(January 9, 2013) -- Overconfidence from fund managers is a sure sign of diminished returns in the near future, research by two academics has found.
Fund managers who are overly keen to impress are usually victims of their own self-confidence, a study by Arman Eshragi of Edinburgh Business School and Richard Taffler of Warwick Business School in the UK, showed in a study last year.
The pair examined performance of large sample of US mutual fund managers between 2003 and 2009.
They found an "overall inverted-U relationship between fund manager overconfidence and subsequent investment performance. Furthermore, a hedging strategy based on shorting funds with abnormally overconfident managers and going long in funds with normally confident managers yields positive average returns after controlling for Carhart factors".
The pair measured managerial overconfidence by analysing the narratives of reports fund managers wrote to their investors and by using a range of proxies including over-optimism, excessive certainty and excessive self-reference.
They found that superior past performance boosted managerial confidence. This self-assurance was further enhanced in the 12 months following the publication of an annual report.
Growth-orientated fund managers were the guiltiest in the sample, but the study found the same effect across the entire range of asset classes.
The study also observed that over optimism and self-reference were likely to be more representative indicators of overconfidence than certainty, possibly due to the fact that fund managers write their reports in a resolute tone by normal practice.
"The investment industry as a whole, and fund trustees in particular, can also benefit by introducing some type of psychological screening in the fund manager selection process," the study suggested.
"The hiring of fund managers, in its traditional form, is heavily dependent on the manager's past performance record… We argue that by adding certain psychological attributes to the list of critical factors in hiring fund managers, investment companies can raise their chances of recruiting more 'successful' managers."
To read the full study, click here.