Spotting tomorrow's fund 'stars' of the future is all but impossible
It’s hard to fathom some of the recent coverage of the Neil Woodford scandal.
I won’t embarrass it by naming it, but there’s one Sunday newspaper that lambasts Woodford and his former cheerleaders Hargreaves Lansdown almost every week. Yet, often on the same page, there’s an article in which a group of pundits (usually the same ones every time) speculate as to who the ‘star’ fund managers of tomorrow could possibly be.
There’s an obvious irony here; and I’m not referring to the fact that this same newspaper used to be one of Neil Woodford’s biggest supporters. No, the question we should be asking is: why do we keep asking self-proclaimed experts to tell us which funds we should invest in when, time and again, the funds they recommend turn out to be duds?
The evidence that spotting tomorrow’s fund ‘stars’ is all but impossible is completely overwhelming. In March 2018, the Competition and Markets Authority announced that its quantitative analysis had found no evidence that investment products rated as ‘buy’ by investment consultants have outperformed, net of fees. This held for all consultants, and for all significant asset classes.
A study published a few months later, came to much the same conclusion. The research was conducted by Tim Jenkinson and Howard Jones from the University of Oxford, in conjunction with Jose Vicente Martinez of the University of Connecticut and Gordon Cookson from the Financial Conduct Authority.
The authors looked at the performance of fund managers recommended by investment consultants between 2006 and 2015.
On average, they found, the products recommended by consultants performed no better than other products available to institutional investors.
In fact, once fees were factored in, all of the recommended products combined produced returns 0.30% per year lower than a portfolio of all the products available to plan sponsors that weren’t recommended.
Why are certain funds recommended?
The researchers also found a possible explanation as to why the funds that were recommended underperformed those that weren’t – they were less likely to deviate from the index. Funds that hug the benchmark are less likely to perform disastrously, but are also far less likely to outperform.
Most worryingly of all, when the researchers examined the claims that investment consultants made about their recommendations, they found that they exaggerated their performance by a whopping 2% a year.
The paper concluded that “investment consultants appear, on average, to have no systematic skills in manager selection… (and) tend to overstate their ability to select fund managers.”
The fired beat the hired
Of course, this inability to identify future winners is not just a UK phenomenon. A 2008 study by Amit Goyal and Sunil Wahal, showed that, in most cases, US consultants recommend funds that have produced three years of strong returns, but which fail to deliver excess returns thereafter.
To add insult to injury, Goyal and Wahal found that the fired beat the hired; in other words, the fund managers whose services plan sponsors dispense with on the advice of consultants, then go on to outperform.
Goyal and Wahal have since built on that their original research with a new paper, published in September 2020, called Choosing Investment Managers.
They studied around 7,000 decisions made by more than 2,000 US pension funds between 2002 and 2017, involving $1.6 trillion in funds and 775 fund managers. In each case they compared the subsequent performance of the fund managers who were hired to managers investing in the same asset class and region and with a similar investment style.
Hired managers underperformed
What they found was that post-hiring returns for the chosen fund managers were significantly lower than those for the managers who weren’t chosen.
But more interesting is their analysis of why certain funds were chosen.
Principally, they found, there were two overriding factors in fund selection: pre-hiring returns, and personal connections between personnel at the plan, or the consultant advising the plan, and the fund management company.
Despite constant reminders that past performance does not predict future performance, it’s well known that investors continue to act as if it does, and that this irrational behaviour also extends to investment professionals. This is certainly borne out by Goyal and Wahal’s findings.
They found clear evidence of performance chasing. Prior to hiring, the cumulative three-year return of the funds that were hired was 3.34% higher than the opportunity set. But after hiring, the average three-year return difference was −0.85%.
Post-hiring underperformance was particularly marked among equity fund managers, with a difference in three-year cumulative excess returns of −1.13 %. In fixed income, the equivalent difference in returns was only 0.02%.
The researchers then turned their attention to the influence of personal connections on hiring decisions. Using data from Relationship Science, a database that measures professional relationships, they found that fund managers with connections to plan managers or consultants are between 15% and 30% more likely to be hired than managers without connections.
You might be thinking that’s no bad thing. After all, consultants could in theory use their connections and personal knowledge to hire money managers they believe will deliver the best returns. But that’s not how it works in practice.
To quote the report’s authors, “the post-hiring returns of firms with relationships are, at best, indistinguishable from those without relationships, and often significantly worse.”
In the three years after they were hired, the connected money managers underperformed their non-hired competitors by an average of 1.12% a year.
So, what should investors and advisers take away from these various studies? Simply put, they should stop trying to identify future star performers – and they should certainly stop paying people to do it for them.
The conventional wisdom that funds that have outperformed in the last will continue to outperform in the future is so strongly ingrained that almost no one stops to ask if the conventional wisdom is correct, even in the face of persistent failure.
We’ve been choosing funds on this basis for decades, and it’s failed to deliver the desired result again and again. If we continue to use the same strategy, why should we expect the outcome to be any better?