Clients and their advisers see investment managers at their best during new business presentations. Data can be carefully selected for a pitch or for a brochure promoting a fund. And, usually, investors have a preference for the style they would like their manager to follow: value or growth, momentum or contrarian. It is easy for clients to get a positive impression of a manager, and clients like to feel good about their choice. Emotion thus tends to win out over rational analysis, and little thought may be given to any negatives.
But time passes, and the rosy glow of the original selection and analysis may fade. At some stage, clients or their advisers may want to reassess, usually because of disappointing investment performance. But behaviour and style can change when a manager is under pressure.
Now, new research based on extensive interviews with fund management groups shows how investment behaviour often changes following a period of substantial underperformance. Often, the impact on subsequent investment performance is not positive. This is not necessarily a question of incentives; the problem stems from personal psychology and the team structure in which professionals operate. Even where the team structure is supportive, personal characteristics and standards can drive an investment professional to act differently. This change in behaviour is an interesting aspect of behavioural finance that has been neglected as a research area.
So, what are the changes to look out for? Greg Richmond and Alistair Byrne, CFA, writing in the CFA Institute Investment Risk and Performance Newsletter, found five key changes in investment behaviour that were typically unhelpful. Shifts in risk appetite, shorter time horizons, lower levels of engagement with colleagues, and increases in loss aversion and in confirmation bias were all common changes. The managers themselves might not recognise their own changes in behaviour, but you can be sure that their colleagues and bosses will. However, these changes will not be featured in investment reports; clients and their advisers will likely need to uncover these changes themselves.
Individuals often aim to correct their record too quickly, despite having accumulated the underperformance over time. This typically involves distancing themselves from the team effort; under pressure, individuals can easily fail to see the big picture. By focusing on only the supporting information — confirmation bias — contradictory evidence can be missed. High levels of stress do not make for good decisions. Gut feelings often support good decision making, as can a mild level of anxiety. But an unrelenting, depressing mood usually undermines good judgement.
For investors with a contrarian or value style, they may even feel under pressure from clients to dig into an underperforming stock or area more deeply. It is too easy for managers to try to second-guess client aims, and problems are then compounded. At the very time when a usually thoughtful and pragmatic manager should be questioning his own judgement, clients may be demanding that he reassure them and explain why he has no doubts.
But attempting to rationalise an investment position by spinning a plausible narrative usually overlooks contrary evidence and instils excessive confidence. Unfortunately, clients like stories and being reassured when they should instead be worried. As David Tuckett and Richard J. Taffler put it in a recent CFA Institute Research Foundation monograph, investment managers often fall back on “meta-narratives”; phrases that distil the essence of their investment philosophies. These are useful in helping investment professionals manage disappointment — “we are value investors, and right now valuations are too rich” — but also encourage maintenance of convictions when the world might have changed.
Usually, supporting information confirming the wisdom of sticking to a losing strategy is easy to find. Of concern, however, investors can also focus too much on small losses in new investments, failing to recognise the risk that must be taken to achieve the desired performance. They can make the right investments, based on good analysis, but simply lack patience or focus too much on the detail of timing.
Changes in risk appetite can be more mixed. Whereas some managers retreat into their own shells, others increase the risks (looking for quick gains) or make higher risk investments that they think reflect current market momentum rather than using considered analysis. Clients need to be alert for surprising portfolio changes or even just a change in turnover rate.
Managers with a history of performance in a fund or with a particular client account may be cut more slack for short periods of reversal. Even the best managers can string two or three bad years together. Investors usually set short-term underperformance by a star manager in the context of the long-term record. But without a cushion of performance, managers often feel they have little scope for further error and simply fail to take the risks that are needed for reward. Clients should note that managers often lag their own style benchmark when their style is in favour but easily outperform a benchmark that is doing badly.
It is clear that underperforming managers should be given support by their firms and colleagues. There is everything to be gained from good communication with clients about the issues and from helping a professional maintain the same research focus and style. But clients may have a role too. Often the degree of variability in returns, even with an excellent manager, is not recognised by clients and advisers. This variability may not have been a feature of the original presentation, or the halo effect might have blinded clients to the mortal nature of investment stars. The only person who “beat markets year after year after year” was Bernie Madoff. But the real world has much more volatility, and all styles move in and out of favour. In general, at least a complete market cycle of five or six years is needed to assess a manager.
Trustees appointing a new manager would do well to write down the reasons for their choice and the basis on which it might change. That written summary could be put in a drawer for a rainy day. What it might do is stop an investor from sacking a manager or selling out of a fund on the wrong timescale or for the wrong reasons. Just as emotion can play too big a role at the start of a relationship with a manager, so it can at the end; leaving can too easily be the result of strong feelings. Documenting expectations and looking for behavioural changes can help clients to be rational about their manager.
Disclosure: The opinions expressed in this article are my own.