Dealing with underperforming managers

From CFA Inside Investing. Clients and their advisers see investment managers at their best in new business presentations. Data can be carefully selected for a pitch, or in a brochure promoting a fund. And, usually, investors have a preference for the style they would like in their manager; value or growth, momentum or contrarian. It is easy for an idealised impression of a manager to be created, and clients like to feel good about their choice. Emotion tends to win out over rational analysis, and little thought may be given to any negatives.

But time passes, and the rosy glow of the original selection and analysis may fade. At some stage clients or their advisers may want to re-assess. This is usually because of disappointing investment performance. But, behaviour and style can change when a manager is under pressure.

Now, new research based on extensive interviews with fund management groups, shows how investment behaviour often changes following a period of substantial underperformance. Often, the impact on subsequent investment performance is unhelpful. This is not necessarily a question of incentives, but comes down to personal psychology and the team structure in which professionals operate. Even where this is supportive, personal characteristics and standards can drive an investment professional to act differently. It is an interesting aspect of behavioural finance that has been neglected as a research area.

So, what are the changes to look out for? Greg Richmond and Alistair Byrne, writing in the CFA Institute Investment Risk and Performance Newsletter, found five key changes in investment behaviour that were typically unhelpful. Shifts in risk appetite, shorter time horizons, lower levels of engagement with colleagues, and increases in loss aversion and in confirmation bias were all common changes. The managers themselves might not recognise their own changes, but you can be sure that their colleagues and bosses will. However, it will not feature in investment reports; clients and their advisers will likely need to work this out for themselves.

Individuals often aim to correct their record too quickly, despite having accumulated the underperformance over time. This typically involves distancing themselves from the team effort; under pressure, individuals can easily fail to see the big picture. By focusing on only the supporting information – confirmation bias – contradictory evidence can be missed. High levels of stress do not make for good decisions. Gut feelings often support good decision making, as can a mild level of anxiety. But an unrelenting, depressing mood usually undermines good judgement.

For investors with a contrarian or value style, they may even feel under pressure from clients to dig in to an underperforming stock or area more deeply. It is too easy for managers to try to second-guess client aims, and problems are compounded. At the very point at which a usually thoughtful and pragmatic manager should be questioning his own judgement, clients may be demanding that he re-assures them and explains why he has no doubts.

But, attempting to rationalise an investment position by spinning a plausible narrative, usually overlooks contrary evidence and instils excessive confidence. Unfortunately, clients like stories, being reassured when they should instead be worried. As David Tuckett and Richard Taffler put it in a recent CFA Institute monograph, investment managers often fall back on “meta-narratives” ; phrases that distil the essence of their investment philosophies. These are useful in helping investment professionals manage disappointment – “we are value investors and right now valuations are too rich” – but also encourage conviction to be maintained when the world might have changed.

Usually, supporting information confirming the wisdom of sticking to a losing strategy is easy to find. Worryingly, investors can also focus too much on small losses in new investments, failing to recognise the risk that must be taken on to achieve the desired performance. They can make the right investments, based on good analysis, but simply lack patience or focus too much on the detail of timing.

Changes in risk appetite can be more mixed. While some managers retreat into their own shells, others up the risks looking for quick gains, or make higher risk investments that may be what they think reflects current market momentum rather than considered analysis. Clients need to be alert for surprising portfolio changes, or even just a change in turnover rate.

Managers with a backstop of performance in a fund or with a particular client account, may be cut more slack for short periods of reversal. Even the best managers can string two or three bad years together. Investors usually set short term underperformance by a star manager in the context of the long term record. Without a cushion of performance, managers often feel they have little scope for further error, and simply fail to take the risks that are needed for reward. Clients should note that managers often lag their own style benchmark when their style is in favour, but easily outperform a benchmark that is doing badly.

It is clear that underperforming managers should be given support by their firms and colleagues. There is everything to be gained from good communication to clients about the issues, and helping a professional to maintain the same research focus and style. But, clients may have a role too. Often the degree of variability in returns, even with an excellent manager, is not recognised by clients and advisers. It may not have been a feature of the original presentation, or the halo effect might have blinded clients to the mortal nature of investment stars. The only person who “beat markets year after year after year” was Bernie Madoff. But the real world has much more volatility, and all styles move in and out of favour. In general, at least a complete market cycle of five or six years is needed to assess a manager.

Trustees appointing a new manager would do well to write down the reasons for their choice and the basis on which it might change. That summary could be put in a drawer for a rainy day. What it might do is stop an investor sacking a manager or selling out of a fund on the wrong timescale or for the wrong reasons. Just as emotion can play too big a role at the start of a relationship with a manager, leaving can too easily just be the result of strong feelings. Documenting expectations and looking for behaviour changes can help clients to be rational about their manager.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. Data and content provided are for information, education, and non-commercial purposes only. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.