One of the biggest problems with the fund industry is that the interests of the fund manager and the end investor are fundamentally misaligned. Yes, of course, individual managers want to see better outcomes for their clients. But they wouldn’t be human if they didn’t also have their own personal interests at heart; and of course the fund houses that employ them have a strong commercial incentive to ensure that their profitability is paramount.
Further evidence of this mismatch between the interests of investors, managers and fund management companies is provided in a new study, entitled A Review of Behavioural and Management Effects in Mutual Fund Performance.
The researchers — two at London’s City University and one at University College, Cork — produced eight key findings, all of which should ring alarm bells for those who invest in actively managed funds.
Professionals are prone to biases like the rest of us
One of the arguments for using active managers is that they are less prone (or even immune) to the sort of behavioural biases that typically hamper the returns of ordinary investors. But this study shows that “a number of manager behavioural biases are prevalent in the mutual fund industry and they generally detract from returns — chief among (them) herding, home bias, a disposition effect, overconfidence and window dressing.”
Struggling managers tend to take more risk
You can hardly blame fund managers for wanting to keep their jobs. To quote the study, “there is a high degree of employment risk for managers as dismissal is often preceded by prior poor performance.” The authors found strong evidence that “relatively poor performance is followed by relatively high risk taking — largely as a gamble to ‘catch up’ with one’s peers”.
Managers on a winning streak are often overconfident
One of the commonest pitfalls for ordinary investors is overconfidence; we have a good run and wrongly assume our success will continue. But professional money managers are guilty of it too. The study refers to “a U-shaped relation between past performance and risk taking where top funds also subsequently increase risk. There is evidence this is due to an overconfidence effect.”
Competition between colleagues encourages risk-taking
In most areas of business, competition is good for consumers, but in fund management it can be harmful — especially if it encourages excessive risk-taking. “Within fund families,” the study claims, “there is evidence that low ranked funds by mid-year take on greater risk in the second half of the year.” It puts this down to “intra-family tournaments where funds are in competition for resources such as advertising and marketing budgets, salaries and bonuses”.
Fund houses give preferential treatment to high-fee funds
From a commercial point of view, fund houses prefer to have more money invested high-value (i.e. high-fee) funds, which presumably explains why there is evidence that “fund management companies give preferential treatment to high-value funds in the family in terms of allocating hot IPOs”. Such IPOs typically attract higher inflows.
Fund houses transfer risk from high-performing to low-performing funds
Ultimately, fund houses want to increase their assets under management, and they know that “investor inflows respond strongly to past good fund performance but are relatively insensitive to past poor performance”. They are, in effect, incentivised “to transfer risk from high-performing to poor-performing funds. If the risky bets pay off, then inflows are greater than any outflows if the risky bets fail.”
Fund houses incentivise customers to stay in the same fund family
Of course, when investors do desert poor-performing funds, fund houses want clients to switch to another of their funds. Consequently they “now typically offer low cost switching options for investors to stay in the same family”. True, it’s only what you’d expect them to do, but once again it’s not in the client’s best interests. To quote the study, “evidence shows that the majority of investors only hold mutual funds in one family. As fund returns within a family exhibit relatively high correlation, investors are less than optimally diversified.”
Predicting future winners is extremely difficult
Anyone can look back at the last 20 years and identify who the “star” managers have been (there haven’t been many!); the question is, who will outperform over the NEXT 20 years? The study concludes: “Finding successful funds ex-ante is extremely difficult, if not impossible.”
In summary, this is yet another report that adds weight to the argument for avoiding actively managed funds. The fund industry is inherently conflicted. Only when fund houses and individual managers genuinely put the interests of their clients ahead of their own will active funds be worth considering for the majority of investors. In the real world we live in, that may never happen.