Thursday, September 11, 2008

Fiduciary Investment Selection - Horses to Courses

This horse-racing expression means a horse should be judged by its suitability for the track on which it will run. Similarly an investment fund should be chosen by a fiduciary based on the context in which it will be used.

When selecting actively managed investment funds, plan fiduciaries should, among other factors, consider the management structure of the funds since academic research indicates that it has an effect on managerial behavior and fund performance. Structurally a fund can be managed by either an individual manager or a team of managers.

According to the study; When Should Firms Share Credit with Employees? Evidence from Anonymously Managed Mutual Funds, the choice of management structure is strategic for the investment fund family and has been steadily migrating through time from individual to team management. This migration can be explained by the migration of star manager to the hedge fund world.

“Between 1993 and 2004, the share of mutual funds disclosing manager names to their investors fell significantly… the choice between named and anonymous management reflects a tradeoff between the marketing benefits of naming managers
and the costs associated with their increased bargaining power. Consistent with this tradeoff, we find that funds with named managers receive more positive media mentions,have greater inflows, and suffer less return diversion due to within
family cross-subsidization, but that departures of named managers reduce inflows, especially for funds with better past performance. To the extent that the hedge fund boom differentially increased outside opportunities for successful named managers, we predict that it should have increased the costs associated with naming managers and led to more anonymous management. Indeed, we
find that the shift towards anonymous management is greater in those asset classes and geographical areas with more hedge fund activity.”

From an investor’s perspective, the decisions of a team managed portfolio are not simply the sum of the individual manager’s decisions. The study; Is a Team Different from the Sum of its Parts? Evidence from Mutual Fund Managers concludes that the behavior and thus the performance of team managed funds are systemically different that individually managed funds.:

“team opinion is the average opinion of the team members. Extreme opinions of members in a team are averaged out and teams eventually make less extreme decisions than individuals do…This holds true for risk taking decisions (total risk, systematic risk, unsystematic risk) as well as for decisions on investment style (value vs. growth, small cap vs. large cap, and momentum vs. contrarian style."
A related study; Team Management and Mutual Funds also concludes that the management behavior of teams and individual managers differ:
“Funds managed by teams exhibit significantly lower (unsystematic) risk than single manager funds and adjust their risk to a lesser extent as response to prior performance. In their investment style teams are less extreme and more consistent over time. Looking at fund performance, we find some, albeit only weak, evidence that team management has a negative impact on fund performance. However, team-managed funds are more persistent in their performance over time. Fund investors seem to care about fund management structure. Our findings show that team-managed funds experience significantly higher inflows.”
As to relative performance, the authors of Performance Characteristics of Individual vs. Team Managed Mutual Funds conclude that:

“funds managed by teams has grown by seven times the rate of funds managed by individuals, there is no significant difference in performance on a risk-adjusted basis. However, funds managed by teams are significantly less risky. In addition to differences in turnover in many fund categories, the total
cost of owning a team-managed mutual fund is nearly fifty basis points lower per year than a mutual fund managed by an individual, on average”

In Horses for Courses: Fund Managers and Organizational Structure, the authors conclude that the individually managed funds might be expected to outperform team managed funds except that the variance drag due to the performance extremes of their idiosynchratic portfolios more that equals the performance potential lost by team managed portfolios due to their more conventional holdings and strategies.

“We find that, consistent with the literature, after we control for investment style, team-managed funds underperform. However, we show that, conditioned on the endogenous selection of team management, team-managed funds outperform single-manager funds. The contrast between unconditional underperformance and selection-conditioned over-performance suggests that the best and brightest managers select into individual management. Consistent with this observation we document rather bland holdings and strategies for team-managed funds. These funds hold more conventional portfolios given their style and also tend to follow investment styles based on generic portfolio investment strategies, such as momentum, book-to-market, and large capitalization stock strategies. These results suggest that institutional design team management, per se, has a positive effect on fund performance. However, this design’s very virtue, restricting managerial discretion, discourages the most talented managers from subjecting themselves to it, leading to the coexistence of team-managed and single-manager funds and only muted differences in performance between them”.
Finally, fitting the horses to the courses:

  • Team managed funds could be a more prudent fiduciary choice for many participant directed retirement plans since individual investors tend to focus more on performance. Higher volatility investments can trigger counterproductive investor behavior, (ie buy high, sell low). More conventional strategies and lower tracking error can reduce investor and sponsor mistakes and fiduciary risk.
  • Team managed funds could be a more prudent choice for fiduciaries that do not want to dedicate additional time or skilled resource to the manager selection process. Individually managed funds may provide the potential for higher alpha but require both skill and patience to be identified and retained.
  • Team managed funds could be a more prudent choice for fiduciaries that do not have the appetite to use a potentially large and diverse collection of investment funds. The high variance associated with any individual managed funds can be mitigated through building a diversified portfolio of volatile funds. Fund diversification can provide an average compound return that is higher than the average return of the constituents because of the reduction in variance drag.

Structural differences in fund management and portfolio construction can have an impact on portfolio performance and should be explicitly considered, along with other factors, in a fiduciary investment selection process

Links to this post:

Create a Link

<< Home