(James Saft is a Reuters columnist. The opinions expressed are
By James Saft
Nov 30 The idea that people succeed at work up
to the point at which they are no longer much good apparently
applies to fund managers too.
A new study bears out the truth in asset management of the
"Peter principle", a theory coined by Laurence Peter, an
academic who studied hierarchies. The Peter principle holds that
managers are promoted up to the point at which they are
incompetent. That's not to say that only the worst succeed,
recent political evidence perhaps to the contrary.
It is instead the idea that just as industry tests business
models to destruction (see: mortgage-backed derivatives), so do
organizations test the abilities of their employees until they
too are found wanting.
In a fund management context, this means you as an investor
stand a non-trivial chance of signing on with a fund manager
who, despite her track record of success, is now in well over
her head. Ironically, there might also be some advantage in
managers who, having demonstrated incompetence at a particular
level, are now given only a diminished mandate.
While older studies did show a relationship between increase
in size of a fund and diminishing performance, a November study
by Richard Evans and Marc Lipson of the University of Virginia
and Javier Gil-Bazo of Universitat Pompeu Fabra looked also at
the way in which the scope of a manager's responsibilities
affects performance. The upshot is that there look to be
diseconomies of scope, just as there can be diseconomies of
scale in investment management.
Scope of manager responsibilities in this context includes
not just size of assets managed, but the number of funds and the
number of fund investment objectives a manager is assigned.
"We find that fund alphas are negatively related to measures
of the scope of manager responsibilities," the authors write. (here)
"Results suggest that better performing managers experience
increases in scope that eliminate outperformance. In these tests
we also find that worse performing managers experience scope
reductions that improve performance to a degree that offsets
underperformance. This reinforces our interpretation that the
results are driven by manager activity."
In other words, it may be that as managers prove themselves
competent they are piled with more work up to the point at which
whatever outperformance they've demonstrated is effectively
arbitraged away by volume, by distraction and by difficulty.
The study looked at U.S. equity mutual funds between 1997
and 2015 and used a range of tests to try to establish the
relationship between performance and the scope of manager
AGENCY ISSUES (AS USUAL)
It is not hard to work out why fund companies load up their
better managers with more responsibilities: this is what
organizations do. Fund firms presumably hope that whatever magic
an active manager has demonstrated thus far can simply be
applied to new and bigger mandates, thus winning the firm more
business and profit. Fund firms also view larger
responsibilities as a way to hold on to talent, as you can pay a
manager more the more assets and functions she handles.
This is the kind of agency issue which is endemic in asset
management. It is in the fund management firm (the agent's) best
interest to get more out of a given manager even if the
principal, the investor, will be hurt. The individual fund
manager has exactly the same issue: she may know she is
spreading herself too thin but be unwilling to make the economic
sacrifice which placing client interests above her own entails.
And unlike problems of size, which many financial advisors
already acknowledge and may be on the lookout for, performance
issues from managerial scope are not currently on their radar,
nor do they require anyone outside the fund firm to do anything
in order to happen.
Taking a step backward, evidence of the Peter principle in
fund management is not just one more reason to be doubtful about
the wisdom of choosing active asset management over passive.
Like doubts over whether managers can successfully handle
bigger funds or if their outperformance can persist over time
even with stable funds under management, this seems to point to
a kind of efficient market hypothesis when it comes to active
management. The market, at least as incentives are set up, seems
to abhor outperformance and works in a variety of ways to
arbitrage it away.
Chasing talent, which is what fund firms do by piling on
tasks to their best managers, is foolish in the same way as it
is fruitless to chase returns.
Well, foolish for investors.
(Editing by James Dalgleish)