When politics blinded hedge fund managers: James Saft

(Reuters) - Call it Obama derangement syndrome or call it principled objection to monetary and fiscal policy, but Republican-leaning equity hedge funds got their heads handed to them in 2008 and 2009.

A new study finds U.S. equity hedge funds run by Republican donors lagged Democrat donor peers’ funds for an unprecedented 10 straight months during a period when Obama took office and the Federal Reserve ran an aggressively reflationary extraordinary monetary policy.

One possible explanation: cognitive biases related to their political preferences caused managers to misread the economy and the markets.

In an election year featuring Hillary Clinton and Donald Trump this finding raises some interesting questions.

The study looked at equity hedge funds' performance between 1999 and 2014, inferring the political beliefs of managers from their political donations. From December 2008 to September 2009 funds identified as run by Democrat managers beat those run by Republicans by 72 basis points per month, an unusually large margin over an otherwise unrepeated period. The outperformance amounts to a relative underperformance of nearly $14 billion, according to an estimate in the study.

“We showed that partisan affiliation is an important bias in the financial industry, which was not considered during the financial crisis and recovery. The difference in 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,” authors Marian Moszoro of the University of California, Berkeley and Harvard University and Michael Bykhovsky of the Center for Open Economics write in the study. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2811350)

The authors theorize, but do not demonstrate, that managers fell victim to cognitive biases, selectively over-weighting information that confirmed their pre-existing beliefs while tending to discount information that would conflict.

“Right-wing media highlighted the risks of hyperinflation and bankruptcy after Obama’s election and during his first months in office; Republicans overweighted the risk of collapse,” according to the study.

This has both the ring of truth and the feeling of being slightly over-egged. At the time there was a definite political divide about the impact of government debt-financed spending and loose monetary policy. Those sympathetic to the Democrats generally saw these policies as likely to pay off, while Republicans emphasized the risks, not just as policies, but in terms of their impact on financial markets. There were, however, many investors who found fault with the policies for less clearly partisan reasons.

BUSH DERANGEMENT SYNDROME?

Of interest is that the study also covers the second Bush administration, when feelings about policy and personalities also ran high. There was no similar period of under- or out-performance at any other time during the study. Perhaps the difference is that the focus during George W. Bush’s time was far more on the impact of foreign policy and less on monetary or fiscal policy.

It is also possible, and again, impossible to prove, that the outperformance by Democrats was the result of a strong rally coinciding with politically motivated over-confidence during the very sharp recovery in stocks in 2009. Note though that a substantial part of the period of beating Republican returns was during the very sharp and stomach-churning final sell-off in early 2009 before the market bottomed in March.

The study was designed to only look at managers identified as partisan. Those who donated to both sides were excluded.

“The case of a selection bias could potentially arise; i.e., it may be that the best Republican equity hedge fund managers are in teams with Democratic managers, so their results are not captured in our estimates,” according to the study.

The implications for the 2016 election season and the next administration are interesting. While Hillary Clinton inspires intense feelings in her detractors, potentially implying scope for cognitive biases, her policies seem likely to be more or less in line with the current status quo, which has not led, according to the study, to the same kind of diverging returns among politically partisan hedge funds.

Donald Trump, on the other hand, brings out very intense feelings, and not without reason. Your correspondent has written about the risks his stated policies, such as protectionism and default as negotiation, would pose to the economy and markets.

Perhaps investors may overweight the validity of their feelings and beliefs about Trump and overestimate his impact, just as Republicans seem to have in 2008 and 2009 about Obama.

With a seemingly less stable political system, unbiased analysis may be more valuable, and harder to achieve, than ever.

(Editing by James Dalgleish)