The Market For Lemmings: Is The Investment Behavior Of Pension Funds Stabilizing Or Destabilizing?

David P. Blake

City University London – Cass Business School – The Pensions Institute

Lucio Sarno

City University London – Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Gabriele Zinna

Bank of Italy


Pension funds are large institutional investors, and yet very little is known about their investment behavior. Using a unique dataset that covers UK defined-benefit pension funds’ asset allocations over the past 25 years, we show that pension funds display strong herding behavior when moving in and out of different asset classes and they herd in subgroups (defined by size and sector type), consistent with the notion of ‘reputational’ herding. We also find that pension funds mechanically rebalance their portfolios in the short term in response to valuation changes, and they systemically switch from equities to bonds as their liabilities mature. Furthermore, the median fund is an index matcher, hence failing to earn a long-run liquidity premium. Thus pension funds do not play the stabilizing role one would expect from long-term investors.

The Market For Lemmings: Is The Investment Behavior Of Pension Funds Stabilizing Or Destabilizing? – Introduction

‘Institutions are herding animals. We watch the same indicators and listen to the same prognostications. Like lemmings, we tend to move in the same direction at the same time. And that, naturally, exacerbates price movements’. (Wall Street Journal, October 17, 1989) `Myriad new unseasoned hedge and commodity funds are started precisely to exploit the distorted incentives of the pension or insurance fund managers who queue like lemmings to dutifully place the public’s money. (Raghuram Rajan, October 6, 2006)

As long-term investors, one would expect pension funds to focus on their long-term investment strategy. Pension funds also have predictable cash out flows and hence are unlikely to face substantial unanticipated short-term liquidity needs. They should therefore be in a position to provide liquidity to financial markets at times when it is needed, for example by investing in illiquid assets during periods of market turmoil or financial crises, thereby helping stabilize financial markets and earning a liquidity premium in return. However, pension fund managers tend to have similar benchmarks. This, in turn, might create a fear of relative underperformance compared with the peer group of fund managers and hence an incentive for pension funds to herd; this type of herding is often termed `reputational’ herding (Scharfstein and Stein, 1990).

In addition, institutional investors know more about each other’s trades than do individual investors (Banerjee, 1992; Bikhchandani, Hirshleifer and Welch, 1992) and react to the same exogenous signals (Froot, Scharfstein and Stein, 1992). The signals that reach institutions are generally more highly correlated than those that reach individuals (Lakonishok, Schleifer and Vishny, hereafter LSV, 1992). This increases the likelihood that institutional investors herd more than individual investors and also, because of the size of the funds involved, institutional herding is more likely to produce a bigger price impact than individual herding (Nofsingerand and Sias, 1999). If pension fund herding results in procyclical or positive-feedback investment strategies { buying assets in a rising market, selling in a falling market { this could have a destabilizing effect on financial markets (Wermers, 1999). In essence, there are good reasons why the investment decisions of pension funds may be stabilizing or destabilizing for financial markets, and this issue is at the center of the active policy debate on the risks that the behavior of non-bank financial institutions pose for financial stability (Feroli, Kashyap, Schoenholtz and Shin, 2014; Haldane, 2014; Bank of England, 2014).

LSV (1992) is one of the few studies to examine these issues in the context of the pension fund industry: they find no evidence of pension fund herding, which suggests that pension funds do not engage in destabilizing practices. However, their conclusion is subject to the important caveat that: `while there is very little herding in individual stocks and industries, there are times when money managers simultaneously move into stocks as a whole or move out of stocks as a whole. Since our dataset contains only all-equity funds, we cannot examine this type of herding’ (LSV, 1992, p. 35). LSV also conjecture that herding might be more prevalent among subgroups of pension funds rather than in aggregate, but their data does not allow them to test this interesting conjecture.

Pension funds

Pension funds

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