Murder by Death (1976): A Tacky Situation
The Financial Analyst Journal of July/August 2012 includes an interesting article about underperformance of institutional money (pension funds etc.): Murder on the Orient Express: The Mystery of Underperformance by Charles D. Ellis. He explains the mystery why institutional investors underperform their benchmark, although they are supposed to be professional and have the best experts at their disposal.
One important driver are the costs of active management: costs for an active equity mandate have risen from 0.1% to 0.5%. Fixed income mandates will be significantly lower, while alternative investment mandates considerably higher.
I have written a post about investors underperforming the mututal funds they are selecting. It is very similar here:
The clients fire underperforming managers and hire managers who have outperformed in the past, expecting the outperformance to continue. Unfortunately, past performance says nothing about future performance.
Suspect # 1: Investment Managers
Client-manager meetings are unfortunately sales meetings. Manager who had a lucky streak the past few years seek prospective clients and present them with their fabulous track record to gain new clients. No manager will admit that markets today are very efficient and competitive, and that it is hardly impossible to beat the market consistently over time. They present their performance as a product of skill rather than luck.Suspect # 2: Investment Consultants
Institutional clients often employ investment consultants who help monitoring hired managers and help selecting new managers. Since no consultant can consistently identify the future winning and losing managers, the consultant will want to diversify into different managers. And the more managers he oversees, the more work he has and fees he can justify. The consultant will want to develop a personal service relationship by increasing the amounts of emails, phone calls etc.Worse, as a consultant, you will not present managers whose investment style suffered in the past few year. You will want to present the investment committee the "winner", but will not tell him, that you are in no position to separate consistently winners from losers. Result: The consulting firm's client will select manager after their best years, and fire managers after their worst years.
Suspect # 3: Fund Executives
Fund executives are usually cautious processing people. But the representatives of investment managers are socially dominant people who are "skilled at closing transactions" with fund executives, called gate keepers among investment managers. Hence, fund executives will be overwhelmed by consultants and the managers sales people.Suspect # 4: Investment Committees
The committee hires usually the the managers whose past performance was most compelling and made the most persuasive presentation (sales skill!)Committees' member suffer usually following handicaps:
- They believe, it is their duty to select top managers and that past performance is a guide for future performance.
- Bevioural finance aspects, like overreacting to recent events and neglecting long term facts (like returns reverting to the mean).
- Listening to closely to an investment consultant, who is primarily following hits own interest.
- Being too much hands on in fields they shouldn't meddle (like investment management decisions) and having not enough time for the important questions of the funds governance.
Conclusion
All involved parties are to blame, yet none will recognize "its own role in in the crime".In my opinion, it is important to keep costs in check and not choose a manager because of his fabulous short term performance. On the contrary, I have recently bought the Julius Baer Multipartner - Gold Equity Fund precisely because their recent performance (this year in USD -17.3%) was bad and knowing that the management team of this fund is very skillful. Also keep in mind, that although capital markets are efficient most of the time, but not always: In the world of efficient markets there shouldn't be any bubbles, and behavioural finance explains why humans often create market anomalies through their irrationality.
