A review of the Forbes top 100 financial adviser firms in the United States in 2017 showed that manager selection is the top service advisers market to clients, and the process required to provide the service claims a meaningful amount of a firm’s resources. The determination of whether manager selection falls into the category of a low impact/high effort thankless task comes down to expectations.
If the expectation is to reduce negative alpha (i.e. underperforming the market) or to minimise regret risk, manager selection will likely have a positive impact, perhaps even enough to justify the resources commensurate with the task’s difficulty. If the expectation is to produce positive alpha, financial advisers and their clients are likely to be disappointed.
How, then, can advisers operate at the optimal position in the impact–effort matrix?
The challenges advisers face
In seeking to meet their clients’ financial goals, advisers face two sizeable headwinds: clients’ investing biases and the difficulties in identifying skilled managers who are able to reliably produce alpha for their investors. Let’s review briefly what the academic literature has found regarding these two challenges.
Retail investors are generally susceptible to a number of biases. Most notably, their returns-chasing behaviour leads to poor buy and sell decisions and disappointing investment outcomes. Barber and Odean (2000) found that the average retail brokerage investor underperformed the market by about 1.5% a year. What was even more telling was that investors who made the most buy and sell decisions had the worst performance, underperforming by 6.5%! This hazardous tendency manifests itself meaningfully when it comes to picking mutual funds and other managed products.
Hsu, Myers, and Whitby (2015) showed that investors earned about 2% less than the mutual funds they invest in because of a bias toward chasing performance (i.e., buying high and selling low). Their research also demonstrated that larger performance gaps exist in high-expense-ratio funds (again more likely to be held by retail investors) versus low-expense-ratio funds. Hsu, Myers, and Whitby concluded that less-sophisticated investors, often those who invest in retail funds, underperformed by a greater margin (i.e., suffered a larger return gap) than those who qualified for institutional share-class funds.
Advisers face tremendous challenges in overcoming such client biases. Mullainathan, Noeth, and Schoar (2012) found evidence that suggests advisers have difficulty de-biasing their clients, and as a result engage in ‘catering’ behaviour, seeking to please existing or new clients by being supportive of returns-chasing behaviour. Linnainmaa, Melzer, and Previtero (2016) also found that the average adviser has difficulty overriding retail investors’ biases, often exacerbating them with recommendations of frequent trading and expensive, actively managed products.
A behavioural bias that favours more of what recently has provided comfort and profit and less of what has produced pain and loss often leads advisers to recommend the managers their clients want—those with the best trailing performance. Thus, clients can find themselves treading the ‘hamster wheel’ of manager selection, continuously replacing poor performers with good performers. Evidence shows this form of performance chasing, however, likely puts advisers and their clients on the outside track to future excess returns.
Cornell, Hsu, and Nanigian (2017) documented mean reversion in mutual fund performance, finding that, when measured by trailing three-year performance from 1994 through 2015, top-decile managers underperformed the bottom-decile managers by 2.3% a year. Arnott, Kalesnik, and Wu (2017), controlling for fund expenses, showed a similar monotonic drop-off in the subsequent performance of prior winners.
The evidence makes it pretty clear we shouldn’t use historical performance as our primary manager selection criteria. Well, maybe we should - just in the opposite direction!
Advisers should focus more on three soft ‘Ps’
Advisers who acknowledge the pitfalls of a pure performance selection criterion could spend more of their due diligence efforts on the so-called soft 'Ps': philosophy, process, and people. Indeed, the institutional investment consulting community has relied heavily on non-performance factors for decades to make manager selection decisions. Jenkinson, Jones, and Martinez (2016) found that consultants’ recommendations correlate partly with the past performance of fund managers, but more so with non-performance factors, suggesting that consultants’ recommendations do not merely represent a returns-chasing strategy.
But the additional insights gained by non-performance factors has not led to an ability to, on average, select ‘winners’. On a value-weighted basis, Jenkinson, Jones, and Martinez found no evidence that the managers’ products recommended by investment consultants outperformed the products the consultants did not recommend. On an equally weighted basis, they found that recommended products underperformed other products by approximately 1% a year, leading them to conclude that non-recommended funds performed at least as well as recommended funds.
Benefits beyond the pursuit of benchmark-beating performance can be realised through careful and well-resourced manager selection. Behavioural finance frequently references individual investors’ willingness to forgo higher wealth accumulation in favour of non-monetary emotional benefits. We assert as much in Research Affiliates’ core investment beliefs that investor preferences are broader than risk and return. Additionally, benefits of a well-documented manager research effort can mitigate regret risk in performance ‘blow-ups’ (particularly with negative press headlines for public entities) and provide a layer of - real or perceived - fiduciary insurance; for example, by performing an extensive due diligence review before recommending a manager, the adviser or consultant best positions themselves to explain a poor-performing manager.
Nonetheless, the literature suggests that financial advisers shouldn’t expect, nor communicate to clients an expectation of, market-beating results via manager selection, at least not with the current (sometimes overwhelming) investor bias of making buy and sell decisions based on performance metrics.
Is zero alpha a win?
Perhaps the biggest value an adviser can add is to save clients from themselves by eliminating their negative alpha. If, as is frequently the case, the starting point is 200 basis points of negative alpha from horrible timing on fund hires and fires, then taking this to zero should be considered a relative win for both client and adviser. Evidence suggests this is a realistic and achievable goal.
Jenkinson, Jones, and Martinez (2016) found that the returns of consultant-recommended funds were roughly in line with non-recommended products, and Goyal and Wahal (2008) found that “post-hiring returns are higher for decisions in which a consultant was used in selecting the investment manager.” Our interpretation is that consultants’ qualitative judgment and research slow down clients’ returns-chasing behaviour. Given the sizeable literature showing the return gap between investors’ returns and their funds’ returns, perhaps the more constructive goal of manager selection is to ‘do no harm’ when replacing poor performers. Perhaps a worthwhile ‘win’ from manager selection is zero alpha!
Seeking positive alpha is hard from two perspectives. It’s hard for fund managers to beat passive benchmarks, and as we’ve demonstrated, it’s hard for fund selectors to pick the winning fund managers of the future. Advisers can feel pressured to please returns-chasing clients. When their mandate is to replace recent bottom-quartile funds with recent top-quartile funds, advisers start at an inherent disadvantage in producing positive alpha. Reframing the goal of manager selection as the positive impact of reducing negative alpha and educating clients so that their expectations are in line with this goal can justify the effort expended by financial advisers on manager selection.
John West CFA is Managing Director, Head of Client Strategies and Trevor Schuesler CFA is Vice President, Client Strategies at Research Affiliates. This article is general information and does not consider the circumstances of any individual.