Fund Manager Selection Part 1; The Private Investor

by Erik L. van Dijk

On days like today, when stock markets bounce back like crazy and fears about the deepest recession in decades (that were talk of the town one week ago!) seem to have been forgotten, it is good to lean back and analyze some older research material. One of our specializations at Lodewijk Meijer is fund manager selection, based on our best-of-breed selection methodology. Our clientele consists of institutional investors like pension plans, banks et cetera. If there is one thing that we can learn from this crisis it is that both institutions and private investors make mistakes, albeit different ones. Private investors are prone to tunnel vision and myopic decision taking as a result of which they tend to take the same decisions at the same time, often guided by panic, fear and greed. Professor Hersh Shefrin’s book Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing should be made mandatory reading material for serious private investors. And that behavioral topics remain fascinating year after year, both in investing and other issues in life, was also shown last October when I organized a seminar in cooperation with French asset manager Ed. Rothschild Asset Management (EDRAM) for a Dutch audience of institutional investors. An old friend of mine, Professor Shlomo Benartzi of UCLA, was one of my keynote guests and Shlomo did what he always does: delivering a great speech, showing the audience what kind of amazing mistakes people make especially under stress or when faced with fear or greed situations.

But to what extent are there differences between Private Investors on the one hand, and Institutional ones on the other? Are the professionals really better? On the one hand one could say that pension plans and other institutions did at least not overreact when the credit crisis was on its way. When markets plummet and you cannot stop things anymore, because the fearful and panicky colleagues wanna hear just one word (SELL!!), you can better sit and wait and make sure that you hold fundamentally strong stocks in your portfolio, that will rebound as soon as markets come to realize that the overreaction has gone too far. The relatively low trading volumes of the recent months indicate that at least quite a few institutions are indeed playing their waiting game in a discplined manner, be it directly or indirectly when they have outsourced their investments to an external asset manager.

So that leaves hedge fund managers that have to unwind their excess leverage and the private investor as the main source of the incredible negative momentum of the last 12-15 months. They were selling, Western institutional investors – in as far as they weren’t banks that were struggling to survive after being fooled into terrible over-levered products by hedge fund managers or their own internal, ignorant staff – were doing nothing and the highly liquid wealth fund investors from China, Singapore and the Middle East were basically still waiting (with a few exceptions like Ping An, the Chinese insurance firm that stepped into Fortis at exactly the wrong moment).

But what was also clear, was that there was a separation within the Private Investor community. On the one hand, we had the private investors that invest directly in individual stocks and on the other hand we see fund investors. Now, research has indicated that it was especially the latter group that has caused the negative momentum. As if they did not want to hear the words ‘investment’ or ‘mutual fund’ anymore. It is therefore nice to analyze how this group of investors ‘thinks’. Jones, Lasseig and Smythe wrote an interesting article in the Journal of Financial Planning back in 2005 entitled Financial Advisors and Mutual Fund Selection. It is interesting to link their results to what we witness in today’s credit crisis. Markets that go down like crazy, many percentage points a day, when there is one negative piece of macroeconomic information, to markets that like today go up like crazy because of an email by mr Pandit, the CEO of Citibank, indicating that results of the first 2 months seem to be more than OK. Relief follows and there we go: 5-7 percent positive return in a day. Both are equally insane: the sudden drop (that didn’t kill us) and this ‘Phoenix from the ashes’ style price increase. The end of the world was not near, and neither is everything solved now. Only things we can be sure of:

a) There is liquidity out there, and it is in the hands of the wealth funds in Asia and the Middle East;

b) When interest rate cuts continue, we end up with an almost zero interest rate and that will trigger a return to stocks from the side of private investors and their advisors (including the mutual funds they use); and

c) The same interest rate cut will also make the cost of capital for firms so much lower that even the most risk averse might start to think about direct investments again.

When we add the effects of a, b and c up, we can be sure that the downward overreaction will be reversed. But unfortunately: it is almost equally certain that we will then move back to an also exaggerated positive momentum. In other words: excess price volatility around the volatility of the fundamental or fair value of stocks will remain, as already indicated many years ago by scholars like Robert Shiller and John Campbell. Compare for instance Shiller’s book Market Volatility.

So it seems that we have to ride the bandwagon and go with the flow. It is therefore good to know how the private investors using mutual funds take their decisions. If you cannot beat your enemy by being the only sane, rational guy out there, you better understand them and predict them! So let us get back to the Jones, Lasseig, Smythe (JLS) paper and study their results. Earlier research had already indicated that private investors focus strongly on a) mutual fund marketing and advertising when deciding which fund to buy (with later rumours and bad news being a strong beacon in mass selling actions); and b) raw returns. High absolute returns are proof that one should buy, and low absolute returns are a selling signal. Now, with studies showing that the average returns on asset classes are relatively stable, we can only conclude that this is exactly wrong! It is much better to buy when things are cheap and sell when things are expensive! The old work by De Bondt and Thaler on overreaction, as published in 1985 and 1987 confirms this. Only over shorter time frames (e.g. up to a year) are momentum strategies useful as part of a technical trading tool box.

But it is clear that a large part of the private investor community investing in mutual funds is not taking decisions alone, or they might not even be involved at all. There is a large financial planner and bank advisor community out there that ‘helps’ the unsophisticated private investor when picking or selling mutual funds. The JLS paper focuses on these advisors. About two-thirds of the private investor community uses such advice. Are these specialists mitigating mistakes that private investors themselves are prone to make?

The answer is yes. First of all, the advisors are not mislead by fund advertising as much as the DIY investor is. Second, they often have at their disposal comprehensive datasources like Morningstar or Lipper. Third, unlike many private investors they don’t make the mistake to look at raw returns only, but they also check relative return (i.e. return in relation to the return of a peer group or investor benchmark).

But were the advisors without flaws? Not at all! What went wrong is the following: advisors to private investors were sensitive to two common mistakes, namely

a) They paid not enough attention to fund costs and fees. Earlier research by Mark Carhart, now a big guy at Goldman Sachs Asset Management, has indicated that – if anything – the best funds were not the most expensive funds, but the cheaper ones. Reason: a good fund manager doesn’t want to make money via some kind of above-average fixed fee. No, he wants to attract money with a relatively low base fee, so that his assets under management become bigger (larger fee base) and then consecutively, he really likes to score through an excess-return related performance fee.

Isn’t it strange that the advisors paid so little attention to fees? Yes and no: on the one hand it might be logical to think that expensive is better, just like it is in for instance the car industry. A Mercedes is more expensive than a Hyundai and yeps, on average it is a better car. It is also logical when thinking about the following: advisors are also human, and they have to eat. To some extent higher fees might be higher, so as to allow the fund manager to pay a kickback fee to the financial planner/advisor. That would then explain a compensating effect that neutralizes the fee level factor. On the other hand, it is illogical not to look at fees according to Carhart. High returns from the past are no guarantee for the future. On the contrary, there is some mean reversion going on. Good managers of the past become on average less good in the future, and the lousiest of the past are on average not so bad in the future. Now, with fee levels being far more stable than returns, it is not logical not to take a more sophisticated look at them and incorporate them in the analyses. Remarkable: in most of the 18 asset classes in our proprietary selection system we did indeed derive quantitatvely that there is a negative correlation between fees and future results. We embedded the cost factor within our decision framework, and would be more than happy to provide you with more information about this, if you are interested in our manager selection services.

b) Fund reputation. Size matters far less than the advisors thought. Again, advisors are human. They are on the one hand – as we indicated above – better than their clients in that they are less sensitive to fund advertising and raw returns, but on the other hand did they turn out to be more than sensitive to ‘fund family size’. Big institutions with well-respected names got a much larger appreciation rating than they actually deserved when compared with nice boutique asset managers. Good fund boutiques need to score better results and work harder to convince financial planners/advisors than well-known big, fund factories do. And this is a big mistake. If anything, we often see that strong teams of investment managers working in big firms leave the big firm to start their own boutique.


* Private investors that follow a DIY strategy in mutual funds are too much advertising and raw return focused. It is therefore logical that their ignorance is quite often translated into big disappointments, like in the 2008 credit crisis period. Nothing like the expected returns and nothing like the promises from the advertising really materializing!

* Financial advisors did a reasonable but not fantastic job in helping the private investors that felt that they couldn’t do the job themselves with their selection process. On average they did improve that decision process in some areas. However, a mix of potential agency problems (do we buy what is good for the client, or what provides us with a nice distribution fee?), status-related factors (we love to work with the big guys) and ignorance about cost related factors in the selection process, makes them far less effective than they should. In other words: manager selection is a special field, and just like stock picking not something every or the average accountant, bank employee, or broker is capable of. The good specialist selectors like ourselves, Russell, Bfinance, SEI and the likes have to be distinguished from the average advisor to private investors.

* There is a market for better, transparent and objective advice to Private Investors. Here in the Netherlands SNS Fund Coach is playing a helpful role, and there are many of those sites in the US. However, objectivity would imply that the data base manager hires some specialist to distinguish between ‘good’ and ‘bad’. Sure, that would still bear the innate risk of the advisor making mistakes, but the alternative – leaving too many things in the database so that the private investor cannot find what is good or bad – is worse.



2 Responses to “Fund Manager Selection Part 1; The Private Investor”

  1. Thanks! I appreciate your compliments!


  2. I personally don’t believe that 2009 will be a year with estimated weak broad market returns. It will be a risky year though. Volatility will remain high. But there are many opportunities to benefit from what will be good, old mean-reversion similar to what we have seen in the 1980s when Werner De Bondt and Dick Thaler wrote their seminar papers on Overreaction (1985 and 1987).

    But obviously, trying to beat the market through active trading strategies is challenging. Just be aware of transaction costs. In the end we have to calculate on a net basis.

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