Speaker: Ron Bird, University of Technology, Sydney
Chair: David Vines, Balliol College, Oxford
How can we explain the existence of a multi-trillion dollar industry that consistently underperforms? This is the provocative question that Prof. Bird addressed in his seminar talk for PEFM. In particular, he focused on asset managers, that is, those that invest other people’s funds. In this arrangement, risk stays with the fund owners who get the investment returns net of all costs, while managers charge an asset-based fee and may charge a performance fee.
The size of the industry is impressive – over 71 trillion USD worth of assets under management, with profits of 102 billion USD. The biggest division within is between active and passive management. Active managers seek to pick stocks that outperform relative to a benchmark index by overweighting better performing stocks. This is opposed to passive management, which is becoming more and more popular in recent years, accounting for up to one-third of US mutual funds.
Active management is supposed to deliver two main benefits. First, active managers are expected to outperform their benchmarks, thus making money for their clients. However, Prof. Bird cites numerous studies demonstrating that as a group, active managers do not outperform indices, and indeed underperform once fees are taken into account. Even more, there is little evidence of consistency, so even outperforming managers do not tend to remain like this for long. Second, active funds could improve the price discovery mechanism, leading to improved allocative efficiency. However, even as information and processing capabilities have increased dramatically, research shows no evidence of pricing in equity markets becoming more informationally efficient.
This leads Prof. Bird to his central conundrum: why academic managers, who seem to not be delivering for their clients or society, receive ever-increasing compensation? There seems to be a priori several reasons. First, quality is almost impossible to measure in this industry as performance is often driven by noise - due to the volatility of equities, it takes about 40 years before one can confidently judge whether an active manager is ‘good’ or not. Second, money is sticky – new money goes to people who performed well recently, but if you don’t do an outrageous job, people generally stay with you. Thus, it is an industry in which principals are relatively less interested in the performance of the agents.
Based on these observations, Prof. Bird presented several of his own empirical studies. The first one is related to how funds change their strategy as they grow. Fund managers aim to maximize the present value of their future fee income and, in doing so, choose how much money to allocate to their own active bets and how much to just following the index. Small funds have an incentive to be aggressive and follow their bets; however, Prof. Bird finds that performance begins to decline with size.
His explanation is that when a manager has more money under management, the cost of losing clients increases and outweighs potential gains of following their judgment. At this point, managers allocate more money to following indices, essentially turning their fund into an index one. Even good managers are tempted to follow this route as using one’s ability increases the probability of bad outcomes, thus creating incentives to lock in their business rather than grow it.
Prof. Bird’s second paper looks at what he dubs “the curse of the benchmarks”. In particular, he argues managers have incentives to follow benchmarks close enough as to attribute any deviations to ‘tracking errors’ rather than underperformance, thus limiting business risk. In this case, they end up buying stocks that are going up and sell stocks that are going down in order to remain within this ‘tracking error’, essentially reducing their bets and enforcing momentum trading.
This results in the ‘momentum life cycle’ of shares to which asset managers contribute. Stocks can thus come down due to bad information signals relative to expectations, leading to a downward momentum, even after they become cheap enough for ‘fundamental’ investors. Eventually such fundamental traders offset momentum people, bringing in asset managers again, who this time drive up value of stocks beyond its fair value, setting it up for another swing in momentum. In this type of trading, tracking constraints end up distorting the relationship between stock selection and the construction of a portfolio as managers seek to minimize risks of making ‘bad bets’ for their businesses.
Overall, Prof. Bird raises an intriguing question, building up on similar observations by other researchers regarding the disjunction between the popularity of active asset management and its actual performance. As he acknowledges, explaining this contradiction is not necessarily easy as the number of moving parts in the system is very high. However, by focusing in particular on the incentives of asset managers themselves in growing their business, he makes an interesting contribution to existing scholarship.
Ivaylo Iaydjiev (St Antony’s College)