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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.

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