For an investment committee, there is nothing more perilous than the selection and termination of active managers. These managers directly affect investment returns, and, despite everyone's best efforts, the decision to change them can result in costly mistakes. But at least when the question of liability arises, the members of the committee expect that their adherence to the committee's investment process will insulate them from legal liability.
Yet most of these processes contain a significant flaw: They focus on the performance of the current or prospective managers and ignore the returns of those managers that have been fired-even though, arguably, a study of these fired managers' returns would yield important insights about the selection and/or termination process. This data could highlight weaknesses in a committee's process and enable it to preserve assets, which is important when questions of liability come into play.
Research suggests that such scrutiny of a manager's post-termination returns would be helpful. First, it may help to refocus committees preoccupied with less important issues. Second, changing managers incurs significant expense and places assets at risk during the transition period. Third, and most significant, economists suggest that switching managers may not improve portfolio returns. Given those findings, a fiduciary would likely want to advocate some system for analyzing and reporting on past decisions. But then you must account for human behavior, which keeps plans like this from taking shape.
Considerations For Fiduciaries
In "Behavioral Finance and Investment Committee Decision Making," Arnold Wood of Martingale Asset Management writes, "Committees spend their time doing what they prefer rather than what is ranked by them as the highest importance." Committees know that investment policy and asset allocation deserve greater emphasis, but the discussion of individual stocks, manager performance or the market consume their time. This preoccupation with interesting returns and activity appeals to the brain-a sensory system activated by change. Thus the market dynamics take precedent over the mundane, whereas a more structured analytical process would help to refocus the committee.
A committee incurs transition costs to move assets between old and new investment positions. These costs consist of explicit and implicit expenses. Explicit costs include brokerage commissions and fees, while implicit costs include factors such as operational failures, timing-delay costs and market impact costs. Within a portfolio of large-cap equities, 100% turnover costs about 90 basis points, while in a small-cap portfolio, 100% turnover costs about 142 basis points. Meanwhile, the transition process during which an entire portfolio is turned over adds complexity and risk. A niche industry has arisen to ease these transition costs.
In "Optimal Transition: Mitigating Risk and Minimizing Market Impact," TABB Group's Monica Shulz, an analyst, writes, "Together, implicit and explicit costs are known as implementation shortfall: the difference in value between the legacy portfolio and the target portfolio as compared to the difference in value between the legacy portfolio and the post-transition portfolio." Given the risk, Shulz writes, "When a transition becomes excessively expensive, it threatens the premise on which the transition decision was originally made." (Emphasis added.) Although transition managers continue to improve methods of mitigating risk, the safest course of action, she notes, is "don't sell if you don't have to."
Perhaps the most compelling evidence supporting analysis of post-termination returns is research finding that switching managers does not increase returns. Amit Goyal and Sunil Wahal, co-authors of Selection and Termination of Investment Management Firms by Plan Sponsors, reach the following potent conclusion:
"Plan sponsors hire investment managers after superior performance but, on average, post-hiring excess returns are zero. Plan sponsors fire investment managers for many reasons, including, but not exclusively, for underperformance. But post-firing excess returns are frequently positive and sometimes statistically significant. Our sample of round-trips shows that if plan sponsors had stayed with fired investment managers, their excess returns would be no different than those actually delivered by newly hired managers."
Goyal and Wahal suggest that investment manager excess returns may persist over time; however, "On average, plan sponsors have no timing ability." The two authors echo Shulz's suggestion that the premise of the transition decision requires careful consideration.
Regardless of potential lessons contained in the returns, common human behavioral traits, including regret, fundamental attribution error and overconfidence, lead to their neglect. First, regret theory suggests that committee leaders likely feel ambivalent about second-guessing past decisions.
Doing so poses a psychological threat. In Your Money and Your Brain, Jason Zweig quotes Nobel laureate psychologist Daniel Kahneman on regret and investment losses: "When you sell a loser, you don't just take a financial loss; you take a psychological loss from admitting that you made a mistake" (Page 197). Personal angst accompanies accepting losses; however, when you are the member of a committee, personal angst may be compounded by external scrutiny: Critics can arise from within the investment committee, from the board of directors, from the institution or even from the general public.
Second, fundamental attribution error suggests that this data may be virtually invisible. Fundamental attribution error occurs when observers overweight dispositional factors and underweight situational factors. Investment skill is a dispositional factor while situational factors, such as "luck," a bull market ("a rising tide") or investment expenses receive little or no consideration. The typical committee process controls singularly for the performance (i.e., "the skill") of existing or prospective managers with the use of benchmarks. This focus on returns correlates with the brain's intense reaction to dynamic information.
The impact of fundamental attribution error on investment professionals finds support within the academic community. Dr. David Dunning is a Cornell University psychology professor and a member of Cornell's Behavioral Economics and Decision Research Center. His research focuses on accuracy and illusion in human judgment. He writes that investment results, both positive and negative, are a "straightforward product of regression to the mean." Given this emphasis, he observes: