Institutional investors are their own worst enemy due to systematic behavioral biases that rob them of potential alpha, according to Research Affiliates.
The firm’s co-founder Jason Hsu argued that there is strong evidence the equity market premium is countercyclical and predictable using valuation ratios. However, investors’ manager selection process and “trend-chasing allocation decisions” could contribute to persistent low returns and return gaps—and this could be hard to fix.
“The prognosis for improvement is unfortunately pessimistic,” Hsu said. “No longer can behavioral biases be overcome by the greater mastery of one’s emotional state or by attaining greater investment enlightenment.”
“Most investors might benefit from simply forgetting the ID and password to their trading account.”Specifically, investors often use short-term performance as the basis of evaluating manager skill, Hsu said, despite data that show underperforming managers tend to outperform in the future and vice versa.
Though many investors attempt to time alpha, they “do so very poorly,” according to Hsu. “These investors earn negative dollar alpha, on a gross-of-fee basis, and thus provide a large reservoir of alpha to others,” he continued.
Furthermore, Research Affiliates said investors tend to fall victim to herd mentality and often blame others for “random bad outcomes.”
These behavioral biases have now become an organization problem, according to Hsu. Investment consultants are unlikely to recommend managers with poor recent performance, and pension CIOs tend to stay away from managers with a negative trailing three-year alpha.
“The investment ecosystem has conspired against the end investor,” Hsu said. “The path of least resistance is the path most often taken: buy recent performance.”
The solution is to become a contrarian—buying the out-of-favor styles and stocks that are trading below historical norms—and earning “a handsome ‘fear’ premium for taking the other side of the industry’s trades.”
However, this is easier said than done.
“Indeed, most investors might benefit from simply forgetting the ID and password to their trading account,” Hsu said.
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