The game of picking stocks is mirrored in a game of picking managers who pick stocks. The performance effects of playing the active management game are the sum of behavioural impacts at both levels: fund managers and the ‘end investor’ or his/her agent. 

Because most investors playing this game are doing so because they believe past performance is predictive of future performance, rather than random, they will naturally tend to select new holdings from the sample of managers/funds that have performed better than average over some recent period.  If, on the other hand, it really is random (or even much less predictable than they thought), there is a very high chance of disappointment – where disappointment is defined as the ‘unexpected’ slippage of the fund through the rankings table. Consistent with the beliefs they held when they bought, they will now tend to sell, because they will assume that they made a mistake or that the manager in question has lost his/her touch – in other words the new performance is predicting more of the same. Because they have not changed their beliefs, they then go through the same exercise to select the replacement fund. And so it goes on, turning random underperformance of holdings into a non-random string of portfolio underperformance – until they realise it is their beliefs that are wrong. 

This second behavioural effect is under-researched in academic studies, perhaps because the key insight itself has not attracted nearly as much attention as the effects at manager level. However, there are a number of industry firms that survey money-weighted returns in mutual funds (measuring client-experienced average returns): Dalbar, Vanguard and Morningstar. This analysis suggests playing the loser’s game costs up to 6% pa – far more than just the incremental costs of active funds (which in the UK we put at between 0.6 and 2% depending on the buyer’s agency relationships). 

The data available to researchers is fund performance (obviously) and fund flows. But when making a connection between the two there are some problems:

• Both are absolute – so if people sell after poor performance they could be making a market timing decision or a switching decision based on poor relative return but the data won’t tell them which. The two may of course be positively correlated. Given the evidence (in Dalbar’s annual surveys, for instance) that net flows are positively rather than inversely associated with market movements, it seems likely most of the effect is due to poor market timing rather than switching, so a reaction to absolute rather than relative performance.
• Flows are partly idiosyncratic decisions and partly regular contributions/withdrawals but the two are not distinguished.
• Money-weighted return calculations are affected by the sequential pattern of returns and flows – although I’m not convinced this methodology point ‘explains’ the apparent behaviour effect.

In ‘Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability’ (Friesen and Travis, 2007) the authors say this about the relative-return  impulses to trade funds:

In testimony to the United States Senate, investment guru John Bogle (2003) argued that the Dalbar (2003) study ignores an additional “selection cost” borne by investors, whereby investors place a disproportionate amount of money into actively managed funds that subsequently underperform the S&P 500 index. Bogle suggests that after accounting for this selection cost, the average mutual fund investor return over the 1984-2002 period is actually negative.

Whilst it may be difficult to measure actual effects for a universe of mutual fund investors, it is possible to model the behavioural effects to test for the likely scale of impact of the relative-return impulse, by applying some simple decision rules, based on rank orders, for both buying and selling.  This is a project for future research.

It is, however, possible to infer something today about the prevalence of this impact just from observation of a limited sample of portfolios. We have taken in new clients from a wide range of advisers/banks/wealth managers over the past six years. Because our clients have well above-average wealth, their previous agents are typically respected and popular firms, so we would expect them to be less prone than the average to systematic wealth-destroying behaviour. We also take on clients who are more experienced than average and so many have previously been wholly or partly self-directed. Our initial financial planning process for all new clients includes a critical appraisal of existing investment arrangements. We observe, in most cases, the same destructive behaviour by both agents and self-directed investors.

Even in the case of investors with agents, we suspect the investor’s own ‘predicted’ behaviour effectively encourages the agents to sell, because the agents think individuals think that poor performance tells them something about the agent’s skill.

When looking at agent behaviours, it is always sensible to consider whether incentives or game theory might explain them. Whilst I believe this is realistic in the case of fund managers, whose active-management payoffs are quite different from their investors, I do not think gaming validates the behaviour of agents selecting funds. Because both these agents and their clients are acting consistent with a set of beliefs (however false) about skill, it looks more like a case of the blind leading the blind.

‘It’s a miracle! I can see!’ cries Eddie Murphy in Trading Places when rumbled as a ‘blind’ beggar. In investing, miracles do happen and when an investor truly can see, their rumbled agents are unlikely to get away with it. They, rather than their clients, are the ones who should have known better.

Note: This article (in draft) was extensively quoted by Matthew Vincent, FT Money editor, in his Serious Money column on 30th July. It followed a piece the previous week about the first, manager, level of the active-management game titled How fund managers get paid for winning the lottery. You may need to be an FT subscriber to view these articles.

‘Wealth management firm No Monkey Business (NMB) believes the National Employment Savings Trust (NEST) should follow its lead and adopt the principles of Liability Driven Investment (LDI). According to NMB, NEST’s newly-published Statement of Investment Principles (SIP) makes ill-advised trade-offs in its target date funds between short-term, nominal volatility and long-term real outcome risk. The impact is that younger members will be irrationally conservative, middle-aged members will exchange equity risk with inflation risk and older members approaching retirement will be matched to the wrong kind of pension.’

Read the whole article here.

WealthAdviser is published by GFM, ’the largest online news publisher serving institutional investors/wealth managers and their investment managers/advisers across all asset classes’.

Following on from his article Bull in a China shop, Stuart has been quoted in the following articles explaining why buying into the popular fund now is likely to result in tears.

The Independent – Is China a bargain or a bubble?

Times Online – Fresh issue of shares on China fund (this link will only work if you have subscribed to Times Online)

Motley Fool – Emerging markets to watch

Grange St. Paul’s Hotel, 10 Godliman Street, London, EC4V 5AJ

6.15pm for 6.30 start, 7.30 finish

Format
A small group of interested individuals (often including spouses) around a table, the content substantive and provocative, more education than sales, more conversation than lecture, with further opportunity for discussion and drinks after a prompt finish.

Speakers and subject
In this seminar, Stuart Fowler, who was a leading innovator in the management of institutional investments before founding No Monkey Business, will explain how and why private client advice and portfolio management is not fit for purpose. The consequences of this are most critical for retirees who will be drawing down their own resources to meet their spending in retirement and depending on the products and services the industry can offer.

No Monkey Business financial planning head, Joe Clark, will take you through an approach designed specifically for this purpose, based on the outcomes driven (or liability driven) investment techniques that have already overturned the traditional approach to occupational pension management. Adopting these techniques in private wealth management has been endorsed by academics but also by the professionals that work in private wealth firms.

Stuart and Joe will help you to visualise how different the experience can be when you work with the best techniques, delivered by smart people who are totally on your side.

Benefits of attending this seminar

• Powerful insights into the essential principles of drawing down from capital (whether in a pension account or other forms) when subject to particular constraints, such as competition from other financial goals; maintaining purchasing power; sustaining the rate of draw through bad markets; control and flexibility
• This should encourage you to think about your own needs in a different light and how they could be best met
• An opportunity for you to meet a firm that is successfully challenging the banking, stockbroking, tied agencies and IFA businesses who currently work with professional people.

Who attends
We invite people like our existing clients: high earning professionals that appreciate smart thinking, elegant engineering and who expect a professional approach to charging.

We hope to meet you at one of these seminars or by other arrangement. Places are limited so if you would like to attend please respond promptly by email joseph@nomonkeybusiness.co.uk or click here.

With input from a number of IFA’s, Rob suggests they should make special consideration of their client’s profile and requirements, recommendations from other IFA’s, costs associated with the manager, the company’s internal stability and the firms investment experience.

However, commenting on this article, Keith Robertson argues that whilst all of these factors may play a part in this decision, they are mostly unquantifiable and the foremost factor when considering a discretionary manager should be whether the client’s desired outcomes have been achieved. That is what a client is predominantly focused on. We, of course, agree with Keith, and Stuart goes on to suggest in his comment that Liability Driven Investment, which is based on a client’s required outcome, is a far superior alternative.  To read the article and Stuart’s comments please click here.