As if mutual fund investors didn’t have enough to worry about, here’s one more thing: Your portfolio manager’s politics.
Of course, it’s no secret that our political feelings can cloud our judgment. Democrats and Republicans routinely report different views about the health of the U.S. economy. But professional mutual fund managers are supposed to be above all that: cool-headed analysts who pay more attention to sales growth and price-to-earnings ratios than the shouting on Fox and CNBC.
Maybe not. A new study by researchers Babajide Wintoki, of the University of Kansas, and Yaoyi Xi, of San Diego State University, found that managers with strong political convictions often let those creep into their investment decisions, making funds more volatile, while also potentially hurting returns.
Wintoki and Xi hypothesized that a kind of bias known as “in-group favoritism” made it likely that fund managers — intentionally or otherwise — select companies whose executives share their political ideology. Using data from the Center for Responsive Politics, the scholars tracked contributions made by managers from nearly 1,300 actively managed mutual funds to political parties from 2000 to 2015.
The duo cross-referenced that data with political contributions made by the executives of companies in the fund portfolios. They then reviewed fund performance for the three groups of funds — Republican-leaning, Democratic-leaning and those funds whose managers had no political contributions on record — to see if political ideology affected risk and returns.
They found that Democratic-leaning fund managers disproportionately selected companies with Democratic-leaning executives, while Republican-leaning fund managers were more likely to go with Republican-backing management. Not only did the researchers find widespread evidence of this bias, they also found significant performance differences between funds with a political tilt and ones where not tilt was detected.
“The consequence is negative and costly to shareholders,” said Xi in an interview. “Mutual funds who buy lots of these holdings based on political ideology alignment tend to have higher risk.”
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Partisan affiliation increased “idiosyncratic” volatility, meaning that the funds managed by political donors were more inclined to unpredictable price swings than funds managed by managers without a track record of political contributions. The scholars found some evidence of underperformance by the partisan-influenced funds, but it was within the margin of statistical error. One thing was clear from all their models: the partisan funds did not outperform the control group. Taking on significantly higher risk without the prospect of higher returns flies in the face of all principles of investment, said Xi.
What’s more Republican-leaning funds were more likely to “over-allocate” investment in politically aligned companies during Republican presidential administrations and vice versa for the Democratic-leaning funds, according to Xi. As presidential elections seldom directly affect a company’s “fundamentals,” like sales and earnings per share, the partisan managers were likely making a political calculation when reallocating portfolios at such times, the researchers concluded.
Xi said the partisan effect is comparable to other invisible investment biases exposed over the years, including the tendency of fund managers to pick stocks issued by local companies.