Are institutional investors any better at dealing with short-term underperformance?

No. They are just as likely as an individual investors to fire poorly performing fund managers and hire managers with strong recent performance.

Readers of my post on Beating the Market Part 2 – Short-Term Under-performance would have seen the example of the CGM Focus fund, the best-performing U.S. diversified stock mutual fund from 2000-2009. The fund had an annualized return of 18%, while the average investor lost -11% (dollar-weighted returns) due to trading in and out of the fund.

Institutional investors, such as pension funds, are plagued by the same behavioral biases that influence all of us.

Amit Goyal and Sunil Wahal compiled a unique database of 8,755 hiring decisions by 3,417 plan sponsors that delegate $627 billion in mandates between 1994 and 2003.

The results of their study can be found in their paper: The Selection and Termination of Investment Management Firms by Plan Sponsors. They found that.

To summarize, we find that plan sponsors hire investment managers after superior performance but on average, post-hiring excess returns are zero. Plan sponsors fire investment managers for many reasons, including but not exclusively for underperformance. But, post-firing excess returns are frequently positive and sometimes statistically significant. Our sample of round-trips shows that if plan sponsors had stayed with fired investment managers, their excess returns would be no different from those actually delivered by newly hired managers.

Institutional investors sack fund managers with poor performance, and hire managers with strong recent performance. The round trip costs – trading, market implementation and tax – are significant. The paper estimates that these costs can range from 2-5% of the assets invested in the fund, depending on the fund or strategy.

Even if the new manager is an improvement over the old one, it needs to beat the market by 2-5% just to break even.

But here’s what happens. As I mentioned in my post, the performance of even the very best fund managers is cyclical. Stated another way, it’s impossible to beat the market over the long-term without enduring periods of underperformance.

These periods of under-performance may last longer than the customary 3-year pain threshold of most institutional investors. So they fire the manager, just before the fund manager’s performance starts to improve! 

The paper offers three possible explanations for why institutional investors might behave this way.

Given our results, a reader could reasonably ask why plan sponsors make decisions that, ex post, appear to be costly. There are three plausible explanations. One is the hubristic belief among plan sponsors than they can time the hiring and firing decisions successfully. We stress that this behavior is not necessarily irrational, especially since there is persistence in performance. A second explanation is job preservation; to quote Lakonishok et al. (1992, p. 342), “those in charge of the plan must show that they are doing some work to preserve their position.” Simply put, if plan sponsors did not hire and fire, their raison d’ˆetre would be nonexistent. We find that elements of hiring and firing tendencies, pre-event return thresholds, and post-event performance are related to plan sponsor attributes that reflect these agency relationships; broadly, the cross-sectional evidence is closely tied to this possibility. A third possible explanation is that these decisions are not as costly as our evidence would indicate because we are unable to fully measure the benefits. For example, it may be that termination disciplines fired investment managers and cause them to improve returns in the future. Indeed, investment managers who lose a larger fraction of their assets have higher post-termination returns. It may also be that termination disciplines incumbent (not fired) as well as potential investment managers. Unfortunately, we have no way of measuring this potentially offsetting benefit. Thus, while our results shed light on the efficacy of hiring and firing, we cannot necessarily conclude that these decisions are inefficient. The above explanations are not mutually exclusive. It is quite likely that all three play some role in the process.

The second explanation is a further example of principal and agent problem at work. Institutional investors and the consultants who advise them, need to justify their existence. This need creates the temptation to “do something” and the temptation is at its strongest when a manager has experienced 2-3 years of under-performance.




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