The propensity to favor local investments is not restricted to individual investors alone but is also common among institutional investors. It also exists in common equity and private equity portfolios of state public pension funds. This phenomenon, known as local bias, has been often attributed to both familiarity and informational advantages associated with geographic proximity to local firms. Recently, state pension funds have come under scrutiny for ‘pay-to-play’ practices. These scandals first appeared in the media and subsequently drew regulators’ attention. On June 30, 2010, the Securities and Exchange Commission issued Rule 206(4)-5 under the Investment Advisers Act of 1940 that “prohibits an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or one of its executives or employees make a contribution to certain elected officials or candidates.” Given the potential for political factors to interfere with state pension funds investment decisions and performance one might suspect that political pressure could be a driver of local bias in their equity holdings. Nevertheless, this is neither established in the literature nor well understood. Accordingly, in our paper, entitled “The influence of political bias in state pension funds”, we examine factors that could contribute to local bias in state pension funds from a political perspective and the impact politics can have on fund performance. We gather a sample of internally managed state pension funds over the 1999 to 2009 period, and analyze whether corporate political strategies (i.e. making contributions to political action campaigns or engaging in lobbying) influence local (state) public pension funds’ portfolio investments. Consistent with previous studies that show evidence of local bias in various settings, we find that pension funds overweight local firms by 26% relative to the market portfolio. What is more important, we demonstrate that state pension funds exhibit “political bias”, i.e. they overweight politically active local stocks. Specifically, we estimate that state pension funds overweight local firms that make political contributions to local (state) politicians or have significant lobbying expenditures by 23% and 17%, respectively.
We proceed to investigate whether this political bias impacts performance and propose three non-mutually exclusive hypotheses highlighting the reasons that politically connected equity investments could influence fund performance. The information advantage hypothesis implies that fund performance should improve when the fund invests in local firms because of superior information available to fund managers about local firms. If political connections lead to better information flow, this effect should be exacerbated in the case of politically-connected firms. The familiarity hypothesis predicts that fund managers overweight local firms simply because they are more familiar with these firms. Familiarity alone, however, should not influence fund performance. Finally, the political bias hypothesis posits that if investment decisions are dominated by conflicted political motivations, then investments made under these conditions are likely to be detrimental to fund performance.
Our evidence is most consistent with the political bias hypothesis. A one standard deviation increase in local political bias results in about a 0.25% to 0.28% decline in quarterly equity performance. Given that the average equity assets of state pension funds is $21 billion, this implies an annual decline in fund performance in the neighborhood of $225 million. When we run a horse race between local and political biases, we find that they largely offset each other. This implies that any potential benefits to fund performance from superior local information are countered by the detrimental effects of political bias.
We also investigate whether political bias has an impact on pension fund investments’ holding durations, i.e. the length of time until equity positions are liquidated. We find that politically connected local firms have significantly longer expected holding durations. In addition, we find that funds display disposition behavior for politically active stocks. That is, they sell winners too soon and ride losers for too long, which can be costly to fund beneficiaries. This disposition effect is not present for non–politically active stocks.
Given our evidence that state pension funds’ overweighting of politically connected stocks has negative implications, we attempt to explain this phenomenon from a fund governance perspective. A key difference between state pensions and actively managed mutual funds is that trustees of state pension funds can be active or former state legislators, members of Congress, ex officio members with official positions in the state’s public sector, or appointed by the governor. By design, this governance structure creates variation in how politically infused the fund’s board of trustees likely is. We exploit such variation and examine if it is related to political bias.
We find that state funds having boards with a larger percentage of politically affiliated trustees invest more in politically connected local firms and those having boards with more financial experts invest less in such firms. Next, we consider the political atmosphere and the power of local congressional politicians, which we measure by the degree of their influence in the congressional bills’ cosponsoring network. Our findings suggest that the existence of more powerful politicians in a state is positively related to political bias in funds of the same state. Using the Bipartisan Campaign Reform Act (BCRA), which became effective on November 6, 2002 and banned unregulated soft money contributions to political parties, serving as an exogenous shock to firms’ political activities landscape, we find a decrease in political bias after the Act and, in particular, for states with stronger ties in Congress. These results suggest that powerful politicians can impose more political pressure on state pensions to invest in politically connected local firms. Moreover, we find that pensions with a higher proportion of politically affiliated trustees invest in riskier assets.
Overall, our results suggest that political interference in state pension funds’ affairs does not produce desirable results. Our study adds to the extant literature on local bias and expands on the developing literature focused on the interplay between politics and investment behavior. It also has important policy implications. Our evidence of politically influenced investment decisions by state pension fund managers that are detrimental to fund performance suggests that at least some managers (trustees) are not upholding their fiduciary duty to act solely on behalf of the plan’s beneficiaries.
The preceding post comes to us from Daniel J. Bradley, Professor and Chair of the Muma College of Business Finance Department at the University of South Florida, Christos Pantzalis, Professor at the Muma College of Business Finance Department at the University of South Florida, and Xiaojing Yuan, Assistant Professor at the Department of Finance at the University of Massachusetts Lowell. The post is based on their recent article, which is entitled “The Influence of Political Bias in State Pension Funds”, forthcoming in the Journal of Financial Economics and available here.