Manager Picking

Manager Picking is a Mug's Game

Manager Picking

The search for investment managers who will deliver alpha is an activity that accounts for billions of dollars that is spent by foundations, endowments, pension plans, and other institutional investors. To determine if these dollars are well-spent, it is fair to ask how successful have institutional investors been in selecting managers who subsequently delivered returns in excess of their benchmark?

To answer this question, we will draw upon "The Selection and Termination of Investment Managers by Plan Sponsors"1 by Amit Goyal and Sunil Wahal from The Journal of Finance, August 2008. The authors examined the hiring and firing decisions of approximately 3,400 plan sponsors between 1994 and 2003. They found that plan sponsors tend to hire investment managers after large positive excess returns only to be disappointed by the failure of these returns to persist. The chart below shows what happened on average with 8,755 hiring decisions made over a ten-year period.

The alpha that appeared to exist prior to hiring turned out to be a mirage. The issue is that with over 7,000 managers to choose from, it is natural that at any given time, there will be some that appear to have skill, and may even have statistically significant alpha at a 95% level of confidence. The problem is that we expect to see several hundred such managers from chance alone, and we don't see more than this number.2 Not only is the appearance of alpha no greater than what we would expect from chance, but so is the persistence of alpha, as shown in the chart below derived from the Standard and Poor's Persistence Scorecard.

Now that we see how plan sponsors do when they have the whole universe of active managers to choose from when they are hiring, we should ask how well they do when they only have to evaluate the funds that they own for the purpose of determining which ones to terminate. Just as plan sponsors tend to hire managers after a period of outperformance, they tend to fire managers after a period of underperformance. After firing, however, the underperformance does not persist, just like the outperformance prior to hiring. Adding insult to injury, the fired managers tend to have higher returns than the hired managers that replaced them. The chart below shows what happened with 660 round-trip decisions.

Now that we have seen the performance of plan sponsors at hiring and firing investment managers, it is reasonable to ask how well they do when they simply move money from one manager to another without hiring or firing. The two charts below summarize the findings of "Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors".3


To conclude, plan sponsor decisions to hire, fire, and move funds between managers are largely motivated by recent performance which has no persistence. As for the investment consultants who are paid by institutional investors to help them with these activities, here is what one of the authors of a recent study4 said about them: "It's a waste of money listening to consultants. It's a service that is useless."5 A better course of action for institutional investors would be to determine an appropriate long-term asset allocation and then implement that allocation with low-cost index funds.

1Goyal, Amit, and Russ Wermers, "The Selection and Termination of Investment Managers by Plan Sponsors". Journal of Finance, Vol. 63 No. 4, pp. 1805-47.

2Barras, Laurent, Olivier Scaillet, and Russ Wermers, "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas". Journal of Finance, Vol. 65 No. 1, pp. 179-216.

3Stewart, Scott, John J. Neumann, Christopher R. Knittel, Jeffrey Heisler, "Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors". Financial Analysts Journal, Vol. 65, No. 6, pp. 34-51.

4Jenkinson, Tim and Jones, Howard and Martinez, Jose Vicente, "Picking Winners? Investment Consultants' Recommendations of Fund Managers" (September 17, 2013).