‘Real World’ Institutional Investment Practices

1. ‘Real World’ Institutional Investment Practices Danyelle Guyatt PhD, Economic Psychology University of Bath d.guyatt@bath.ac.uk 6 June 2006

2. Introduction • Institutional investors play a key role in the capital allocation process (size/power) • Theory suggests ‘rational’ investors can exploit inefficiencies created by ‘irrational’ investors and market inefficiencies • BUT growing evidence of behavioural biases suggests theory does not adequately explain investor behaviour • Institutions fall short of achieving their stated goals/objectives

3. Behavioural shortcomings (1) • Professional investors are not always rational decision makers, with economic, social and psychological factors at play: • Economic (maximise bonus and career prospects) • Social (the opinion and behaviour of others) • Psychological (heuristic simplification, self-deception and emotion-based judgement)

4. Behavioural shortcomings (2) • Markets do not always reflect underlying fundamentals • Shiller type effects such as herding, bubbles, fads/fashions and the bandwagon effect • Potential misallocation of resources • Exaggeration in business and investment cycle peaks/troughs • Encourages ‘bad’ behaviour at the corporate level

5. Research Aim • Study how institutional assets are actually invested • Focus on institutional objectives and the extent to which these are reflected in the investment process • Phase 1: Case studies on 3 UK institutions that have adopted some form of long-term responsible investment (LTRI) policy • Phase 2: Questionnaire on investment beliefs relating to the promotion of good CG and CR

6. Why focus on ‘responsible’ investment? • Confront some of the assumptions made by mainstream investors in capital allocation process • Potential improvement in corporate and investor behaviour • Better reflection of beneficiaries’ long-term needs and preferences • Unconventional approach to investing, hence additional challenge in terms of implementation and meeting institutional objectives

7. Methodology • Grounded Theory meets Action Research • Avoid the normative approach as to what institutional investors could or should be doing and focus on observing and understanding what they do & why • Listen to their ‘story’ and consider the wider influences on investor behaviour • Consider the extent to which the institutional objective to invest in a long term responsible manner is being met

8. Phase 1: Case Studies • Longitudinal case studies on 3 large UK institutional investors that adopted some form of LTRI investment policy across their assets • Data was collected through: • 20 semi-structured interviews. The average interview was 1.5 hours; all recorded and transcribed for analysis • Informal communication, e.g. email and telephone • Textual analysis of key policy documents amounted to >250 pages of text

9. Findings: A snapshot • There is a disparity between institutions’ objectives and that of portfolio managers • There is a pull towards the short-term • Investors gravitate towards easier to defend decisions • Investors are drawn towards the ‘herd’ and may be overly influenced by market gyrations

10. Findings (1) Objectives • The core objective at the institutional level: • In the pursuit of long-term financial returns, appropriate regard should be given to corporate governance, social, ethical and environmental considerations in the management of the institution’s assets • The core objective of portfolio managers: • To outperform the market (to maximize their annual bonus payout and reputation) through research, valuation estimates to identify mis-pricings and to stay abreast of news and information that may impact on market price

11. Findings (2) Short-termism • Investors are pulled towards the short-term as a form of risk reduction: • “I think any fund manager will tend to focus more on short term goals because you have to be very brave to take a long-term, say a five year view, because if you get it wrong for the first three years, the chances are that you’re going to get fired before the five year period is up!” • “…I mean it always tough, people talk about time scales, but the issue is more about size of out-performance. In other words, we’re looking for things that we think we can outperform by 15-20% or more… that may come in a few months or it might take longer…”

12. Findings (3) Defensible • Gravitate to investment decisions that are considered easier to defend: • “…you have got to get it absolutely right, otherwise you can get talked out of it quickly – well, not really talked out if it but questions on why on earth are you in this thing will follow…” • “…if the trust is not in place, you are far more likely to get a fund manager making decisions looking over his shoulder. He tends to gravitate towards those decisions which can be most easily defended after the fact in case he gets them wrong. And that’s a natural human instinct. And we don’t want that.”

13. Findings (4) The ‘herd’ • Investors speak more of ‘the market’ and ‘trading’ than ‘the company’ and ‘investing’: • “If the whole market became more long term and was trading on a 10 year outlook then it would be fine [to be longer term], but they’re not so you just have to trade on what they’re trading on…it’s just what you’ve got to do really…if I were to take a 10 year forecast it would be hopeless…” • “It depends on what the market really looks at, you’ve got to know what’s going to drive the share price and if it is responsible investment then you’re going to have to be up to speed on those issues…”

14. Phase 2: Questionnaire • Conducted as part of a collaborative project for a group of investors called the Marathon Club • A total of 110 respondents completed the questionnaire (61% response rate) with 104 responses used for analysis, of which: • 33% represented fund/portfolio managers; 29% trustees; 16% fund executives; 15% investment consultants; and 7% other (corporate governance specialists)

15. Results: Lengthening the horizon • Over 30% of respondents believed that the most important way to improve corporate behaviour, performance and ultimately portfolio performance was to lengthen the investment horizon • Despite this, within the same question the ability to ‘withstand short-term trends and cycles’ was given the lowest ranking • Inconsistency in beliefs about what short-termism actually means

16. Results: Absolute vs. relative returns • 20% of respondents ranked absolute returns as the most important component of the investment process for achieving long-term returns • Less than 4% believed that actively investing against an index was important • BUT, over 30% of respondents still ranked excess returns above an index as the most important performance review metric • Discrepancy between performance goals (absolute) and review metrics (relative)

17. Making sense of the evidence • Investment practices are disconnected from stated objectives at the institutional level (case study evidence) • Investment beliefs are not adequately reflected in the investment process (questionnaire findings) • Dominant conventions, conformist tendencies and the justification process reinforce inappropriate behaviour

18. The role of conventions • Conventions are more than automatic mimicry of others’ behaviour; they are the modus operandi • Shared understandings, knowledge and beliefs (Gomez and Jones, 2000 and Bibow et al, 2005) • Implicit, unquestioned and relatively stable over time • Considered justifiable and legitimate (Boltanski and Thevenot, 1999)

19. Examples of conventions • Performance measured and reviewed against asset-based index/benchmark (peer review risk) • Short-term performance review cycles (quarterly) • Emphasis on tangible financial criteria • Risk as relative to index, not beneficiary needs • Focus on near-term drivers of asset prices (less conviction for long-term valuations) • Focus on second-guessing market reaction to news/events (beauty contest investing)

20. Conformist tendencies • Feels risky to be different from the crowd (Asch, 1952) • Reputational herding (Scharfstein and Stein, 1990) • Lack of trust in own judgment and analysis (Deutsch & Gerard, 1955) • Investigative herding (Froot, Scharfstein and Stein,1992) • Natural human tendency to conform (Epley & Gilovich, 1999) • Solution to the co-ordination problem when investing under uncertainty (Schelling, 1960; Lewis, 1969; and Sudgen, 1986)

21. Changing behaviour • Cannot change the tendency to conform • Focus on challenging the conventions that underpin investor behaviour • Minimize the extent to which investors focus on the ‘market’ and shift attention to the long-term needs of beneficiaries

22. THANK YOU!