One of the most commonly employed methods for judging whether an active equity fund manager possesses skill is monitoring performance consistency – that is the regularity with which a particular manager outperforms their benchmark index over specific time periods (frequently calendar years, but often briefer).  This shorthand gauge of quality is pervasive across asset management groups (sellers), fund selectors (buyers) and the media.  The use of such a context free number is deeply flawed.  Not only does it disassociate process from outcome, and lure investors into strategies with a high probability of mean reversion; but it biases us against the distinctive, high conviction equity managers that better justify the use of active management.

Although the pull of performance ‘reliability’ is difficult to resist; the use of short-term excess return consistency measures to assess active equity managers is predicated on two flawed notions:

– Active equity managers have the ability to dependably predict short-term market behaviour.

It is surely now incontestable that the short-term movement of equity markets is highly unpredictable.  For an active manager to deliver consistent returns across discrete time periods through the application of skill, they must hold the uncommon ability to anticipate market direction and drivers, and appropriately shape their portfolios to benefit.

– The market consistently rewards good investment decisions.

To believe that short-term performance consistency can be employed to identify skill, one must contend not only that a manager makes consistently good investment decisions (on average) but that the market duly rewards these judgements in the near-term.  Markets are reflexive and for sustained periods can be driven by narratives and momentum, detaching dramatically from any semblance of fundamental reality.  Objectively robust decisions can go unrewarded for prolonged periods.  The implicit assumption embedded in performance consistency analysis of an active equity funds is that the market has unerringly validated the manager’s investment decision making.

Although the point of this post may seem relatively minor, it is critical to how we view and assess active equity management.  Performance consistency is employed in marketing campaigns, is frequently used by fund selectors to ‘screen’ sectors for talented managers, and often drives the external ratings given to funds.  This widespread acceptance of consistency as a robust indicator of skill exacerbates the damaging focus on short-term outcomes and leads to extensive attribution errors.  Furthermore; it must reduce the opportunities available for genuinely long-term focused active equity investors.

As difficult as it is to separate performance consistency from the skill of any active equity manager, unless a specific link can be drawn between the outcomes delivered and the underlying investment process, this should be our default stance.  Markets embark on prolonged trends and are driven for sustained periods by in-vogue themes;  against such a backdrop it is inevitable that groups of active managers will deliver consistent headline performance as they (often inadvertently) hold style biases that benefit from the prevailing tailwinds.  Given the structure of the market it would be surprising if there were not clusters of equity managers exhibiting consistent excess returns.

The behaviour of financial markets creates patterns of outcomes that are ideal for establishing a mirage of skill, and whilst we are hardwired to draw links between these outcomes and the related process, the simple fact is that skill in active equity management cannot be gleaned from performance alone, irrespective of the form it takes.

It is not only that headline performance consistency is a deeply misleading means of assessing the ability of an active equity manager, but as a characteristic it is the exact opposite of what fund selectors should be seeking.  By definition, long-term, high active share, conviction investors will not deliver performance consistency over the short-term.  There will be periods (often prolonged) when their style is out of favour and the ‘market’s perception’ diverges materially from their own.  Through such spells of challenging performance we should expect them to remain disciplined and faithful to their philosophy and approach; not wish them to latch onto the latest market fad in an effort to achieve improved short-term returns.

Consistency is absolutely paramount to the assessment of active equity managers, but we are focused on the wrong sort of consistency.  Rather than obsess over the persistence of short-term outcomes; we should focus our attention on the consistency of manager behaviour relative to their stated philosophy.  Doing so would improve the probability of achieving excess returns from holding active equity managers over the long-term.

In my previous post I explored how quality uncertainty for both buyers and sellers of active management created a bloated market structure with homogenous fees and average pricing greater than that justified by average quality.  One potential solution to these inefficiencies is the use of performance fees for active management; which, it is argued, brings alignment between fund manager and client, by ensuring that fees are linked to the ultimate objective of the end investor.  Performance fees are also said to limit the desire of fund managers to engage in asset gathering – conduct that is detrimental to long-term returns.

Whilst there are optical attractions to the wider implementation of performance fees within the field of active management, it is highly questionable whether they incentivise the correct activities or provide genuine alignment between fund manager and client.  It is more likely that they exacerbate harmful behaviours.  The main drawbacks are as follows:

Process versus Outcome: The importance of focusing on process over outcomes has become better understood in recent years, and is particularly crucial in active fund management where the randomness and variability of results means that outcomes can be grossly misleading when attempting to discern skill.  Despite awareness of this issue, the clutches of outcome bias are difficult to escape and the industry remains obsessed by headline past performance.  Linking fees directly to performance inflames the issue – it expressly ignores the quality of process / decision making, whilst delivering substantial rewards for positive outcomes, whether they be driven by skill or pure chance.

Incentives Matter:  Although not entirely in unison on the subject, both mainstream economics and behavioural science focus on incentives as a key determinate of an individual’s actions.  As Charlie Munger commented:  “Never, ever, think about something else when you should be thinking about the power of incentives.”  Whilst it may appear that performance fees for active management represent a perfectly aligned incentive structure, this is far from the case. Performance fees create a very singular dynamic – reward is related to outperformance, irrespective of how it is generated.  It is naïve to believe that the behaviour of a long-term investor won’t alter based on potential near-term payoffs; it could result in increased risk taking or protective strategies to preserve potential performance fees.   Furthermore, the asymmetric nature of most performance fee structures also creates disconnect between the interests of the fund manager and client.

Reference Points Matter:  Intrinsically related to the power of incentives is the manner in which reference points can dominate our perceptions and behaviour.  Performance fee structures often create reference points for fund managers that are inconsistent with the long-term goals of an investor.  For example, based on the lessons of Prospect Theory, we might expect the employment of a high watermark to lead fund managers to engage in more risk seeking behaviour when performance falls below this threshold, than when they are above it.  Performance fees can also foreshorten fund manager investment time horizons – whilst their stated investment philosophy might be focused on five year periods, performance fees often create short-term reference points focusing on relative returns over the next quarter or year.

Structural Challenges:  Performance fees are difficult to apply in a daily dealing structure in a manner that treats all clients equitably – despite the myriad of methodologies employed.  For example, if levied annually, four years of modest outperformance could lead to handsome profits for the fund manager, even if the fifth year is disastrous and returns for the client over the entire period are disappointing (depending on clawback arrangements).  Furthermore, fee structures that ratchet the base management charge higher following a prolonged spell of outperformance lead to new investors paying higher fees based on historic excess returns that they never enjoyed.

Active Management Fees are not about Performance Alone

It may sound an absurd contention given that outperformance above some benchmark or passive investment is the ultimate goal of employing active investment management, but the fees levied should not be about performance in isolation.  Active management fees should be paid because the fund investor believes that the underlying investment process (in the broadest sense of the term) is of sufficient quality that it materially increases the probability of delivering market outperformance over the long-term.  There can be no guarantees – in a random and variable system even good decisions can lead to disappointing outcomes.

It is a misnomer to believe that performance fees bring better alignment between clients and fund managers, in many cases they are likely to encourage behaviours that are inconsistent  with investor expectations and even the manager’s own investment philosophy. Performance fees are an unnecessary distraction from what is required to improve the market for active fund management, which is lower flat fees, genuinely distinctive investment approaches and patience.

Prior to being awarded the Nobel Memorial Prize in Economic Sciences, economist George Akerlof authored the seminal paper: “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (1970). The piece focused on the used car market in the United States with a central contention that an information asymmetry existed between buyer and seller, which led to low quality cars (lemons) being overpriced and high quality vehicles under-priced; the consequences  for the market were considered as follows:

– Withdrawal of higher quality vehicles.

– Reduced size of market.

– Reduced average quality.

– Reduced average willingness to pay.

Though the ‘information asymmetry’ term is somewhat oblique, the core concept is simple – where the seller knows more about the product than the buyer, this can be used to their advantage.  Whilst the prospective purchaser can make a general assessment of a car’s qualities, they are likely to have limited knowledge of its detailed history.  In the absence of this information, it is difficult for the buyer to differentiate between cars of contrasting quality except by judging headline factors such as appearance.  This leads to a price convergence between low and high quality cars as buyers are unable to accurately distinguish between options, and a subsequent withdrawal from the market by those offering higher quality vehicles.

I previously held the view that the active fund management industry was consistent with the ‘market for lemons’ concept, but, on reflection, whilst there are certain echoes, the impact of quality uncertainty in active management is distinct.  Most notably, in Akerlof’s example, the condition is created by a significant disparity in the awareness of a product’s quality between buyers and sellers – the aforementioned information asymmetry.  However, in the case of active management, doubt over the quality of the product is true for both buyers and sellers – neither party is certain that skill exists. Although there may be an informational edge held by asset management groups regarding the underlying quality of their active offerings, this is likely to be marginal and often erroneous.

The central problem of the market for active fund management is the subjectivity around what constitutes quality (or skill) and the spurious use of past performance as an indicator of said quality.  From a buyer’s perspective, at the point of purchase it is difficult to know with certainty whether one has purchased a manager with skill or a ‘lemon’.   In addition to this, given the randomness of outcomes inherent in financial markets, even if a manager with skill is correctly identified – there is no guarantee that positive outcomes will be delivered.

In the majority of purchasing decisions – a washing machine or TV, for example, – there is a reasonable level of clarity over what the key indicators of quality are and how they might influence the product’s cost.  In the case of active fund management, it is far more difficult to ascertain what characteristics define quality and how they should be valued.  Given this uncertainty the temptation is to depend on past performance as the best indicator of quality / skill; a situation which allows many ‘lemons’ to masquerade as high quality active funds merely due to good fortune.

The reliance on past performance as the primary marker for quality also leaves investors vulnerable to a distinctive aspect of the active fund management market –  ‘evidence’ of historic high quality (strong past performance) may actually increase the probability that future outcomes will be of a lower quality (poor performance through mean reversion).  This is a perverse situation, akin to a scenario where a hotel that has received consistently five star reviews on TripAdvisor is more likely to deliver disappointing holidays to future guests.

Given the majority of active funds producing sustained underperformance will close or be subject to manager change; we are left with a pool of active managers, most of which will have delivered outperformance for certain periods, some through luck, others skill (and a combination of the two).  Within this collection of managers the quality will inevitably vary significantly, and it is the challenge of differentiating between these (for both buyers and sellers) that gives the market for active management its most distinguishing features:

– Proliferation of active strategies / Reduced average quality:  The subjectivity around what constitutes quality and the randomness of performance (particularly over shorter-time horizons) means that a vast number of low quality / unskilled active strategies can exist, creating a bloated market.

– Homogeneous pricing:  The problem of discerning between different levels of quality leads to minimal distinction between active fund costs.  Active funds with no evident skill (which should cost zero – at most), are priced under the assumption that they do possess skill; whilst the highest quality offerings may struggle to charge a ‘premium’ price to the wider market because the buyer is uncertain over their true quality.

– High average price relative to average quality: The entire market is priced as if skill is pervasive.  On balance, there are a greater number of lower quality funds overcharging, than there are higher quality funds ‘undercharging’; thus, the average price for active management is skewed upward.

– Withdrawal of highest quality operators:  This is perhaps a factor at the margins, with certain high quality operators moving away from the mass market and into (even more) rewarding fields, such as hedge funds.  This move, however, will also be attractive to unskilled participants, who wrongly believe they possess skill.  Overall, the market is currently sufficiently lucrative for the majority of participants to remain.

In essence, the structure of the market for active management is defined by a cocktail of random markets and our own behavioural frailties.  Our focus on the short-term, obsession with outcomes and susceptibility to compelling narratives serves to cultivate its core characteristics.  Whether these features are indelible or materially vulnerable to the changing investment management landscape witnessed in recent years, remains open to question.

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Key reading:

Akerlof, G. A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 488-500.

Despite the paramount importance of the findings of behavioural science to our investment decision making, there is limited evidence of its lessons and principles being applied.  Given the long-term benefits from engagement with this area, why has there been such a reticence to embrace behavioural concepts?  There are four factors, which I consider to be the major impediments:

• Individual Acceptance: The investment community has certainly not ignored behavioural science, but there is a tendency to consider how it affects other people. Acknowledging personal behavioural vulnerabilities is not easy; particularly for professional investors operating in an industry where accepting mistakes and limitations can have a deleterious impact on career prospects. However, individual ownership is crucial if behavioural issues are to be tackled.
• Amorphous Ideas: The range of biases highlighted and heuristics identified in behavioural research is vast; furthermore, they frequently overlap, are sometimes contradictory, can suffer from replication issues and are often not directly related to the field of investment. Given these factors, the struggle to develop a coherent means of addressing the topic is unsurprising.
• Challenging Application: Developing solutions that serve to mitigate the impact of behavioural weaknesses is difficult; they often face criticism for being too simplistic (‘surely re-ordering the presentation of performance data won’t impact our decision making’ ) or are contrary to conventional wisdom (‘I need to be on top of my portfolio, so checking it less is not a feasible option’). More broadly, there is limited empirical evidence on successful ‘de-biasing’ strategies that are directly applicable to investment decision making.
• Investment Process Afterthought: Through a combination of the aforementioned factors, behavioural concepts are often an afterthought in an investment process, serving at best as an adjunct to the ‘real’ investment decision making and, at worst, a pure marketing ploy designed to capture some kudos from the current interest in the topic, but lacking in any substantive value.

These issues are by no means insurmountable, but action is required to effectively incorporate behavioural science in a meaningful and consistent fashion. As simplicity is at the heart of most successful behavioural interventions; an ideal starting point is to develop a checklist encompassing the most significant and influential behavioural hurdles. Although a seemingly minor advance, such a step could have a material impact on investment decision making.

As detailed in the popular and engaging ‘The Checklist Manifesto’ (Gawande, 2009); concise checklists are an incredibly effective means of encouraging behavioural consistency, whilst limiting mistakes and omissions.  Furthermore, if correctly structured, they can easily be integrated within existing processes and rapidly applied.  Of course, a behavioural checklist for investors cannot be as specific or definite as those that might apply in surgery or aviation; however, they can serve to ensure that the consideration of behavioural issues becomes an integral part of the decision process.

Although it may seem superfluous, making a checklist memorable is also a vital means of ingraining its core ideas.  Behavioural science is particularly fond of acronyms; notably, the MINDSPACE and EAST structures employed by the UK Behavioural Insights Team when designing policy (EAST, for example denotes: Easy, Timely, Attractive and Social).  More prominent, on a global scale, is Thaler and Sunstein’s highly influential NUDGES framework.

Given that the purpose of this behavioural checklist is to better reflect on our own and others’ investment decision making, I propose the use of MIRRORS, where each letter pertains to a prominent behavioural factor that exerts a material influence on investors:

M	Myopia	We are overly influenced by short-term considerations
I	Integration	We seek to conform to group behaviour and prevailing norms
R	Recency	We overweight the importance of recent events
R	Risk Perception	We are poor at assessing risks and gauging probabilities
O	Outcomes	We focus on outcomes when evaluating the quality of a process
R	Reference Points	We make judgements using, often erroneous, reference points
S	Stories	We are frequently beguiled by compelling narratives

Whilst there is depth and complexity underpinning the behavioural issues included in the checklist, which I will endeavour to explore in future posts, the fundamental problems and potential implications of each should be readily apparent.

The checklist is not designed to be exhaustive, thus there will inevitably be pertinent issues not adequately captured; however, it incorporates what I perceive to be the major behavioural impediments encountered, and those which forge a significant ‘behaviour gap’ between underlying asset performance and the returns realised by investors.  Moreover, employing a concentrated list makes it simple to bring these crucial considerations from the periphery to the core of investment decision making

Creating a checklist is, of course, no panacea and one cannot hope to ameliorate the impact of ingrained biases and predilections, simply by ticking boxes.  However, the starting point for improvement in our investment choices and judgements is an awareness and acceptance of our behavioural flaws.  Employing a checklist is an acknowledgement of susceptibility and an expression of willingness to engage with the issues in a consistent and rigorous fashion.

In my next post, I will explore in greater detail how such a checklist might be utilised as part of an investment decision making process both to stimulate debate and to develop interventions. However, even without a precise application in mind, simply beginning to think about and discuss the areas covered in the checklist when making decisions should prove a major benefit to investors.

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Key Reading:

Dolan, P., Hallsworth, M., Halpern, D., King, D., & Vlaev, I. (2010). MINDSPACE: influencing behaviour for public policy.

Gawande, A. (2010). The checklist manifesto : How to get things right. London: Profile Books.

Insights, B. (2014). EAST: Four Simple Ways to Apply Behavioural Insights. London: Behavioural Insights.

Sunstein, C., & Thaler, R. (2008). Nudge. The politics of libertarian paternalism. New Haven.