Investors pick wrong managers

For almost two decades now, the average hedge fund has delivered a lackluster return. Actively managed mutual funds generally fail to beat the market after fees, either in a given year or over time. Although most fund managers could beat the market trading on their own, the fees they charge cancel out their investing edge.

There are some fund managers who do beat the market, even taking fees into account. But how do you know who they are?

There’s a branch of economic theory that says picking a manager based on past performance is a rational thing to do. In 2004, Jonathan Berk and Richard Green showed how this could work. In their model, investors judge managers’ skill based on their performance, so money flows to the managers who do the best. But since most investing strategies don’t scale up very well, the inflows of money drive returns back down. In Berk and Green’s model, inflows of money balance out manager skill exactly, so the average fund performs as well as the market, after fees.

The fact that the average fund underperforms the market after fees means customers routinely overpay, which isn’t possible in a fully rational model.

- Advertisement -

Economists Guillermo Baquero and Marno Verbeek have a new paper, in which they examine the factors that make investors give their money to hedge funds. Using data from an advisory firm, they look at how performance predicts fund flows. What they find is one factor is very important – the length of a fund’s unbroken winning streak, defined as the number of quarters it has beaten Treasury bills. The more consecutive quarters a fund does better than T-bills, the more money goes to the fund.

This is strange, because it’s very easy to imagine a world in which this is a very bad indicator of performance. Suppose Fund A returns 0.1 percent in 99 out of 100 years, while Fund B returns -0.1 percent half the time and 10 percent the other half. Fund A is going to generate much longer winning streaks. But Fund B earns a much higher return on average.

Baquero and Verbeek find the best way for predicting returns is the Sharpe ratio, measured over the previous two years. Unlike the length of a winning streak, a Sharpe ratio allows for both wins and losses. It also takes into account both reward and risk, instead of just measuring how long a fund can tread water.

The authors have basically discovered it’s possible for investors to behave like rational performance-chasers. For some reason, they just don’t.

Baquero and Verbeek suggest people have “extrapolative expectations,” meaning they expect current trends to continue. But there are other possibilities. Maybe investors have a model in their heads of how long a fund is able to keep its edge after discovering a profitable trading strategy. Or maybe investors judge risk by scanning performance records for recent losses, and just try to minimize risk.

But whatever the reason, the result is clear – investors aren’t choosing funds in a rational way. Maybe that’s why returns have been lackluster in the hedge-fund industry in recent years – investors might just be sending their money to the wrong ones. •

Noah Smith is a Bloomberg View columnist.

No posts to display