(October 1, 2013) – We know we shouldn’t, but it seems we still do: Aon Hewitt EnnisKnupp has reminded investors about the dangers of only looking at recent performance when selecting a fund manager.
Analysis carried out by the consultancy of outperforming and underperforming fund managers across the world showed the idea of mean reversion to be factually correct, meaning what performs well today won’t necessarily perform well tomorrow.
Mean reversion theory suggests that strong periods of outperformance can be followed by less attractive results, and that frequently strong periods of underperformance can be followed by improved returns.
The study looked at two distinct groups – equity managers which were below benchmark performance after looking at five years’ worth of returns up until 30 June, 2008, and those equity managers who outperformed over the same period.
EnnisKnupp then tracked the performance of both groups, relative to benchmark, in the subsequent five years to June 30, 2013.
The data, provided by eVestment Alliance, showed that those underperforming managers saw their returns improve, while the high flyers saw their returns fall.
“These trends can directly impact client portfolios when making decisions about hiring and firing managers. Typically clients terminate managers after periods of underperformance. Our analysis shows that investors can be better off by being patient with underperforming managers, especially those that have not experienced material changes in staff or process,” wrote Chris Riley, associate partner at EnnisKnupp.
“Investors are also better off selecting managers based on criteria other than just chasing past returns; managers that are hired after a strong run of outperformance often have difficulty sustaining significant levels of outperformance.”
The full report can be found here.
It’s not just investors who are accused of getting the hiring and firing decisions wrong though: on an equal-weighted basis, US equity funds recommended by consultants underperformed other funds by 1.1 % a year between 1999 and 2011, according to analysis by Oxford University’s Said Business School.
Mitesh Sheth, consultant at Redington, accepted that some consultants were guilty of box-ticking when it came to manager research, but stressed there were ways of “getting under the bonnet” and choosing the right fund manager.
Sheth said: “Fund managers are hugely incentivised to say the right thing and to avoid saying anything that might cause concern. The rewards for getting it right are massive and the cost of getting it wrong is bigger.
“Fund managers get coached, briefed and trained ahead of due diligence research visits. Only the best communicators are usually presented to researchers. This understanding is so ingrained that roles and promotions often depend critically on communication skills in consultant and client meetings. These many layers of polish take some getting through.”
To cut through the polish, Sheth recommends doing the following:
1) Compare stories for accuracy across different individuals in a team or have face-to-face meetings with all the managers of a particular strategy/sector in a short period of time;
2) Interview people at all levels of a company from CEOs, to fund managers and analysts, to risk managers, operations, and support;
3) Retain an element of surprise and visit managers at short notice; and
4) Appeal to the “better angels” of fund managers’ nature, and share your own research, on the chance that it moves the discussion towards an honest basis of engagement.
You can read more of Sheth’s tips here.
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