The Evidence-Based Investor

Why rising stars are often the first to fizzle out

Posted by Robin Powell on December 5, 2016

There’s at least one in every corporate workplace. You know the type. Bright-eyed and bushy-tailed, they make an instant impact and, before long, they’re being tipped as rising stars. Then they’re promoted, promoted and promoted, with each step up the managerial ladder taking them further and further away from the job they originally excelled at.

It was a Canadian academic called Laurence Peter who, in 1969, identified the tendency of employers to promote their most talented staff up to the point at which they become incompetent. The so-called Peter Principle is alive and well today — including, it seems, in asset management.

A new study of US fund managers between 1997 and 2015 by Richard Evans and Marc Lipson from the University of Virginia and Javier Gil-Bazo of Universitat Pompeu Fabra, called Diseconomies of Scope and Mutual Fund Performance, produced the following conclusion:

“We find that fund alphas are negatively related to measures of the scope of manager responsibilities.

“Results suggest that better performing managers experience increases in scope that eliminate outperformance.”

It’s easy to see how this happens in the context of the fund industry. A fund management company naturally wants to give more responsibility to a manager who appears to have shown skill in managing their first, small fund, in order to attract more assets and to boost its profits.

And who can blame the emerging star for going along with it? Greater responsibility, after all, comes with bigger financial rewards.

But, as the authors of this latest study identified, all too often, it doesn’t go to plan. Of course, one explanation could be that, early in their career, the manager just got lucky. But whatever the reason is, whether it’s the longer days, the added distractions, having too much to do, or they simply aren’t up to the job, today’s hero becomes tomorrow’s zero as their returns revert to the mean.

Ironically, these over-promoted fund managers are precisely those who tend to get featured in the financial media. And because investors love a good story — who wouldn’t want to take a punt on “the next Neil Woodford”? — they pile into that particular fund at just the wrong time.

Conversely, the researchers found, “worse performing managers experience scope reductions that improve performance to a degree that offsets underperformance”. In other words, fund managers who have demonstrated incompetence at a certain level, and are then relieved of some of their responsibilities, may go on to outperform once they’re less encumbered!

The lesson to learn is a simple one — chasing talent is as bad an idea as chasing performance. It doesn’t matter how many double-page spreads in Forbes a particular manager may have featured in; no one in the brutal world of fund management is immune from mean reversion.

 

You can read the study here:
Diseconomies of Scope and Mutual Fund Manager Performance

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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector. Regis Media.

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