Investment Herding Risk

What was suspected, has now been proved:

Investment Herding Exists!

Dutch Pension Funds are active Traders
In a 2011 research document called "Herd behavior and trading of Dutch pension funds", researchers Rubbaniy, Lelyveld and Verschoor of the Dutch Erasmus University in Rotterdam, provided evidence that repudiates the popular belief that - in specific - Dutch pension funds are long-term passive institutional traders.

De facto Dutch pension funds are active traders and trade about 8.5%  of their portfolio on a monthly basis!

Conclusions

Main conclusions of Rubbaniy (et al.) are:

• Significant feedback trading strategies, both momentum and contrarian
• Robust herding behavior in investments of Dutch pension funds
  Overall (LSV) herding level of 8.14% (significant at 1% level !!)
  On average if 100 PFs are active in the same security in the same month, there are 8.14 more PFs trading on the same side of the market than what would be expected under null hypothesis of random selection of securities.
• Herding asymmetry in buying and selling of securities
  Across asset classes there is a higher degree of herding in less-risky assets.
• Recent financial crises have a positive impact on both turnover and herding while it negatively affects feedback trading.

Explanations
Possible explanations of these herding effects are:

• Possibly outsourcing of portfolio management and small PFs imitation of large PFs’ lead to the same kind of asset allocation strategy.
• Many small Dutch PFs often hire the same large and reputed asset management firms for their portfolio management and are likely to have same asset allocation of their portfolios. 
• Even if they do their own portfolio management, small Dutch PFs may mimic the investment behavior of large PFs - a widespread belief about the small investors - and thus, add to (LSV) herding measure.

Remarks

Let's conclude with some remarks....

• Dangerous Big Brother Hedge
  Although large PFs (investors) have some 'economics of scale' and budget for experimenting on a small scale with (alternative) non-conventional investments, their investment strategy probably strongly differs from a small PF, as liabilities, sponsor obligations and pension benefits conditions are often are fund specific. 
  
  Therefore, following a large PF asset strategy as a small PF, is extremely dangerous and will eventually not turn out to be the 'big brother hedge' the fund was aiming at.
   
• Unfounded First Mover Risk
  Key question remains if all this herding, hedging and active trading results in an outperformance above a long term sustainable asset-location strategy.
  
  Probably not. But although investors pretend tot act on a rational basis, in reality irrational and conformist behavior take the upper-hand. Small investors often don't dare to formulate a unique fund specific asset allocation strategy because of 'first mover risk'.

Keep care and formulate yur own specif pension fund strategic asset mix!

Related Links & Sources
 - "Herd behaviour and trading of Dutch pension funds" (2011, PDF)
 - Momentum or Contrarian Investment Strategies:
    Evidence from Dutch Institutional Investors (2011)
- Momentum and Contrarian Stock-Market Indices

Pension Fund Death Spiral

In a very simplified model (Pensions Dynamics, PPT), professor of investment strategy, Alan White, concludes that defined benefit pension plans probably cannot succeed on the long term.

Death Spiral
White shows that every pension fund with a non risk-free asset approach, will eventually encounter a “Death Spiral” which will lead to the collapse of the fund. The only solutions are:

• Raising contribution rates
• Lowering promised pension benefits.

Assumptions
All conclusions are based on the next summarized main assumptions:

• Compensation growth: 2% per year
• Pension contribution: 15% of yearly compensation
• Yearly retirement income objective: 70% of his final salary
• Risk-free rate of interest is 3%;Risk premium on the risky assets: 3%
• Annual volatility of the risky assets: 15%
• Time horizon: 100-year
• Risky Assets investment part : 60% of the portfolio
• Corresponding final pay pension defined as 20 year annuity
• Required minimum average Pension Fund asset value in steady state
  - at 3% return: €/$ 47,200
  - at 6% return: €/$ 23,600

Frequency Distribution Outcome
One of the most striking outcomes of this study is the fact that as we look farther in to the future of the simulated pension fund, the amplitude of the frequency distribution of asset values appears to be dropping to zero. The chance that (average) asset values will be between $10,000 and $100,000 gets smaller and smaller.

The reason for this is that the probability of very high asset values and the probability of entering a collapsed state (the collapsed funds are not shown in the next figure) both increase as we expand out time horizon. As a result the probability that assets remain in the intermediate interval, is reduced.

Another interesting facts are:

• Asset values appear to become more sustainable as the part 'risky assets' increases
• Collapse rates for growing pension funds are, (almost) independently of the asset mix, negligible.
• Collapse rates for more mature (steady state) pension funds are substantial and increase to deadly percentages as the time horizon increases from 50 to 100 years.

Remarks
Although Whites model is perhaps oversimplified and can be easily criticized, it clearly shows the essential principles of running a pension fund.

In a commentary, Rob Bauer (ABP, University of Maastricht) argues White's conclusions. Nevertheless, interesting stuff, that stimulates actuarial insight.

Links
Interesting corresponding links:

• Longer Horizons Can Handle Riskier Holdings
• Stochastic Interest rate models (2008)
• The calculus of retirement income