Manager Hires/Fires Show Short-term Thinking

The institutional investing community has been known to pride itself on the level of investment sophistication when compared to the common retail investor. The typical argument is that the retail investor often follows the “hot money” or the asset class that has recently outperformed, a trap which leads to buying high and selling low (which won’t make you any money in the long term).  The self proclaimed differentiating characteristic of the institutional investor is that they are “long term investors”. However, evidence suggests otherwise – they make short term decisions. Institutional investor behavior with respect to hiring and firing investment managers has been shown to be a losing proposition. Investment managers are hired after they have exhibited superior performance and fired after they have underperformed. In a recent article published in the Financial Analyst Journal entitled “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors”, Stewart, Neumann and Heisler illustrate that this behavior doesn’t serve the institutional investing community well. In short, they are able to show that investment products experiencing outflows outperform those experiencing inflows by 74 bps over the first year, 59 bps over 3 years and 44 bps over 5 years. Other studies in the past have shown directionally similar results with varying degrees of relative performance.

What causes this phenomenon if the institutional investor is reputed to be the most sophisticated market participant? The factors likely have something to do with a focus on historical results and the process by which managers are hired and fired. The typical decision making process for hiring managers is based on a recommendation by a consultant or staff advisor to a committee of individuals for approval. There is a tendency for advisors or consultants to recommend managers that have had recent success and for investment committees to gravitate towards the best performing manager. This makes sense from a behavioral perspective – why would a committee hire a manager that hasn’t delivered recent proven results? Unfortunately, the classic tagline that accompanies most marketing material about past performance not being indicative of future results is often overlooked (not just because of the small font). Institutional investors collectively have put too much emphasis on the results and not enough focus on how the results have been achieved through the manager’s investment process and the people responsible for implementing it. It takes considerably more time to understand the way in which investment managers operate than it does to compare their investment results against a benchmark. However, this extra effort should be worth it – especially in the long term.