Are You Still Trying To Catch Light Beams?
Do you dabble in the daunting and predominantly unfruitful process of attempting to correctly stock-pick and market-time in the belief that this is the key to outperform the market? Or are you placing your trust and money in the hands of investment recommendations from organizations such as Morningstar and Lipper? Astonishingly enough, habitually choosing the highest rated stocks or managed funds from these companies is a fool’s errand. Even the multi-billion dollar pension fund industry reacts emotionally to trading in the same way individuals do, which by itself is very surprising since pension fund consultants earn one of the highest salaries in the financial services industry. By hiring highly paid pension fund consultants to hire previously outperforming fund managers and to fire previously underperforming fund managers, the pension fund industry is showing the same overly active investment behavior as individuals do with their privately invested money.
You may be asking why outperforming the market is so difficult, or, why underperformance amongst fund managers occurs so often. Well, the answer can be found in the nature of the pension fund industry. A study performed by Professor Goyal and Professor Wahal in the Journal of Finance illustrates the relationship between hiring/firing and investment performance. Not surprisingly, when performance was positive, more managers were likely to be hired immediately after these excess returns; however, these previous excess return vanished entirely after hiring. Actually, to add insult to injury, consistent losses were generated after hiring. The top hiring reason cited in the study is to replace fired managers while prior underperformance is always cited as a key reason for termination of a pension fund manager. The most shocking result of this study is that the fired fund managers actually outperformed the hired fund managers after having been fired by the respective plan sponsor. Thus, the entire process appears to be completely paradoxical. Wouldn’t they realize that the costs of hiring new managers would have an impact on the previous portfolio performance?
You may be questioning why you should rely on these funds and whether these funds and managers have a specific hiring/firing strategy, or, a hidden investment strategy that sets them apart from the rest. The study also examined style chasing on behalf of the funds. In the pre-hiring performance analysis, there was evidence of style-chasing as well as positive excess returns across all asset classes—the same style of investing individuals exhibit! On the other hand, this style-chasing tendency, similar to that of habitually investing in top rated Morningstar or Lipper rated funds, does not remain successful after having jumped on board this style-chasing strategy. When observing post-hiring performance, the study noted future market underperformance. Consequently, these fund managers actually are engaging in the same behavior individual investors may when investing and hiring/firing—making them no different than yourself choosing stocks. Ultimately, the respective plan sponsor would have been better off by just sticking with the old (underperforming) fund manager.
Because fund managers are compensated with multi-million dollar bonuses, it makes sense that there should be some professional reason or logic behind this madness. In fact, the whole process of hiring and firing performance is completely nonsensical. An illogical habit uncovered is that plan sponsors ultimately hired more on the condition of previous superior performance even though post-hiring performance is almost always underperforming. Because of this lack of persistence in the performance of investment managers, hiring decisions produce negative excess returns. This demonstration is just another example of how even professionals lack timing abilities. Additionally, because of this inability to correctly time the market, underperformance is always the consequence. Furthermore, due to the fact that pension fund consultants are highly-paid professionals and charge a significant fee for their services, their fees serve as a drag on gains following the firing and hiring process which compound with high transaction costs, ranging anywhere between 2% and 5% (based on estimates provided by public press) and between 1% and 2% (based on estimates from an anonymous large pension transition management firm cited in the study by Professor Goyal and Professor Wahal).
Hence, the seemingly intuitive strategy outlined above (hiring during times of success as well as consistently believing that what performed well in the most recent past will continue to perform well in the future) is similar to trying to catch light beams: they are is so easy to imagine, yet light beams are so difficult to catch. Likewise, it is so easy and makes so much sense to image that winning active fund managers will continue to win, but such winners are equally hard to catch consistently once added to the portfolio. In fact, there seems to be a regression to the mean in the data, where past winners are significantly more likely to be future losers and past underperformers significantly more likely to be future winners.
And, after all, isn’t it obvious that merely eying past performance is akin to driving a car in forward motion by only looking into the rear view mirror? Don’t use your fund picking strategy as a template for your car driving strategy. In both cases, you are better off ignoring past portfolio performance and trusting the insights of academically clean portfolio structure—looking to the future (i.e. the road ahead) rather than the past.