Behavioral finance analysis a boon to British plans

LONDON — Large U.K. pension plans are using behavioral finance analysis to help them select money managers.

Both the £3.4 billion London Pensions Fund Authority ($6.3 billion) and the £4 billion Merseyside Pension Fund, Liverpool, have used a system called Behavioral Performance Strategies to help them select money managers from consultants' shortlists.

BPS analyzes manager portfolio holdings and trading activity over a certain period in order to understand the source of a manager's performance, said Rick Di Mascio, chief executive of Inalytics Ltd., London, which operates BPS.

In March, Merseyside used BPS in conjunction with manager search specialists bfinance, London, to find a European equity manager, said Paddy Dowdall, investment monitoring officer at the pension plan. Money managers were asked to provide trading data for BPS to analyze. The £100 million mandate was eventually awarded to JPMorgan Asset Management, London, in September.

"We feel a lot more confidence in the process behind this appointment," said Mr. Dowdall. "The more involvement you have and the more information available, the more confidence you have in the decision that is made."

The BPS data shed an interesting perspective on managers' convictions, said Mr. Dowdall. He was intrigued that money managers are far better at managing the stocks they feel positive about.

"All managers, including underperforming firms, attained positive performance from overweight stocks whilst neutral and underweight positions often acted as a drag on performance even for managers who outperformed," he said.

"The data also show that fund managers tend to have very good skills at buying and less at selling," he added.

According to Mr. Di Mascio, this "disposition effect", where fund managers sell their winning stocks and continue to hold poorly performing ones, can reduce performance by as much as 200 basis points a year.

The Merseyside Pension Fund has been using BPS to monitor all of its money managers, both internal and external, since early last year, he said.

Until 2002 the plan managed its entire portfolio internally. According to Mr. Dowdall, it now has outsourced about two-thirds of its assets. With its in-house investment team, the plan was able to take a self-sufficient approach to manager searches, he said.

Previously the Merseyside plan had used Mercer Investment Consulting, London, for manager searches. But trustees decided late last year to follow the Myners Principles for institutional investment and no longer use the same consulting firm for both strategic advice and manager searches. Mercer continues to provide strategic advice and asset-liability studies, said Mr. Dowdall.

Late last year, the London Pensions Fund Authority used BPS in hiring a global equity manager through a search conducted with consultant Hymans Robertson LLP, London, said Paul Kessell, the fund's assistant investment manager, in an e-mailed reply to questions.

He said BPS data was one of the tools used by the LPFA trustees to award £315 million mandates each to Newton Investment Management Ltd., London, and MFS Investment Management, London.

Mr. Di Mascio said BPS differs from traditional performance analytics in that it analyzes every decision (buying, selling, underweight or neutral) the portfolio manager takes over time to establish patterns of strength and weakness in the decision-making process. Money managers have skill but this is often eclipsed by behavioral biases in portfolio management, he said. "To use a sporting analogy, performance measurement tells you if you've won or lost the game. What we are interested in, is how you played the game," said Mr. Di Mascio.