Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 14

Peering into peer risk

“Rank among our equals is perhaps the strongest of all our desires.”  Adam Smith, c. 1780.

Two linked factors explain and justify our concern for rank relative to peers, one largely psychological and sociological, and the other primarily economic.

Our concern is so deep and persistent it is probably best explained in evolutionary terms. High status confers advantages in attracting mates, in acquiring food, in surviving. The Whitehall Study of British civil servants found that after controlling for all known relevant factors, high status civil servants live four years longer than low status ones. Our well-being depends on how others perceive us, on keeping up with the Joneses.

Fear of being wrong and alone

After leaving my role as a fund CIO, I saw the fund had scraped into the first quartile which, given its value bias in a growth period, was by all rational criteria a strong result. My visceral response to self, “why wasn’t it higher up?” was by all rational criteria absurd. But biology is far from destiny; we can learn to moderate our impulses. A self-help Peer Risk Anonymous group might be laughable but the principle of seeking out others for support is a useful step in nudging us away from an excessive concern for peer risk. Smith’s “strongest desire” varies across people so those who need a fix of peer-respect should seek support from those with a strong tolerance for peer risk.

The second more economic justification is that peer risk encourages adapting ideas from others, a process that can increase aggregate welfare. Mimicking other funds’ benefit-enhancing activities in administration, custody, insurance and communication will serve members’ interests, though not necessarily their best interests. In a strongly regulated industry mandated to manage people’s retirement savings, the dominant business risk is the fear of being wrong and alone, which makes copying at the margins the dominant modus operandi, as it is in banking and insurance. That MO results in (far too) many essentially identical funds, a structure that may not optimise economists’ utility functions but may satisfice society. By ensuring stability without sacrificing on-going marginal improvements, that structure may be both satisfactory and sufficient. But it might not best-serve members’ interests because it is exposed to opportunity cost and vulnerable to the risk of disruptions from new entrants (think SMSFs) or new technologies (think internet banking) that can end in Jurassic-style destruction.

Investing is different. There’s a strong aversion to peer risk among investment managers generally and the consequent strategy of mimicking is dangerous. Dangerous because there is little evidence that rankings of superannuation funds by agencies such as Mercer or ChantWest influence members’ or employers’ investment decisions. Maybe they’ve absorbed the industry’s shouting about past performance. Dangerous because surveys focus on neither the longer-term nor on risk-adjusted performance. Dangerous because a strategy under-performing in the shorter-term may be well-placed to out-perform in the longer-term. Dangerous because differing from rather than copying the market is necessary to beat it.

Reducing peer risk creates other risks

Investment strategies crafted largely to keep up with the Joneses, and to lower peer risk, create new risks. One such risk arises when small funds mimic strategies in private markets where large funds have non-replicable advantages in information and in the power to better align fees. Another arises where funds mimic only after a strategy has been successful, by which time altered market conditions or capacity constraints may lead to significantly lower future returns. Copying another fund’s active strategies can suffer from both these risks, as occurred with US endowments’ rush to be like Yale. The boring 60/40 equities/bonds strategy has now outperformed all but a handful of the early sophisticated endowments.

Mimicry can also require skills and capacities funds may not have. Some Australian funds believe they can mimic hedge fund and venture capital programmes, over-riding the insight that both are fast-moving, local, network-driven and demand a strong presence in the incubating areas of New York and London for hedge funds and Silicon Valley for venture capital. Even mimicking a passive listed equity strategy has elements of that risk. One fund that believed all it needed was a tame quant, a powerful computer and a live feed developed such a poorly constructed index fund that it underperformed by an outrageous 100 basis points.

Notwithstanding these risks we all suffer from peer-risk-induced performance anxiety, even sophisticated contrarian investors.  US endowment funds do, sovereign wealth funds do and pension funds do. Beyond Adam Smith’s claim lies a more subtle contributing explanation. Most industries and professions have broad agreement on reasonable, evidence-based principles or theories on which they base their practices. Investing largely lacks these. Theories are weak, agreed principles are compromised by arbitrage, data is poor and uncertainty rather than risk rules, OK? That leaves the ‘Comfort of Crowds’ as a not unreasonable way of assessing what one is doing, an assessment made even more reasonable if courts take ‘industry standards’ as a benchmark for prudence.

Do you really have a tolerance for peer risk?

The barriers to reducing our aversion to peer risk are highlighted by a (not-so) hypothetical. Your fund’s objective is to generate ‘3.5% pa after inflation over the long-term with moderate levels of risk.’ With global 30-year inflation-linked sovereign bonds yielding 4% real, should you allocate massively to them because they meet the return objective (plus a margin) and effectively have neither credit risk nor inflation risk (ignore the unfortunate requirement to mark-to-market)? As you and your fund have a declared strong tolerance for peer risk, you do that even though your peers eschew that opportunity in favour of equities. Then 30 years hence and your peers’ funds have ridden an equity bull market and generated returns of 6% real leaving your fund meeting its objectives but languishing in the bottom decile. Do you and your fund retain a strong tolerance for peer risk? And do investors reward you for exceeding your fund’s objective?

 

Dr Jack Gray is a Director at the Paul Woolley Centre for Capital Market Dysfunctionality, Faculty of Business, University of Technology, Sydney, and was recently voted one of the Top 10 most influential academics in the world for institutional investing.

 


 

Leave a Comment:

RELATED ARTICLES

Are SMSFs getting too much of a free ride?

How to prevent excessive superannuation balances

Meg on SMSFs: Winding up market linked pensions with care

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

Latest Updates

Investment strategies

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

Planning

Super, death and taxes – time to rethink your estate plans?

The $3 million super tax has many rethinking their super strategies, especially issues of wealth transfer on death. This reviews the taxes on super benefits and offers investment alternatives.

Taxation

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

Shares

The megatrend you simply cannot ignore

Markets are reassessing the impact of AI, with initial euphoria giving way to growing scepticism. This shift is evident in the performance of ASX-listed AI beneficiaries, creating potential opportunities.

Gold

Is this the real reason for gold's surge past $3,000?

Concerns over the US fiscal position seem to have overtaken geopolitics and interest rates as the biggest tailwind for gold prices. Even if a debt crisis doesn't seem likely, there could be more support on the way.

Exchange traded products

Is now the time to invest in small caps?

With further RBA rate cuts forecast this year, small caps may be key beneficiaries. There are quality small cap LICs and LITs trading at discounts to net assets, offering opportunities for astute investors.

Strategy

Welcome to the grey war

Forget speculation about a future US-China conflict - it's already happening. Through cyberwarfare and propaganda, China is waging a grey war designed to weaken democracies without firing a single shot.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.