Four for Friday ~ It’s The Political Season (Always)

The last posting, “Cliques and Claques in the Ecosystem,” examined some aspects of social proof and pressure that affect investment decision making and organizational behavior.

When speaking of groups — and relationships between groups and between individuals from different ones — politics comes immediately to mind.  The divisions seem to be ever greater and, in the United States, the coming midterm elections are heightening the drama and inflaming the passions even more, although the political season never ends these days.

Starting point

Public surveys regarding the economy show a sudden and sizable change in opinion whenever the presidency switches from one party to another.  Republicans and Democrats swap views about whether things are improving or deteriorating.

It’s not surprising, then, that something similar happens regarding the prospects for markets, as is found in “Political climate, optimism, and investment decisions” (Yosef Bonaparte, et. al; published version and working paper):

We show that people’s optimism towards financial markets and the macroeconomy is dynamically influenced by their political affiliation and the current political climate.  Individuals become more optimistic and perceive markets to be less risky and more undervalued when their preferred party is in power.  Accordingly, investors increase allocations to risky assets and exhibit a stronger preference for high market beta, small-cap, and value stocks, and a weaker preference for local stocks.  The differences in optimism and portfolio choice across political regimes are not explained by shifts in economic conditions or differential response to economic conditions by Democrat and Republican investors.

Given the data that is available regarding political contributions — and evidence from gleaned from natural language processing — academic researchers are increasingly exploring whether important economic actors have the same tendencies.

Companies

In “The Political Polarization of Corporate America” (Vyacheslav Fos, et. al), the authors write:

This paper establishes a new stylized fact, namely, that executive teams in U.S. firms are becoming increasingly partisan, leading to a political polarization of corporate America.  This trend implies the growing tendency of U.S. individuals to socialize and form relationships and friendships with politically like-minded individuals extends also to the highest-level decision makers in the workplace.

One example of research about how that partisanship can manifest itself is found in “CEO Partisan Bias and Management Earnings Forecast Bias,” (Michael Stuart, et. al paper):

We find that firms with CEOs whose partisanship aligns with that of the US president issue more optimistically biased management earnings forecasts than CEOs whose partisanship is unknown or not aligned with that of the US president.  Our results suggest that CEOs fall prey to partisan bias, which results in suboptimal forecasting behavior.

With any research finding, you have to ask yourself whether the conclusion makes sense.  For one, “Politically Motivated Credit Ratings” (Quan Nguyen, et. al paper) seems a little out there:  “The results indicate that [credit rating agencies] successfully use biased credit ratings as an indirect channel of political party support.”

If there are firms that are making suboptimal decisions because of political bias, you’d expect asset managers to figure that out (and not do it themselves), right?

Asset managers

From “Partisanship and Portfolio Choice: Evidence from Mutual Funds” (Will Cassidy and Blair Vorsatz paper):

Political beliefs matter for the behavior of institutional investors.  Contrary to conventional wisdom, we show that whether a mutual fund team is Republican or Democratic has a first-order effect on the fund’s portfolio choice.  The flip in trading behavior rules out conventional risk aversion-based explanations for the role of partisanship.

And from “Partisan Bias in Fund Portfolios” (M. Babajide Wintoki and Yaoyi Xi paper):

We document that fund managers are more likely to allocate assets to firms managed by executives and directors with whom they share a similar political partisan affiliation.

Of particular interest is another paper from Vorsatz, “Costs of Political Polarization: Evidence from Mutual Fund Managers during COVID-19,” which focuses on partisan versus nonpartisan portfolio management teams.  Some excerpted conclusions:

I find that strong political partisanship is associated with large costs — both lower fund returns and lower net fund flows — following the onset of Covid-19.

Non-partisans’ active outperformance is consistent with greater cognitive flexibility and their passive outperformance is consistent with greater ideological flexibility.

In terms of flow performance, non-partisans also receive more net flows than partisans.

I argue this is because investor clienteles are partisan and only non-partisans can appeal to both Democrats and Republicans.

My findings emphasize that political partisanship is more consequential for the asset management industry than previously believed . . . political polarization entails large costs [implying] that increasingly polarized US organizations may be cause for concern.

Principal-agent conflicts

In the paper cited immediately above, Vorsatz closes with a paragraph on principal-agent conflicts.  A much-different earlier version of the paper explained that:

if investor clienteles and fund managers are aligned in terms of risk attitude and risk perception, then the fund managers have simply acted as an intermediary in implementing the investors’ preferences.  If, instead, investor clienteles are both (1) unaware of the fund manager’s partisanship and (2) disapproving of how the manager’s partisanship may affect his risk perceptions and risk-taking, then partisan misalignment between the fund manager and fund investor becomes a concerning principal-agent conflict.

The newer version includes an angle that has become a political football, especially in recent months:

Political misalignment is a source of principal-agent conflicts because a politically-misaligned fund manager will express undesirable ESG and risk preferences, now and in the future, in the portfolio construction process.

Of course, the opposite misalignment is possible too.

Many investment professionals are dealing with this now, most notably employees of public pension plans and the outside asset managers who do business with them.  Political polarization has intensified and this is the issue on which it has landed with full force.

The specific topic of ESG and the broader set of hot buttons also are challenging for investment advisors.  Most firms (especially large ones) want to try to stay neutral if they can (and take everyone’s business), although some clients are looking for political alignment, so they will end up elsewhere.  For them, there are advisors who proudly wear their colors, and whose conversations and recommendations are infused with political interpretations.  Those advisors end up with a homogeneous group of clients, whether by design or not.

Trying to keep politics out of investment decision making is getting harder and harder, which could make the payoff for doing so even bigger.