Watching Grass Grow

The Fired Beat the Hired - A Deeper Look

Watching Grass Grow

Numerous studies have shown that actively managed investments generally carry more risk and lower returns than globally diversified, risk-calibrated index portfolios. Despite this fact, governing boards of retirement plans, foundations and endowments frequently fall prey to manager picking consultants and the allure of past winners, hiring the hottest new fund managers only to fire them later because their past performance doesn't persist in the subsequent periods. A recent study conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University found that manager hiring and firing decisions made by consultants and board members of retirement plans, endowments, and foundations was a complete waste of money and the board members precious time. "The Selection and Termination of Investment Management Firms by Plan Sponsors" reveals the negative impact of manager chasing. The results, as set forth in the figure below, demonstrate that during the ten-year period from 1994 through 2003, consultants and boards which based their fund manager hiring decisions on consistent above benchmark past performance were largely disappointed with subsequent index-like results. They often then fired their managers in favor of another recent top performer, repeating the cycle again. This cyclical motion undermines their investment policy statements and the opportunity of achieving optimal returns, the kind of returns that are available by simply buying, holding and rebalancing a passively managed portfolio of index funds that keeps costs low and controls risk.

The Abstract from The Selection and Termination of Investment Management Firms by Plan Sponsors:

"We examine the selection and termination of investment management firms by plan sponsors (public and corporate pension plans, unions, foundations, and endowments). We build a unique dataset that comprises hiring and firing decisions by approximately 3,700 plan sponsors over a 10-year period from 1994 to 2003. Our data represent the allocation of over $737 billion in mandates to hired investment managers and the withdrawal of $117 billion from fired investment managers. Plan sponsors hire investment managers after large positive excess returns up to three years prior to hiring. However, this return chasing behavior does not deliver positive excess returns thereafter; post-hiring excess returns are indistinguishable from zero. Plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive. Using a matched sample of firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be larger than those actually delivered by newly hired managers."

The two charts below summarize their first finding that newly hired managers tend to have superior performance prior to hiring which evaporates after hiring.

 

In November 2007, two actual hiring decisions at a foundation were analyzed to verify the above findings. As seen by the two charts below, the study of 8,755 hirings matched the live results of two managers at the foundation.

 

 

 

 

 

In reference to the two figures below, plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive. Using a matched sample of firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be larger than those actually delivered by newly hired managers.

 

 

From the Discussion at the end of "The Selection and Termination of Investment Management Firms by Plan Sponsors": "How does one interpret this evidence? One way to think about this is in terms of opportunity costs and frictions. For hiring decisions that are necessitated by the termination of an existing investment manager (due to performance, organizational or reallocation reasons), the opportunity costs of hiring can be identified as the returns that the fired manager would have delivered relative to what the hired manager actually delivers. Our round-trip results suggest that these opportunity costs are positive."

And from the Conclusion: "In this paper, we examine the selection and termination of investment managers by plan sponsors. To do so, we build a dataset that comprises hiring and firing decisions by 3,600 plan sponsors over a 10-year period from 1994 to 2003. We find that plan sponsors hire investment managers after these managers earn significant excess returns. Post-hiring returns, however, are statistically indistinguishable from zero [IFA inserted comment: after management fees and transition costs they are decidedly negative]. In contrast, plan sponsors terminate investment managers after poor performance but the performance of these investment managers appears to rebound after firing. We also examine a set of round-trip firing and hiring decisions and find that the post-firing returns of fired investment managers are generally larger than the post-hiring returns of hired investment managers. Given the magnitude of the return differences, and the transactions costs associated with transitioning portfolios from fired investment managers (legacy portfolios) to hired investment managers (target portfolios), our results suggest that the termination and selection of investment managers is a costly endeavor."

Active managers have often told us that academics don't see the real world from their ivory towers, but it appears that they do a better predictor of outcomes than the manager pickers who selected these managers.

This data are all that is needed to prove that manager picking doesn't work and is not a good basis on which to invest money. But there is more for the Doubting Thomas' among you. The two charts below summarize the results of a study of plan sponsor decisions to move money among their hired managers (as opposed to hiring and firing). The majority of those decisions ended up destroying value.