Ah, yes, past performance is no guarantee of future results. How familiar is that disclaimer — and how often ignored! Investment professionals have long maintained that chasing returns by switching money managers is like trying to make headway in heavy traffic by changing lanes, only to find that the lane just abandoned zooms ahead faster. Yet, just like impatient drivers, plan sponsors dissatisfied with a manager that underperforms in one year will replace it the next with a hotshot that has been posting stellar returns, only to . . . well, you know the story.
Conventional wisdom holds that such knee-jerk reactions are counterproductive at best, but until now that has been an unquantified assumption. Recently, though, three academic papers have put hard numbers on the harm that performance chasing can do. Though the studies’ methodologies differ, their conclusions are similar and stark: Within the first three years, the annualized performance of newly hired managers lags behind that of the fired ones by about 1 to 2 percentage points. A big plan will quickly find itself out millions of dollars in missed returns and transaction-related expenses.
“Plan sponsors should be going to the beach instead of hiring and firing managers,” says Boston University School of Management associate finance professor Scott Stewart, a former portfolio manager at Fidelity Investments and State Street Global Advisors and co-author of two of the papers. “On average, they’re hiring the winners, who turn into losers.”
Stewart and three colleagues analyzed hiring, firing and returns data from 1985 to 2000 of 7,000 institutional money managers that had more than $4 trillion under management at the end of the period. Typically, the prior year’s star managers took in almost twice as much new money as the laggards. They then proceeded to underperform the former laggards by 3.2 percentage points in the first year and by an annualized 1.9 percentage points over three years. Multiplying the percentage underperformance by the amount of money that flows from terminated managers to new ones, Stewart’s group calculated a total annual loss of $20 billion.
Separately, Sunil Wahal, a finance professor at Arizona State University, and Amit Goyal, an assistant finance professor at Emory University, looked at the hiring and firing decisions of 3,400 plan sponsors from 1994 through 2003. They found that both fired and newly hired managers, on average, turned in middling performances for the first two years, just meeting their benchmarks. But after three years, the fired managers outperformed their benchmarks by 3.3 percentage points; the hired ones outperformed by only 1 point.
Both sets of researchers found manager switching to be common. About 8 percent of the assets in Stewart’s sample got shifted annually. Wahal and Goyal counted 15,000 manager hirings in their time frame. The most cited reason for changing managers was performance and, particularly evident in Stewart’s data, the most-recent one-year returns.
It’s not just diminished returns that make manager churn a bad idea. Pension plans also must pay for consultants, searches and the trading costs of liquidating and then buying the various portfolios. Carl Hess, director of Washington-based Watson Wyatt Worldwide’s investment consulting services, estimates that these ancillary expenses can amount to 2 to 5 percent of the assets moved.
So why do sponsors keep switching? Stewart sees it as a “hardwired” aspect of financial behavior. Hess says it’s a consequence of misdirected, short-term thinking; Wahal suggests that pension officers mistakenly believe they can time the market. “Another possibility,” Wahal adds, “is that plan sponsors have to show they’re doing some work.”
Of course, there comes a point where consistent losers truly need to be dumped, and a plan sponsor’s taking that action can have a beneficial “discipline effect” on other managers, says Wahal, shaking them out of complacency. But such decisions should take into account qualitative factors beyond short-term performance. Gino Reina, a vice president at New York–based investment consulting firm Segal Advisors, says his firm urges clients to focus on issues like “stability of the organization and stability of investment personnel,” as well as whether the market environment is conducive to a manager’s investment style. Realistically, says Reina, “Over a five-year period, the manager isn’t going to outperform every year — though clients seem to demand it.”
IIMAGAZINE.COM EXTRA: Research on manager-switching and its costs
By Professors Amit Goyal and Sunil Wahal
