‘‘Real World’ Institutional Real World’ Institutional Investment PracticesInvestment Practices

Danyelle Guyatt

PhD, Economic Psychology

University of Bath

d.guyatt@bath.ac.uk

6 June 2006

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IntroductionIntroduction

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

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Behavioural shortcomings (1)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)

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Behavioural shortcomings (2)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

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Research AimResearch 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

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Why focus on ‘responsible’ Why focus on ‘responsible’ investment?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

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MethodologyMethodology

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

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Phase 1: Case StudiesPhase 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

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Findings: A snapshotFindings: A snapshot

There is a disparity between institutions’ objectives and that of portfolio managers

There is a pull towards the short-termInvestors gravitate towards easier to

defend decisionsInvestors are drawn towards the ‘herd’

and may be overly influenced by market gyrations

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Findings (1) ObjectivesFindings (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

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Findings (2) Short-termismFindings (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…”

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Findings (3) DefensibleFindings (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.”

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Findings (4) The ‘herd’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…”

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Phase 2: QuestionnairePhase 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)

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Results: Lengthening the Results: Lengthening the horizonhorizon

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

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Results: Absolute vs. relative Results: Absolute vs. relative returnsreturns

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)

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Making sense of the evidenceMaking 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

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The role of conventionsThe 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)

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Examples of conventionsExamples 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)

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Conformist tendenciesConformist 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)

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Changing behaviourChanging 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

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THANK YOU!THANK YOU!