Investors are always on the lookout for a successful fund manager, so there is a vast array of academic research on how to find one. Identifying successful people in active fund management seems easier than in other industries, as there are huge data sets associated with specific fund bosses publicly available; by contrast, there are probably many reasons and people behind the (latest) failure of Marks & Spencer’s womenswear collection or the surprising success of a new car model. So what does the data tell us?
Is there no substitute for experience?
An old adage says there is no substitute for experience. Andrew Clare, associate dean and chair of asset management at London’s Cass Business School, set out to test this idea. Using data from the fund platform Morningstar from 1986 to 1995, he examined the performance of 93 “experienced” fund managers – those in charge of the same fund for at least ten years. The mean tenure of this set of fund managers was 17.4 years. Analysing their performance data, Clare found little evidence to show that good performance persists over time. There was also no evidence that how a manager performed in the first five years of their career was in any way predictive of how they would do over the last five years.
“We found that the benchmark-adjusted performance of these managers was good in their early careers, but that this performance tended to decline the longer the manager was in place,” says Clare. These managers may have had a good start owing to luck or skill, but then their luck ran out or their skills deteriorated. “Another complementary and equally plausible explanation” is that as time passed, initially successful managers became increasingly loath “to risk their reputations and their careers by continuing to take the risks necessary to outperform their benchmarks”.
Either way, don’t assume a highly experienced manager will necessarily produce better returns than his neophyte counterpart. Interestingly, however, for those investors who would still prefer to plump for an experienced fund manager, Clare’s analysis reveals certain additional key traits that are related to positive performance: relatively low fund fees, concentrated portfolios and a small-cap bias.
Ruthlessness won’t help
Next, the stereotype of the aggressive, ruthless Wall Street trader has given rise to the idea that people with certain personality disorders can thrive in the world of finance. Do ruthlessness, a lack of empathy and remorse, superficial charm and boundless self-regard actually increase returns? A team of academics, led by Leanne ten Brinke, a social psychologist at the University of Denver, explored the “psychopathic, Machiavellian, and narcissistic tendencies in 101 hedge fund managers” last year.
The researchers watched video interviews of these 101 hedge fund managers. They took notes on how each manager behaved. Did they dominate the conversation at the expense of others? Did they show any signs of embarrassment? Did they talk about themselves excessively?
What they found was that managers with greater psychopathic tendencies and narcissistic traits produce lower returns than their peers by 1% a year. “When choosing our leaders,” they argue, “we should keep in mind that psychopathic traits – like ruthlessness and callousness – don’t produce the successful outcomes that we might expect them to.”
Psychological studies have also shown that we are intuitively good at gauging other people’s personality traits. So, next time you’re making an investment decision, look up a video of the manager and pay attention to your gut feeling. Don’t assume that their ruthlessness or apparent powers of persuasion will work in your favour.
Equally, it helps to be aware that everyone has a tendency towards mild narcissism: we can get far too keen on our own stocks or funds. The subconscious thought process appears to be that if we bought them, they must be good. In their famous 1990 study on the “endowment effect”, US economists Daniel Kahneman, Jack Knetsch and Richard Thaler divided participants into buyers and sellers, and gave out coffee mugs to the sellers. The latter were offered the chance to sell the mug, and on average demanded a price more than twice as high as the sum a buyer was willing to pay. We overvalue what we already own.
Can there be too many cooks?
Another area of interest is whether two heads are actually better than one. Some asset management companies promote the idea of teamwork, while others focus on one “celebrity” fund manager. Sometimes, two managers work together because they have two areas of expertise. Those who advocate a team approach might partly be mitigating the risk of a high-profile manager jumping ship.
But employing two people at the helm is more expensive. Out of 384 funds in the UK All Companies, UK Equity Income and UK Smaller Companies sectors in 2017, 270 were led by single fund managers, according to Morningstar. Meanwhile, 88 funds were managed by a pair. And 26 funds had a trio at their helm. So the large majority of funds (more than 70%) are run by a single manager.
In 2016 Professors Sergei Sarkissian at McGill University and Saurin Patel from Western University studied the performance of 4,000 US funds managed by single managers and teams. Looking at the funds’ performance figures, they found team management leads to better investment returns.
On average, team-led funds outperformed single- managed funds by 0.3%-0.5% a year. They explain that co-managers do better because team members temper their colleagues’ overconfidence, and are therefore less likely to overtrade and risk trading costs reducing returns. All long-term investors can greatly benefit from keeping their trading frequency down and incurring fewer charges.
Another advantage of teamwork is that it can help to keep biases at bay. Andrew Wheatley-Hubbard co-manages The BlackRock Global Income Fund with
Stuart Reeve. Commenting on the advantages of a team approach, he told Money Observer: “The debate has to be frank. You have to be able to tell the other he’s a moron [knowing that] when you walk out, that doesn’t influence the next debate.” He reckons that “behavioural biases are much easier to spot in other people” than in oneself.
Three is the magic number
Sarkissian and Patel’s study also found teams with three fund managers are “golden”. They generate the highest returns compared to both single and pair fund managers. That is because three people provide more diversity of information. But once there are more than three co-managers the group becomes unwieldy. The upshot is that up-to-three cooks don’t spoil the broth. In the same vein, investors can benefit from getting a second or third opinion. Discuss investment choices with a friend, and test your reasoning.
In another study, Sarkissian and Patel discovered a further advantage of the team approach: they cheat less. The activity of “portfolio pumping”, whereby fund managers illegally inflate returns by buying more shares of their holdings just before the quarter ends, is more pronounced among single-managed than team-managed funds.
That’s a result of what they call “peer effects”. When two managers work together on the same level, they are better at keeping an eye on each other’s behaviour and actions than their employer would be. This kind of “monitoring” can create greater peer pressure to adhere to the right behaviour.
There is another reason they cite for why teams are less likely to cheat. Since fund managers’ compensation is tied to attracting new inflows of money to their funds, they have a strong incentive to inflate their performance when it’s time for reporting. But for teams, who share monetary incentives, cheating is less worth it. Sarkissian says that at the same performance level “cheating is less profitable to team-managed funds” – another reason to consider the dynamics of how your investments are managed.
Find a fund with male and female managers
A final intriguing pattern is that mixed-sex teams work best. In the UK, 11% of funds are led by a team of both genders. A study earlier this year by Citywire analysed the performance of 16,000 fund managers. They found that over three years, teams made up of both men and women produced a 0.5%-4.3% greater return than teams made up of just men, or just women.
Commenting on the findings Nisha Long, head of cross-border investment research at Citywire, says: “Female-only teams tend to have lower risk, while male-only teams have higher risk.” She adds: “A mixed team’s returns can be less volatile and produce more alpha.” That is, together, men and women hit the right level of risk.
However, others reject such beliefs. “There is a feeling that many women are more risk-averse than male investors. That may be true among asset managers, but I would argue there are many female traders I have worked with who were pretty punchy themselves,” says Paola Binns, senior fund manager of several fixed income funds at Royal London. “That said, I do think there is a feeling among asset managers that female fund managers are more likely to act with a moment’s pause rather than jumping straight into something.”
But gender generalisations aside, this is a powerful reminder that instead of jumping on a bitcoin bandwagon or following the herd into the latest racy biotech, you can save a lot of money if you “act with a moment’s pause”.
This feature was originally published in MoneyWeek on 19 October 2018: https://moneyweek.com/496620/what-makes-a-successful-fund-manager/