Resisting the Force Field of Observed Performance

The introduction to a Citywire Selector video reads, “Dropping fund managers for non-performance reasons, or cutting back on outperformers who may have become too big, are two of the most challenging aspects of fund selection, according to an expert panel of fund buyers in Milan.”

In each case, the problem emanates from the primacy of performance in manager selection, retention, and “de-selection.”  Let’s take the two challenges one at a time.

If you survey organizations about the reasons that managers are fired, you get quite a mix of responses.  A few report that most managers are let go for performance reasons, but that’s not the normal distribution.  Instead, the “fired for performance” percentage is strangely low.

Do a little digging and you find that non-performance concerns often precede the firing of a manager.  But as long as the performance is good, there is a reluctance to act.  When the numbers deteriorate and a change is made, what’s the reason for breaking the relationship?  The qualitative concerns came first, but they weren’t sufficient to lead to action. So the real reason for making the change was performance, even if it’s reported to be because of something else.

The reluctance to act while the numbers look good is reinforced by others, including investment committees, advisors, clients, and other interested parties.  No one wants to step away from a winner over “concerns.”

In a similar fashion, recommendations to cut back on managers that have grown too big can lead to pushback.

There are a variety of flavors of “grown too big.”  Within a portfolio, a strong performer can alter the allocation mix over time, raising important questions about rebalancing policy and whether to let winners run rather than trim them.  That’s a matter of investment belief, which should be outlined in advance and implemented accordingly.

Another too-big risk is that the relationship between manager and allocator changes over time.  Increased familiarity and comfort can lead to diligence standards that are more lax (without intending for that to happen).  Bigger positions should require more attention, but they also engender more faith, which can be a powerful deterrent to clear-eyed observation.  Long relationships are good for managers and investors alike, but not if you can’t recognize the changes that are taking place or aren’t willing to act on them.

And there is a pronounced tendency for asset managers to focus on growing assets rather than trying to stay at a size that’s optimal for performance.  Yet determining the capacity of a fund, of a strategy, or of an organization is difficult (and accepting the capacity projections of managers foolhardy).  Greater scale does not always lead to a deterioration of performance, but there is no doubt that’s the general effect.

As with voicing qualitative qualms, fretting about any of these matters of size usually does not resonate with others, unless the performance is deteriorating already.

To fight these inherent tendencies:

Track the number of procyclical decisions (as to performance) versus countercyclical ones.  Do it for hiring decisions and firing decisions.  If the ratios are heavily skewed (and they almost always are), then performance is overwhelming everything else.

Be clear about your beliefs regarding the assessment of performance versus other elements of manager analysis.  If qualitative factors are truly important, design ways to ensure that they are given their proper due in decision making.  Make sure your approach matches the narrative description of it.

Repeatedly communicate with others (governing boards, advisors, clients, etc.) about those beliefs and the difficult decisions that are required if the purpose of manager selection is estimating the probability of future outperformance rather than reacting to reported performance.

The keeping-track part is simple.  The other recommendations are not.  But it’s hard to resist the force field of observed performance without that kind of commitment.