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Wednesday, 28 April 2010

Seeking Alpha, Finding Omega

Institutional Efficiency?

Having hopefully now established that behavioural bias in finance isn’t a figment of various researchers’ fevered imaginations we still need to think about whether the total market might, possibly, be a bit efficient. For even though psychological maladaptation seems to be everywhere we look this still doesn’t show that markets might not be basically sensible under the covers.

Consider that in the US over 50% of the monies invested in markets aren’t under the control, even by proxy, of demented, short-term private investors. No, in fact the majority of investment funds are under directed by a relatively small number of people – so-called plan sponsors – who are responsible for how institutional groups invest their cash. As they’re responsible for over six trillion dollars worth of investments these people matter – a lot – but fortunately, as they’re professionals, we can sleep comfortably knowing that markets are basically in safe hands.

That’s a joke. Kind of. Sort of. Ha ha.

Calm Institutions

Despite the tons of research around private investment channels, including mutual funds, there’s been surprisingly little attention paid to the institutional funds, a wide raft of groups managing retirement plans, endowments and the like. Back in 2004 these groups managed over $6.3 trillion as opposed to the $5.4 trillion under the control of the various mutual funds. When you consider that a lot of this institutional money will fund the retirement of an ever-increasing proportion of aged Americans its importance is only likely to increase.

Recognising that this money is overseen by a relatively small number of people then we can hope that the behavioural biases that so disturb private investors will be significantly reduced in the hands of such professionals. Given the amount of money under management it’s easy to imagine that this will provide a calming effect on choppy markets.

Crazy Institutions

Of course, that’s not the case. Not at all. In fact these investors are magnificently irrational on a scale that makes your average private investor look like the only sane person in a political debating chamber. So when Goyal and Wahal went and looked at the effectiveness of US institutional investors at generating excess returns due to shuffling their fund management mandates, guess what they found?

Well the research, documented in The Selection and Termination of Investment Management Firms by Plan Sponsors found a whole raft of interesting stuff but most pertinently they found that that these decisions didn’t improve performance very much. To be precise: it made no difference at all. Zero. Zilch. Nada.

Superior Performance Guaranteed

Of course, it’s complicated. Only not in a very good way. The plan sponsors don’t manage this money themselves, they hire fund managers to do it for them, most of them specifically created for the purpose of managing institutional money. What they also do, however, is fire underperforming fund managers and replace them with new managers, presumably in the expectation that the new bunch will do a better job.

What the research showed is that the managers that the institutions hired generally did exhibit superior performance. Unfortunately they did it in the three years before getting hired and once they’d got the job they proceeded to do no better than the bunch they got to replace.

Meanwhile, rather surprisingly, the fund managers that got fired also demonstrated superior performance. Equally unfortunately they proceeded to do this after they got fired having not done so well in the three years beforehand. The net result, for the plan sponsors, is that the complex process of hiring and firing appears to have zero effect on investment returns. Indeed, ex the thorny question of costs it may actually reduce their returns.

Seeking Alpha, Finding Omega

This, of course, is simply wonderful. The authors are cautious in their conclusions, noting that the effect of firing the odd manager may have the same effect as the generals who liked to shoot the odd soldier, to encourage the others. They also point out that fired managers may be incentivised to prove the plan sponsor wrong. Either of these reasons could have an effect. But we don’t really believe that, do we?

In fact research from the same stable has already indicated that if the plan sponsors were smart enough they really could generate excess returns – “alpha” in the jargon – by swapping fund managers to capitalize on momentum effects. What they found was
“The general pattern that emerges for domestic and international equity portfolios is as follows. Performance lasts up to a year after portfolio formation. Among winners, this persistence elicits capital inflows, and excess returns subsequently revert.”
Gee, those woods are just full of bears doing, uh, bear stuff ...

Moving Markets

Basically as the managers starting producing excess returns the dumb institutional money started chasing the alpha but succeeded only in scaring the bejesus out of it. Under the weight of new money returns reverted to the mean so rotating fund managers on the basis of, say, a three year period of underperformance is just about perfect timing to catch the bottom of the waves, ditching the old manager just as they’re floated upwards and capturing the new one as they’re beginning the long dive to the bottom.

This level of institutional myopia matters hugely. That these plan sponsors believe that they can somehow time the swapping of their mandated managers is the private investors’ equivalent of ditching poorly performing stocks to purchase the latest and greatest growth stock. Only on a huge, massive, market moving scale.

Underperformance of Outperformers

The question is, whether this relentless chasing of superior returns can ever be worth it. Well, here we can turn some more research, from the ever-excellent Brandes Institute, where some bright spark who understands the concept of mean reversion and the inevitability of some periods of underperformance, wondered how the very best mutual funds made their money. If you take the evidence of the plan sponsors at face value they seem to be arguing that they expect that their fund managers will outperform some benchmark every single year; but is that likely or even possible?

Well, as Death, Taxes and Short-term Underperformance shows, the probability is that even the best managers will go through significant periods of poor returns. Studied over a decade even the top performing funds managed, on average, to underperform the S&P500 by over 8% during at least one three year rolling period. One (unnamed) fund managed to trail the index by over 40% in one year. All of the top five performing funds managed to underperform at some point during the decade. 53 out of 59 funds appeared in the bottom 10% of performers during at least one quarter and 10 of them managed this for a rolling three year period.

Gissa A Job, Then

Basically firing a fund manager because of a couple of years of poor performance is simply shooting them because you don’t like noise in the system. Bad stuff happens, all the time. The best investors aim to have a margin of safety so that even when the worst happens they’ll be OK, but generally almost any half-decent stock will grow over long enough if you let it go on its merry way.

This is all basic really, the stuff of standard self-help books for investors. What the plan sponsors are doing, like many behaviorally compromised individuals, is chasing returns in the same way a retriever brings back a lit stick of dynamite. Perhaps the people running the plans feel they have to do something to justify their fees because presumably it’s embarrassing just sitting there twiddling your thumbs while performance temporarily degrades. Well, if they’re not up for that onerous duty I, for one, am.

Related Articles: Finance: Where the Law of One Price Doesn't Apply, Basel, Faulty?, Perverse Incentives are Daylight Robbery


  1. Isn't it the very irrationality exhibited by professional investors one of the key reasons why behavioural finance offers insights into one of the major reasons why so few institutional investors outperform the market or have alpha without finding omega either...

  2. "chasing returns in the same way a retriever brings back a lit stick of dynamite."

    Ha-ha, good stuff.

  3. This is what we know I think. Do all the high level research you want. Use the highly paid, super intelligent staff at CALPERS. Bring in the leading behavioral finance experts. Employ the Nobel Prize winning economists from the now defunct Long Term Capital Management. Come up with your top 10 stock managers in the country and pick the best three. Give them $10 million each and tell them to beat the S&P 500. What we find is that over the ensuing 10 years they basically match the index. In other words 3 out of the 10 will outperform but we can't pick ahead of time which 3 it will be.
    It is why even the largest funds in the country with highly paid staffs index up to one-third of their assets.
    If there was a $20 bill lying there someone would have already picked it up.

  4. My view is that there are thousands of twenty-dollar bills just sitting there waiting to be picked up. But most of us refuse to look at them, much less pick them up.

    The entire idea that professionals should do better than average investors is rooted in a presumption that effective investing is an intellectual game. No! This is a primarily an emotional game.

    The thing to check is whether those who lower their allocations when prices get out of hand do better in the long term or not. It is overvaluation that signals investor emotion. If we find that those who know that prices matter always do better in the long run, that should tell us that it is emotional savvy that matters in investing, not intellectual savvy.

    The ones who believe that it is intellect that matters keep using intellect-rooted tests to see whether they are right or not. Intellect-rooted tests can never tell you much about the realities of stock investing because this is not an intellect-driven game. We need to study the effect of emotions. Which means studying the effect of valuations, the only numbers-related evidence we have of the effect of emotions.

    Both professionals and average investors who take valuations into account have always done better. It is not how much you study this stuff that determines whether you do well or not, it is how open you are to considering the effect of emotions/valuations.


  5. Rob,
    that was very, very, well said. I have always had a joke running in my office. It goes like this, "If you want to lose 100Million Dollars as an institution, make sure to hire an MBA to run the money. However, if you want to lose a Billion Dollars, make sure to hire an MBA who also has a CFA".....

  6. It is more than emotions. I come from the institutional side and I can tell you its more than emotions. In 1998 everyone looked at each other and said it was crazy but did they do anything? If they had raised cash then by the beginning of 2000 they had lost big clients and maybe were out of the business. It turned shortly after that but the market could have gone higher for another couple of years.
    Look what happened to Bill Miller's fund when he was on the wrong side of the market!