to fund equity performance,” write authors Daniel Bradley and Xiaojing Yuan of the University of South Florida and Christos Pantzalis of the University of Massachusetts at Lowell. (here)
“Our evidence is most consistent with the political bias hypothesis.”
Remember too, state pension funds are hardly in good shape and cannot afford to make poor and politically motivated investments.
The aggregate funding ratio of U.S. public pension funds was only 72 percent of liabilities in 2013, according to a survey by the National Association of State Retirement Administrators. That leaves more than $1 trillion of future liabilities unfunded nationwide.
It has long been known that state pension funds have a tendency to invest in firms within their state. Some argue that this is due to mere familiarity, though were this true it would not affect performance. Others assert that pension funds invest at home because they enjoy some information advantage which they seek to exploit. If this information advantage were due to political connections, then holdings of firms in this group would outperform.
What the study seems to have found, though, is that the allocations are going to local firms for political reasons and that this, because it comes from conflicted political motivations, leads in turn to underperformance.
It should be noted that the study used a relatively small sample size: 16 pension funds which manage their own money and made Securities and Exchange Commission disclosures for at least 20 consecutive quarters between 1999 and 2009. That said, the sample included large and well-known pension funds including the Virginia Retirement System, the California Public Employees' Retirement System (CalPERS) and the New York State Common Retirement Fund.
To determine which companies qualify as politically connected or active, the study constructed measures to weigh the extent that a given fund invests more with firms making political action committee (PAC) contributions to home state politicians or engaging in lobbying.
The finding was that state pension funds will tend to overweight their holdings of local firms that make PAC contributions by 23 percent and those that lobby by 17 percent relative to their neutral weight in a market portfolio.
Interestingly, the only local companies that displayed significant positive outperformance were non-politically connected local firms. Perhaps if you are good enough to overcome a biased, politically influenced system your company might actually be a winning investment.
As well, state pension funds tend to hold on to the stocks of politically connected companies longer. They are also poor at making decisions about when to buy and sell these politically connected stocks: selling winners too soon and riding losses too long. This phenomenon is not present for non-politically active stocks, according to the study.
Unsurprisingly, the degree of political bias in state pension funds is linked to how they are governed. Local political connection bias - the tendency to own the shares of politically connected local firms - is stronger in state pension funds with a higher percentage of politically affiliated trustees.
And while having an influential member of Congress in your home state might help bring home some political bacon in government spending, it is a drawback for pension governance. States with more influential politicians in Congress tend to invest more in politically connected local firms, suffering the underperformance that that implies.
Pension fund managers and trustees have an obligation to the members of their funds as well as taxpayers who ultimately might be called on to make good any shortfall. This trumps any woolly local economic development that might come from providing capital locally.
While it would be good to see a larger sample, a responsible state pension fund ought to be doing this analysis for itself and making changes in the holdings based on what they find.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may bean owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)