Delegation of Investment Decisions Results in Massive Failures
Individual investors delegate investment decision making to mutual fund managers. Pensions delegate investment decisions to institutional asset managers. Delegation is supposed to prevent less sophisticated investors from being the proverbial pig, slaughtered by better-informed bulls and bears. Putting aside the facts that the average investment manager charges just enough fees to extract all of the alpha they create, the delegation of investment decisions has failed miserably along a dimension that has received scant attention.
The modern investment delegation practice is one in which manager skill has minimal impact on the wealth outcome of investors. To fully understand this, we need only examine the buying and selling activities of professional managers. In 1999, when value stocks were as cheap as they have ever been, value managers were the biggest sellers of value stocks. This was also true in 2008. It isn’t at all surprising when we realize that the selling is driven by redemptions! The manager could be doing exactly the right thing by tilting the investor’s portfolio toward value stocks. But by redeeming the allocation to value managers, the investor is able to more than offset the manager’s insight and effort.
Similar to the findings of Brinson, Hood, and Beebower (1986), manager skill has proven to be a sideshow once again. Indeed, the industry’s focus on the “alpha” of managers appears to be a distraction from the “negative alpha” “earned” by investors. Asset managers, at the end of the day, have far less sway on what happens to prices of stocks and investor wealth than do asset owners and their consultants.
The Wisdom or Madness of Crowds
The classic study on the wisdom of crowds suggests that a large collection of investors with different information, experience, and expertise tend to get prices right. Experiment after experiment shows that the crowd is better at figuring things out than the experts. Yet the wisdom of crowds can give way to the madness of crowds when the crowd herds on the same piece of information and/or adopts similar thinking. Experiments show that if the crowd is made aware of the presence of experts, its members synchronize to the expert opinion, and the wisdom that once was, is no more.
When the majority of investors adopt an investment selection process based on recent performance, they are forced to pile into similar stocks belonging to similar styles—that is, they allocate to an increasingly crowded trade. There is little wisdom in the prices that result, though the madness can certainly persist for a long while, creating the illusion of investment “guru”-ness on the part of many.
The Institutionalization of Individual Behavioral Biases
The good news is that style returns or factor returns appear to be predictable. Additionally, a large cohort of mutual fund investors and pensions attempt to time, but do so very poorly because they use an investment selection process based on recent performance. These investors earn negative dollar alpha, on a gross-of-fee basis, and thus provide a large reservoir of alpha to others. The bad news is that we are they. We are the mutual fund investors and the pension fiduciaries. We are our own worst enemy, placing high-fee managers a distant second on the list of people contributing to our wealth destruction.
The prognosis for improvement is unfortunately pessimistic. What started as behavioral biases—that we confuse short-term performance as vital information on manager skill, and that we enjoy blaming others and holding them accountable for random bad outcomes—have been institutionalized.6 No longer can behavioral biases be overcome by the greater mastery of one’s emotional state or by attaining greater investment enlightenment. These biases are now organizational problems that cannot be easily fixed by any single individual in the process. Would a consultant or financial advisor recommend a shortlist of managers with poor recent performance? Would the pension CIO and his staff choose a manager with a negative trailing three-year alpha to present to their layman board? Given a keen understanding of investors’ buying behavior, would salespeople and marketers educate client prospects on products that have recently underperformed? The investment ecosystem has conspired against the end investor. Oddly, the end investor is leading the conspiracy against himself. The path of least resistance is the path most often taken: buy recent performance.
The Individual Investor’s Edge
Given the institutional challenges of traditional investment advice that plague pension sponsors and the wealth management industry, in general, a savvy individual investor could actually have an edge by being a contrarian in the modern investment-selection process. Buy the style that is out of favor and whose stocks are trading meaningfully below historical norm. Sell the popular style and its expensive stocks. The individual investor may be early in buying or selling, but has a far greater ability to deal with that potential discomfort than does an institutional investor. An individual is unencumbered by the constraints and oversights—a board, quarterly reviews, asset-raising goals, angry clients, or other pressures—that dominate institutional investment decision making.
Investors who have the courage to be a contrarian will earn a handsome “fear” premium for taking the other side of the industry’s trades, counter to those who seek to avoid uncomfortable client conversations. For those unable to fully embrace a contrarian stance, they should at least consider adopting a buy-and-hold strategy. Indeed, most investors might benefit from simply forgetting the ID and password to their trading account.
1. See Shiller (1986) and Campbell and Cochrane (1999).
2. The CAPE mean reversion has a roughly 5½-year half-life.
3. See Cohen, Polk, and Voltanahou (2003) and Hsu (2014) for evidence on timing the value premium and Garcia-Feijóo, Kochard, Sullivan, and Wang (2015) for evidence on timing the low-beta premium.
4. This meaningfully captures the practice of institutional investors, such as pension funds and retail investors. Most institutional mandates are awarded to managers chosen from a short list of finalists with strong recent performance. Many retail investors, with or without a financial advisor, select funds with a five-star Morningstar rating, which simply measures recent past performance.
5. To be perfectly fair, the estimated negative return gap experienced by pensions is meaningfully lower than for mutual fund investors.
6. See Hsu (2013 and 2014) and Hsu, Myers, and Whitby (2015).
Brinson, Gary, Randolph Hood, and Gilbert Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal, vol. 42, no. 4 (July/August):39–44.
Campbell, John, and John Cochrane. 1999. “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior.” Journal of Political Economy, vol. 107, no. 2 (April):205–251.
Cohen, Randolph, Christopher Polk, and Tuomo Vuolteenaho. 2003. “The Value Spread.” Journal of Finance, vol. 58, no. 2 (April):609–641.
Frazzini, Andrea, and Owen Lamont. 2008. “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns.” Journal of Financial Economics, vol. 88, no. 2 (April):299–322.
Garcia-Feijóo, Luis, Lawrence Kochard, Rodney Sullivan, and Peng Wang. 2015. “Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios.” Financial Analysts Journal, vol. 71, no. 3 (May/June):47–60.
Hsu, Jason. 2013. “Does Blame Predict Performance?” Research Affiliates Fundamentals, March.
Hsu, Jason, Brett Myers, and Ryan Whitby. 2015. “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies.” Forthcoming in Journal of Portfolio Management (Winter 2016).
Hsu, Jason, and Jim Ware. 2014. “Blame, Accountability, and Performance: When a Firm’s Culture Plays the Blame Game, Performance Loses.” CFA Institute Magazine, vol. 25, no. 5 (September/October):16–17.
Hsu, Jason, Jim Ware, and Chuck Heisinger. 2015. “The Folly of Blame: Why Investors Should Care About Their Managers’ Culture.” Journal of Portfolio Management, vol. 41, no. 3 (Spring):23–35.