Political Cognitive Biases Effects On Fund Managers' PerformanceVW Staff
Political Cognitive Biases Effects On Fund Managers' Performance
Marian W. Moszoro
University of California, Berkeley – Haas School of Business; Harvard Law School; IESE Business School
Center for Open Economics
July 18, 2016
Under rational agent hypothesis, financial industry practitioners should not be affected by political discourse, and investors cannot realize abnormal returns on publicly available information. Rare events, however, may silence rationality and potentiate cognitive dissonance on a spectrum of agents. We assembled a comprehensive dataset of hedge fund performance and matched equity hedge fund managers' political affiliation by their partisan contributions. We document higher returns of equity hedge funds managed by Democrats for 10 subsequent months — from December 2008 to September 2009. This result is unique and robust to placebo time windows and random partisan affiliation shuffling. We conjecture that the conjunction of the financial crisis, Obama's election, and politically polarized interpretation of the US central bank policy during that period had an asymmetric impact on hedge fund managers' perception. In other periods, when the political discourse did not involve central bank policy, there was no statistically significant difference between the performance of equity hedge fund managers depending on their political beliefs.
Political Cognitive Biases Effects On Fund Managers' Performance – Introduction
“The great enemy of truth is very often not the lie-deliberate, contrived and dishonest-but the myth-persistent, persuasive and unrealistic. Too often we hold fast to the cliches of our forebears. We subject all facts to a prefabricated set of interpretations. We enjoy the comfort of opinion without the discomfort of thought.” — John F. Kennedy, Commencement Address at Yale University, June 11, 1962
At the heat of the 2016 primary race for presidential nomination, Sir Michael Hintze-founder of a large British multi-strategy hedge fund-warned against predicting chaos and assured that the US political system is “strong enough to withstand whoever.”1 This statement could probably be applied to an analogous overreaction to Obama's first presidency, when Republican equity hedge fund managers-identified by private campaign contributions-underperformed their Democratic peers for an unprecedented period of 10 months straight.
Ideology is an important bias in the financial industry which is not usually factored in. This study adds to the body of research on a variety of “irrational” factors in financial decision-making
(Barber and Odean 2001; Shiller 2014). The partisan-based difference in the performance by hedge fund managers is an indication of the extent to which ideology can affect the processing of information and whose effects become salient during abnormal situations.
American equity hedge funds allocate clients' capital in US equities subject to constraints agreed to by the investors. These constraints may include the extent of exposure to the overall market moves (beta) and sector concentrations. Managers commonly have substantial discretion within these constraints on how to allocate the capital, and both beta and concentrations are subject to that discretion. The managers are compensated by receiving a percentage of the total returns of the fund over a benchmark plus a percentage of the capital under management. Funds underperforming a benchmark are frequently closed early, since the managers lose the expectations of the performance-based fee and want to remove the poor performance from evaluation by prospective clients.2 It is generally assumed that, although there is a difference between the principal's (investor's) and the agent's (manager's) utility functions, managers have sufficient incentives to deploy their full capabilities to maximize the fund's returns. Efficient market theory implies that the managers will utilize their training and all available information to maximize the fund's returns and that they will ignore irrelevant data.
The details of the US monetary policy, although scrupulously dissected by the professional classes, is rarely a subject of political rancor, much else for dramatically different interpretations of its expected effects by the political parties. The one exception was the period after Obama's election. While several expected policy actions-including quantitative easing operations undertaken by the US central bank-were viewed by the economic profession as largely consistent with what was understood at the time, there was an exceptionally wide partisan divide in their interpretation by the political parties. Republican commentators were prognosticating “hyperinflation” as a result of these policies and the subsequent debasement of the dollar, while the Democratic ones were either muted in their response or offered a defense for these policies.
Rational managers seeking to maximize their funds' returns would ignore these prognostications in their allocation decisions (Fama 1970; Fama 2014). One should not expect to observe a difference of decisions by rational agents based on their own political preference. Yet, we have observed differences in funds' performance depending on the political preferences by the managers. These differences became salient during the period of intense partisan discussions about the central bank's policy, but not in any other periods.
We identified political preferences by the managers by their political contributions. Although it may be argued that they were attempting to buy policy or contributed for other reasons, the relatively small amounts of the contributions make expressing partisan preference the more likely explanation for contributing. It may also be argued that, although the fund managers have common professional political interests, the diversity of the contribution represents a diversity of political preferences.
Figure 1 presents three-month moving average returns of hedge funds by managers' partisan affiliation for the period 2004-2014 (left graph) and augmented for the period 2009-2011 (right graph). The correlation between managers' performance by partisan affiliation is strong (both plots are almost identical) for all periods, but the plots diverve at the beginning of 2009.
Upon closer inspection using monthly regressions, we find that the Democratic managers outperformed the Republican managers from December 2008 to September 2009 by approximately 7 percentage points annualized return, which conversely is a high price paid by Republican managers and their clients to maintain a consistency of beliefs.
The paper proceeds as follows: In sections 2-4, we describe the data collection and matching, identification strategy, and main results. In section 5, we sketch a behavioral framework and narrative explanatory to our results. In section 6, we perform a series of robustness checks, including placebo time windows and randomized partisan affiliation. Section 7 discusses (and weakens) the possible alternative explanations of our results. Section 8 concludes and draws policy recommendations.
See full PDF below.