Are investors better off when investing with ‘superstar’ fund managers?

1492038255334.jpg

Summary of academic paper by Dr Eric Tan, University of Otago

Investing with managers that have just won a prestigious award like Fund Manager of the Year (FMOY) has, on average, resulted in underperformance of over 3% a year!

That’s the finding of Dr Eric Tan of the University of Otago, and his colleague, Dr Jerry Parwada, Head of the School of Banking and Finance at University of New South Wales.

How did they reach this seemingly counterintuitive conclusion? 

They looked at the evidence.

Organisations such as Morningstar proffer such awards as Fund Manager of the Year at expensive gala dinners, and what fund manager doesn’t want to win an award?  It gives them a distinct marketing advantage and a prestigious third party endorsement of their management acumen and style.

However, this does not always translate into benefits for investors, who may be more likely to invest because of the award.

Tan and Parwada’s study looked at fund managers that won the FMOY award in the US stock category from 1995 to 2012.  Their findings were published in the paper, “Superstar Fund Managers”, which was presented in December 2016 at the 29th Australasian Finance and Banking Conference. 

What they found was fascinating.

Predictably, winning an award like FMOY leads to an increase in new investment.  In the chart below we summarise the findings.  The dark purple bars show the new investment flows for award winners, whereas the light grey bars show the flows for other fund managers.

Screen-Shot-2017-09-08-at-4.26.46-PM.png

Just after winning the award (at time t=0, in the middle of the horizontal axis), average new investment inflows were received at much higher rates than before the award was announced. 

To win the award, the fund would generally have delivered better than average peer performance.  If this additional performance was not fully explained by known risk factors, then, in investment jargon, it would typically be referred to as alpha.  Alpha is generally attributed to skill, but it can also just relate to a run of good luck. 

The chart below shows this alpha prior to the FMOY award.  Note most of the bars are positive.

Screen-Shot-2017-09-08-at-3.26.57-PM.png

However, the following chart shows average performance after the award was won.  The red bars show the average alpha achieved after the win - note that most of the red bars are negative.  In other words, winning funds performed worse than average after winning the award.

Screen-Shot-2017-09-08-at-4.34.32-PM.png

Dr Tan summarises his findings in a single number.  “Award-winning managers on average underperform by 3.08% in the 12 months following the announcement of the FMOY award.”[1]

 These findings undermine the idea that the alpha contributing to the FMOY award was to do with skill at all.  If it was, it generally didn’t persist post the award, ultimately to the disappointment of investors who were attracted by it.

 To make matters worse, the also study found that award-winning managers often increase fees after winning the award, meaning new investors get below average returns and pay a higher fee for the privilege.

 This study is just one more reason why we follow an evidence based investment process.  We never allow recent performance to guide why we select or replace a fund manager.  Recent performance may help you win an award, but it’s no guide to future performance!

 Instead, we use facts such as low overall fees, high diversification, consistent exposure to sources of expected return, low investment turnover and having an easy ability to turn investments into cash to help guide our selections.  

 Whilst none of those factors are especially flashy, they do correlate with better performance over time, and they allow us to provide investors with a much better overall investment experience.

 

[1] http://www.otago.ac.nz/accountancyfinance/study/profiles/otago639066.html