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We all have a local bias. We root for the Patriots, invite our neighbors for dinner, and, if we invest, we bet on US companies. Public pensions have a local bias too: 44.2 percent of private equity investments by public pensions in Massachusetts are placed with funds headquartered in the state.
This is troubling, because those investments have historically earned, on average, 8.62 percent less annually than out-of-state investments, which means that local bias could be costing our pension funds more than $150 million each year.
A striking new paper by Yael Hochberg and Joshua Rauh, two Northwestern University economists, examines the local bias of state and municipal public pensions when they become limited partners in private equity funds, which engage in activities like corporate buyouts or providing venture capital. The economists combined state and municipal funds; in Massachusetts, 36 percent of the private equity investments come from the state.
The economists did not know where the private equity funds themselves were investing, but they did know the funds’ reported returns and the locations of the funds’ headquarters. To calculate the extent of local bias, they compared the percentage of out-of-state public pension investments in each private-equity fund to the percentage of in-state public pensions invested in each.
For example, more than a fifth of the private equity investments for public pension fund investments in Tennessee or Ohio go to private equity funds in those states. Less than one percent of pension fund investments from other states head to either the Buckeye or the Volunteer state.
Massachusetts, according to Hochberg and Rauh, is a national leader in public pension local bias. Our public pension funds place 44 percent of their investments in home-state private equity funds, more than either New York or California. By contrast, only 14 percent of non-Massachusetts public pension investments land in funds headquartered here. One important caveat is that this figure treats all investments equally, no matter the size, because the researchers lacked complete information on investment size. The value-weighted local bias seems lower but is still significant.
Local bias isn’t obviously an investing error. Perhaps pension funds invest locally because they know more about local conditions. Tennessee’s public pension funds may just understand the opportunities offered by local private equity while outsiders stay away out of ignorance.
The alternative view is that public pension bias reflects politics or convenience. Perhaps, politicians pressure pension funds to support local companies. Perhaps, pension funds find it easier or more pleasant to work with nearby private equity fund managers.
One way to test between these two views is to examine returns on investment. If local bias reflects superior investment information, then yields should be higher for in-state investments. If local bias reflects politics or convenience, then returns should be lower in-state. Hochberg and Rauh find that, on average, public pension’s in-state private equity investments yield 5.5 percent lower returns annually than their out-of-state investments. Public pensions seem to lose money by parking their money at home.
Hochberg and Rauh’s numbers for Massachusetts are particularly remarkable. In-state, public pension private equity investments appear to have averaged an anemic 2.24 percent return, while out-of-state investments have averaged a powerful 10.86 percent return.
This gap is particularly surprising since private equity investments in Massachusetts from outside pension funds have earned 11.33 percent. Investing in Bay State private equity funds has done well for out-of-state investors, but for some reason, investing in-state has poorly served our own public pensions. Hochberg and Rauh estimate that our pensions could earn $180 million more per year by moving from local to out-of-state equity funds.
These numbers are preliminary and based on 30 years of data, so they may not reflect current investment opportunities. But if the study holds up, we should ask our pension funds to invest less parochially. Some argue that public pensions should invest with state funds to provide support for the local economy, but given the financial problems of our pension systems, earning good returns should be a higher priority.