By LARRY SWEDROE
One of the mistakes that prevents investors from achieving their goals is that when it comes to evaluating investments and investment strategies, most think three years is a long time, five years a very long time and 10 years an eternity. This is true of individuals and institutional investors (such as pension plan sponsors) alike, as the typical review cycle for institutional money managers is three years. This traditional approach continues even though the research consistently shows that this approach leads to underperformance.
Among the studies finding that the fired managers go on to outperform the new hires that replace them are The Trust Mandate by Herman Brodie and Klaus Harnack, Institutional Investor Expectations, Manager Performance, and Fund Flows by Howard Jones and Jose Vicente Martinez, and The Selection and Termination of Investment Management Firms by Plan Sponsors by Amit Goyal and Sunil Wahal. And Tim Jenkinson, Howard Jones and Jose Vicente Martinez, authors of the Picking Winners? Investment Consultants’ Recommendations of Fund Managers, found no evidence that consultant recommendations add value to plan sponsors.
These studies showed that while plan sponsors hire investment managers after those managers earn large positive excess returns up to three years prior to hiring, if they had stayed with the fired investment managers, their returns would have improved — all the activity was counterproductive.
Despite the evidence demonstrating that manager performance-chasing is a loser’s game, the tradition continues, making this behavior one of the great anomalies in behavioral finance. Why do investors keep repeating the same behavior and expecting a different outcome? Einstein said that is the definition of insanity.
Explaining the anomalous behaviour
The explanation for the anomaly perhaps is that it does seem logical to believe that if anyone could beat the market, it would be the pension plans of large companies and government entities, and the endowments and foundations of universities and very high net worth individuals:
• Given the large sums they control, they have access to the best and brightest portfolio managers—managers most individuals don’t have access to because they cannot meet required minimums.
• It’s not even remotely possible they ever hired a manager with a record of underperformance.
• The vast majority of plan sponsors hire professional consultants to help them perform due diligence in interviewing, screening and ultimately selecting the very best. You can be sure these consultants have thought of every conceivable screen: management tenure, depth of staff, consistency of performance, performance in bear markets, consistency of implementation of strategy, turnover, costs, and so on.
• The fees they pay are much lower than fees individuals pay.
Despite the logic, the evidence demonstrates that the hypothesis is false. And when your hypothesis disagrees with the evidence, smart people throw out the hypothesis, not the evidence. Amit Goyal, Sunil Wahal and M. Deniz Yavuz provide further evidence on the ability to choose future outperformers with their July 2020 study, Choosing Investment Managers.
Goyal, Wahal and Yavuz studied how plan sponsors choose investment managers. Their data sample included almost 7,000 decisions made by 2,005 global plan sponsors delegating over $1.6 trillion in assets to 775 unique investment managers between 2002 and 2017. The data included public plans, corporate plans, endowments and foundations. Their data sample was global, covering 639 unique plan sponsors from 35 unique non-U.S. countries (mostly from the U.K. and Australia). They noted: “The investment of these assets is mostly delegated to external investment management firms with expertise in particular asset classes.”
Goyal, Wahal and Yavuz focused on two primary determinants of manager choice: past performance and the influence of relationships. To measure connections between plan sponsors, investment managers and consultants, they used proprietary data from Relationship Science, a firm that specialises in relationship measurement, especially among financial institutions. The authors explained: “The data provide detailed information on the nature and timing of linkages between individuals, currently or formerly employed by the institutions in our sample.” Following is a summary of their findings:
— Two factors play an influential role in choice: pre-hiring returns, and pre-existing personal connections between personnel at the plan (or consultant advising the plan) and the investment management firm.
— Investment managers connected to plans are between 15 and 30 percent more likely to be hired than unconnected managers.
— Connections between investment managers and consultants who shepherd the search process also increase the probability of being hired by about the same amount.
— There was clear evidence of return-chasing, as the cumulative three-year return difference prior to hiring was 3.34 percent (t-stat = 13.9). However, post-hiring returns for chosen firms were significantly lower than those for unchosen firms. The average three-year post-hiring cumulative returns for hired investment managers were lower than those for the opportunity set by 0.85 percent (t-stat = 2.6).
— While post-hiring returns of firms with relationships generated large and statistically significant negative returns for plan sponsors, fees charged by connected investment managers were indistinguishable from those of unconnected investment managers—fees are not the compensating differential for underperformance.
— The underperformance of hired managers was markedly larger in equity versus fixed income mandates: -0.92 percent versus -0.23 percent in the U.S., 0.80 percent versus -0.44 percent in the rest of the world, and -0.88 percent versus -0.48 percent in public versus private plans.
— While relationships are conducive to asset gathering by investment managers, they do not appear to generate commensurate benefits for plan sponsors via higher gross returns or lower fees.
Their findings led Goyal, Wahal and Yavuz to conclude: “Plan sponsors have no discernible selection ability.” Damning with faint praise, they did add that “the post-hiring performance of investment managers in selection decisions where the consultant was connected to the investment manager is ‘less worse’ than the performance of opportunity set that was not connected to the consultant.”
While consultants may add value in other ways (such as determining the appropriate asset allocation and spending rates), there’s no evidence to suggest that they add value in the selection of actively managed funds. Which begs the question: Why do plan sponsors continue to utilise them for that purpose? One explanation is that they are shielding themselves from blame in case their chosen managers perform badly.
Of course, they could avoid that risk by shunning actively managed funds altogether. The evidence demonstrates that doing so would improve returns and the odds of achieving their financial goals — which is why there is a strong trend by such plans to reduce allocations to active management.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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