This article first appeared as part of the Research Roundtable at Fiduciary Wealth Partners.
Written by Elisabetta Basilico, PhD, CFA and Preston McSwain
What people buy and sell can be influenced by prominent figures. Social media calls these people influencers.
The influencers of the investment world tend to be large investors, such as pension funds, large foundations, and endowments. Countless articles are written on how Yale, CalPERS, and other prominent so-called allocators invest, with the assistance investment consultants.
This is understandable, as collectively these institutional investment allocators manage $37 trillion. They have significant resources, connections, access, and spend large amounts of money on finding top investment managers. It is often suggested that other investors “need” to follow their lead and join their “club” to be pioneering in search of value. They truly influence much of the industry.
Considering all of this, more and more researchers have been evaluating how these evaluators have done, asking this question:
Do these trillion dollar influencers consistently add value?
Some have done well, but as a group, research continues to question their manager selection skills.
Last year we summarized a 2015 peer reviewed academic study that asked this question:
Our answer according to this research was, “No.”
More recently, academics from the University of Lausanne, Arizona State University, and Purdue University asked similar questions.
In a paper published by the Swiss Financial Institute, Choosing Investment Managers, Amit Goyal, Sunil Wahal, and M. Deniz Yavuz analyzed investment manager hiring decisions made on almost 800 managers by 2,005 global institutional investors from 2002 – 2017. Collectively the influential allocators studied manage over $1.6 trillion in assets.
Using regression analysis techniques, the researchers took a relatively novel approach. They not only looked at managers that were hired, they also looked at managers that were not hired. By doing so, they were able to come to conclusions on the effectiveness of an institutional manager selection process. In summary, they were asking this more real-life question:
Did actual final hiring decisions add value over other options that were both available and could have been considered?
To help put their findings in context, the researchers started by reviewing how allocators of investment funds pick managers.
The institutional process of selecting managers often starts with the hiring of an investment consultant, who strives to find and hire top performing investment funds. Think of them as the retained headhunters of the investment world. They are paid to keep track of who is good and match investment manager skill with the needs of investors.
Investment consultants generally send out questionnaires and request for proposals (RFPs). They collect significant amounts of quantitative information on a manager’s experience, resources, background, type of clients, and long-term performance record. You might think of RFPs as detailed job applications.
Managers who make it through the application process are then invited in for job interviews or finalist presentations. Allocators, often with their investment consultants, may also visit with a sub-set of the finalists at their home offices and speak with references, to access qualitative factors.
At the completion of the manager selection process, institutional investors tend to hire managers based on recommendations from their investment consultants.
From our experience of being on both sides of this, both working for investment managers and allocators, selection methods place a lot of emphasis on understanding a manager’s philosophy and evaluating an investment manager’s process. By collecting information on the philosophy and process of investment allocators and their consultants, and analyzing their manager selections, Goyal, Wahal, and Yavuz somewhat turned the tables, evaluating the evaluators.
This is what they found.
“Clear evidence of return chasing.”
If a manager did not have recent performance that ranked in the top quartile of their peer group, they had a lower probability of being hired.
Quoting the researchers, “selection based on prior performance could be rational if there is persistence in performance.”
Many studies have consistently shown, however, that this is not the case. As an example, a 2018 report on the performance persistence of managers found this:
“An inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status.”
“It is worth noting that no large-cap, mid-cap, or small-cap funds managed to remain in the top quartile at the end of the five-year measurement period.”
Based on this, it came as no surprise when we read this related to the following chart from the new paper:
“On average, [final manager] selection generates negative returns relative to the opportunity set.”
Looking at equity manager searches, where both fees and performance differences are higher, managers that were selected underperformed managers that were considered, but not hired, by an average of -1.1% over a three year period.
The paper goes on to say that investment manager selectors “do not show discernable selection ability.” As they also say, their research “paints a grimmer picture” than past studies, due to their analysis of actual hiring decisions as compared to opportunities investors had, but did not chose.
How large might this opportunity cost be?
“Even a [0.50% difference] multiplied by $1.6 trillion in mandates implies a [lost opportunity cost] of $8 billion.”
Next, the researchers found this….
Clubby Relationships Matter
Good news was found for asset manager CFOs. Dinners, trips, conferences, and rounds of golf at private clubs, that the industry is famous for, pay off.
The paper reports that “the influence [of relationships] on the probability that an investment manager is hired is striking.”
Investment managers with prior connections to hiring decision makers, allocators, and their consultants, increase the probability of being hired by as much as 30%.
As with being anchored on past returns, being anchored on connections also seems to negatively impact returns.
Researchers state that multiple forms of analysis produced “statistically significant evidence that [allocator and consultant] connections to investment managers generate worse return outcomes.”
Even though we often hear investors claim that connections, premier access, good partnerships with managers add value, Goyal, Wahal, and Yauz state this:
“There is not support for the idea that connections improve returns.”
“Returns of firms with direct relationships [to investors] are worse than those without.”
In addition, it seems that…
Fees Don’t Matter
Due to the connections and influence that institutional investors and consultants have, one might expect value added fee negotiations – for managers that were hired by investors to have lower fees than managers that were not hired.
Connections seem to again not have provided much benefit, though, as it was found that “connections are unrelated to fee levels.”
“Lower fees are not a compensating differential for lower returns” of the connected managers that were hired.
Empirical analysis of data finds – again – that allocators and consultants don’t seem to be good at selecting the correct managers at the correct time.
It can be hard to resist following prominent investors that have good looking return presentations – the “Halo Effect” is indeed strong.
What should investors do?
We continue to recommend that investors not be passive, and actively resist the call from those who say they can consistently pick top managers.
Research is consistent.
Many influencers seem to be influencing trillions the wrong way.
The Selection and Termination of Investment Management Firms by Plan Sponsors – Journal of Finance – Amit Goyal and Sunil Wahal – 2008
Can the Best Stock Pickers Still Beat the Market? – Elisabetta Basilico, PhD, CFA and Tommi Johnsen, PhD – 2020
Does Past Performance Matter? – S&P Dow Jones – 2018
Are Selectors Good at Selecting? – Elisabetta Basilico, PhD, CFA – Research Roundtable – 2019
Stay It Ain’t So, Joe – Preston McSwain – Fiduciary Wealth Partners – 2017