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.

Behavioral Impediments
    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:

"Why do people fail to [obtain] the feedback to detect this [regression to the mean]? First, people fall prey to the 'fundamental attribution error' and attribute too much of a manager's performance to skill rather than luck. Second, people miss the importance of control conditions (i.e., a situation in which we had not fired the manager)-even if the data [for] such control conditions exists."
Post-termination returns remain practically invisible to committee leaders who fixate on skill.

A singular preoccupation with presently retained managers dovetails with regret theory. As mentioned above, committee members avoid personal angst associated with poor decisions; an investment process that saddles asset managers with blame also allows committee members to avoid personal and professional scrutiny related to a flawed investment process.

Dunning also mentions committee failure to control for this seemingly irrelevant data. Control conditions help to distinguish random data from causally related data. Typically, investment committees will switch managers and compare the cumulative returns from both managers to a benchmark.     Dunning suggests controlling also for "a situation in which we had not fired the [active] manager." The returns of the terminated managers would then be weighed against both the benchmark and the returns of those managers who were retained.

The third trait, overconfidence, like fundamental attribution error may render post-termination returns irrelevant in the minds of committee leaders. Overconfidence describes a mindset that exaggerates personal ability and encourages risk-taking; when a committee member receives feedback on past judgments, it counteracts this overconfidence. Meteorologists, for example, show little overconfidence because they are publicly predicting the unpredictable. Instead, each day's weather provides them with feedback on their accuracy.

Dr. Erik Angner of the University of Alabama at Birmingham and author of "Economists as Experts," writes as follows:
"The psychological literature indicates that overconfidence is endemic, [unless] feedback is regular, prompt and unambiguous. If the latter condition doesn't [exist] for investment managers, you would expect them to suffer some degree of overconfidence."

Unfortunately, as Arnold Wood reports, investment committees function with anemic levels of feedback on their past decisions.
Dr. Anand Goel of DePaul University has studied CEO decisions and overconfidence. CEOs often feel ambivalent about the added expense and time of accumulating information in preparation for an imminent decision. If hasty, CEOs may not obtain sufficient data, while too much caution wastes resources and money. Overconfident CEOs introduce an extra element of risk: These men or women are more likely to cut short the gathering of information and injure their businesses through ill-advised decisions.

Goel suggests that committee leaders operate with similar limitations. Investment committees, Goel suggests, should "evaluate the effectiveness of their own decisions by observing the performance of retained versus fired managers (and controlling for changes in environment that may have affected the performance of fired managers)." This self-evaluation may validate past decisions or lead to more patient and informed decisions.

Status Quo

Again, a systematic analysis of a manager's post-termination returns rarely occurs in the retirement industry. A retirement plan consultant interviewed for this article remarked, "That's a great idea, but I don't know anyone who does it." Similarly, Russell Olson, a former director of pension investments for Eastman Kodak, does not mention the practice in his Handbook for Investment Committee Members.

Jason Zweig, author of Your Money and Your Brain, relates the following anecdote:

"I once gave a speech at a meeting of retirement plan consultants and was heckled for pointing out that they do a lousy job at manager selection. 'Prove it!' called one of the hecklers. I responded with a question: 'How many of you track the performance of the managers you fire AFTER you fire them? Let's see a show of hands.' There were roughly 100 people in the room, [but] not a single person raised a hand. In other words, they all believed their sell discipline worked, but not a single one of them had ever gathered a shred of empirical data to test whether it was actually true. It was as if Neil Armstrong had come back from landing on the moon and insisted that it was made of green cheese because the lunar soil had felt sort of squishy under his feet."

For Zweig, claims of performance warrant more than untested and overconfident assertions.

Often, the closest example of post-termination analysis is something like the following scenario: One current investment committee chairman says that when he terminates a manager who had faith in a particular market sector, he checks to see how the sector performed after termination. But this process would not reliably reflect the performance of a specific active manager.

Conclusion

An investment committee can obviously strengthen its investment process with an analysis of post-termination returns. Committees may refocus on priority issues, and active managers may retain their posts for longer periods. This will reduce an investor's transition costs without sacrificing returns. Generally speaking, fiduciary liability begins and ends with adherence to a sound process; therefore, prudent fiduciaries will strive for a process that reflects behavioral and economic reality.

Michael C. Keenan, MA, CFP, JD is the founder of Fidelis Financial Planning LLC in Lynchburg, Va. and welcomes your correspondence at [email protected].