Pension fund managers are threatening the stability of financial markets by “herding” in and out of asset classes at the same time, a study has shown.

Entitled The market for lemmings: Is the investment behaviour of pension funds stabilising or destabilising?, the study by the Pensions Institute at Cass Business School found that pension funds of a similar size and sector herd together in the short-term, potentially driving assets away from their fundamental values.

Market stability is also being put at risk as pension funds rebalance their portfolios to match liabilities rather than in response to changes in the expected risks and returns on the assets in their portfolios.

The short-term objective of pension fund managers is to automatically rebalance their portfolios when valuation changes violate short-term investment mandate restrictions, while their long-term objectives is to systematically switch from equities to bonds as their liabilities mature.

“As a result, the average pension fund’s investment behaviour can be destabilising, since it does not respond to the release of new information,” Cass Business School professor Lucio Sarno said.

“This mechanical rebalancing risks driving prices away from, rather than towards, equilibrium prices.”

The study also examined the liquidity premiums earned by pension funds over 25 years.

“The long-term nature of pension funds’ liabilities and their predictable cash flows should allow them to earn higher net investment returns by investing in illiquid securities at times when other investors are facing liquidity shortages,” it said.

However, the study found no evidence of a positive liquidity premium in the pension funds’ total return in excess of the peer group return.

Cass Pensions Institute director Professor David Blake said "the bottom line is that, although they are long-term investors, UK pension funds have not earned a positive long-run liquidity premium on their investments.

"This is because their behaviour is driven by different incentives. Pension fund managers fear relative underperformance against their peer-group, which encourages them in the short-term to herd around the average fund manager, who turns out be a closet index matcher.”

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