STANFORD, Calif.--(EON: Enhanced Online News)--In the borderless and market-driven world so aptly described by Thomas L. Friedman eight years ago in The World Is Flat, manufacturing would flow where production was cheapest and money would go where it earned the highest returns.
“They’re getting themselves drawn into the cult of alternative investments”
However, cross-border capital flows actually collapsed during the financial crisis of 2008 and 2009, and in 2012 they remained 61 percent below their peak in 2007. According to new research by faculty at the Stanford Graduate School of Business (Stanford GSB), that’s because politics and localism still play big roles in institutional investing, even with institutional investors bent on maximizing returns. And that’s true in the United States as well as in Asia or the Middle East.
Two separate studies by Stanford researchers found similar patterns of parochialism at two different levels: public pension funds in the United States, and sovereign wealth funds operating around the world.
The first study — by Shai Bernstein of Stanford Graduate School of Business, Josh Lerner of Harvard Business School, and Antoinette Schoar of MIT Sloan School of Management — looked at the direct investments by sovereign wealth funds, giant funds that are usually owned by national governments.
Sovereign wealth funds have become major players on the world stage. Their aggregate holdings have climbed tenfold since 1990, to $5 trillion in 2012. Many sovereign wealth funds were created to reinvest money earned from state-owned resources, such as oil reserves; China has created several huge ones to manage the money tied to its trade surpluses.
Bernstein and his colleagues studied the funds’ direct investments — partial or complete stakes in companies. All told, they looked at 2,662 transactions by 29 sovereign wealth funds from 1984 through 2007.
When politicians were involved in management — in about 24 percent of the funds — sovereign wealth funds were 41 percent more likely to invest in domestic companies. Not only that, the sovereign funds tended to buy high and sell low: They bought into industries with inflated valuations that often deflated later. Put another way, many sovereign wealth funds engage in trend-chasing that hurts their long-term returns.
“Political pressures seem to force these sovereign wealth funds to use their funds to support underperforming local industries rather than build a savings buffer for the long run,” Bernstein and his coauthors wrote.
It’s tempting to assume that provincialism is higher in less-developed countries than in countries with long histories of professional money management. But a second study, by Joshua D. Rauh of Stanford GSB and Yael V. Hochberg of Northwestern University’s Kellogg School of Management, finds that localism is alive and well in the United States.
Rauh and Hochberg analyzed how public-employee pension funds, university endowments, and other institutional investors make “alternative investments,” that is, investments in venture capital funds, private equity funds, and real estate limited partnerships.
Pension funds are plowing ever-bigger shares of their money into such investments, hoping to generate higher returns and reduce their huge projected shortfalls. But those higher returns can be illusory, in part because many pension funds pour money into subpar local deals.
Rauh and Hochberg found that state pension funds generally reap lower returns on their in-state deals than on their out-of-state deals. Nationwide, they estimate, those diminished returns cost state pension funds about $1.28 billion a year.
Nationally, that’s less than 1 percent of annual pension contributions. But it turns out that more than half of that underperformance is in just two tech-heavy states: California and Massachusetts.
In Massachusetts, the authors estimate, the drain from in-state private-equity deals is equal to a whopping 10 percent-plus of annual state pension contributions. In California, the local losers cost the equivalent of 3.5 percent of annual pension contributions. That’s a real bite.
Are public pension funds being corrupted by political pressure? Rauh and Hochberg found that states with higher conviction rates for public officials did have higher rates of local favoritism.
But Rauh suggests that the localism stems from more than old-fashioned cronyism. Public pension funds are under enormous pressure to reduce their massive projected shortfalls, and they are allowed to reduce those estimated shortfalls by assuming that higher-risk “alternative” investments will bump up their annual returns to 7 percent or 8 percent. Yet because there are only a limited number of premier deals, Rauh argues, some pension funds settle for low-quality deals from people close by.
“They’re getting themselves drawn into the cult of alternative investments,” Rauh says. “If they don’t invest in these risky assets, they say, they won’t have any hope of making those returns. But it’s illusory. It’s kind of like saying that the only way to become a millionaire is to play the lottery.”