Selecting and Firing Investment Managers

After long deliberations between trustees and their investment managers, the choice is finally made to select manager GoodInvest* to manage the fund’s emerging market equities. The investor relations department has its work cut out.

The press release is prepared, including:

  • Gem 1. Goodinvest  today announced that it has been appointed to advise a newly-launched emerging markets mandate. The agreement recognises Goodinvest’s track record and expertise in emerging markets debt.
  • Gem 2. With over 25 years of experience in emerging market investing, Goodinvest has pioneered investment emerging markets due to its conviction in the potential of this asset class to generate superior returns for investors. “We are pleased to be partnering with the fund to offer investors access to this investment capability.”
  • Gem 3. John Smith, chairman of the board of trustees, comments, “We are pleased to appoint Goodinvest to manage this fund.  Following a thorough due diligence process, our decision to choose  Goodinvest endorses the quality of the team, and the robust risk-adjusted returns delivered through differing time periods. We look forward to working together.”

Pension funds spend considerable time and resources on selecting the best organizations to invest in.  While this constitutes as one of their core activities, our knowledge about the effectiveness is still rather limited.  A sobering study is from Amit Goyal and Sunil Wahal, who investigate the hiring and firing of investment management firms by 3,400 US pension funds between 1994 and 2003**. Their findings:

  • Pension funds hire investment managers after large positive excess returns but this does not deliver positive excess returns thereafter.
  • Investment managers are terminated for a variety of reasons, including but not limited to underperformance. Restructuring the investment strategy is also a reason.
  • Holding on to an external manager who’s nominated to be fired is not always worthwhile. Excess returns after terminations are indistinguishable from zero but in some cases positive. The authors find that if plan sponsors had stayed with fired investment managers, their excess returns would be no different from those delivered by newly hired managers.

Pension funds should be aware of these findings. But how to incorporate them in your selection and monitoring strategy? Four suggestions:

  1. Aim for adequate, instead of best in classWhat is the purpose of selecting external managers? Selecting the “best in class”  is rather ineffective if all the effort doesn’t guarantee the best investment results. There, a fund could consider switching to a “value for money”  approach. Once a short list is composed, assume that the fund is not able to pick the future winner. Choose therefore the one from the short list with the lowest costs. That’s always a winner.
  2. Manage your own expectations. When hiring the manager, pay more focus to potential disappointment than potential happiness. Ask the manager in which periods, or under which conditions his strategy doesn’t work. How does he deal with this? What sort of measures did (or will) he take to pursue a consistent investment style? If future excess returns are cut by half, would the manager still advise investing in his fund, and would your fund remain content investing in it?
  3. Bet on the casino. Assume that the manager has no extraordinary skills, but that, in the words of Mauboussin, the casino always wins. A sound investment philosophy, process is far more valuable in the selection process than prior performance. Based on Goyal and Wahal’s research, a forward looking pension fund’s dream might well be to select a fund in the lower quartile performance, but with a superior investment philosophy and process. That requires clear communication with the stakeholders, since it introduces reputation risk for trustees: it’s after all far more safer to select yesterday’s winners.
  4. When entering, look for the exit. When hiring the manager, also communicate the firing conditions internally and externally. If the fund cannot agree on the firing conditions, it shouldn’t hire the manager in the first place. This should help avoid holding on to disappointing mandates too long.

*    Ficticious name
** Amit Goyal en Sunil Wahal.  The Selection and Termination of Investment Management Firms  by Plan Sponsors. The Journal of Finance, Vol. LXIII, No. 4, August 2008.

About Kees Koedijk

Kees Koedijk is Professor of Financial Management and Dean of the Tilburg School of Economics and Management at Tilburg University. Kees Koedijk was the chairman of the Raad van Economisch Adviseurs (REA), an important council of economic advisors to the Dutch Parliament. In the past, Koedijk has won several awards for his research on sustainable development. He has published extensively on finance, responsible investment, and pension management. During the last 10 years he served at several investment committees of pension funds.
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