Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 251

Is manager selection worth the effort for financial advisers?

A review of the Forbes top 100 financial adviser firms in the United States in 2017 showed that manager selection is the top service advisers market to clients, and the process required to provide the service claims a meaningful amount of a firm’s resources. The determination of whether manager selection falls into the category of a low impact/high effort thankless task comes down to expectations.

If the expectation is to reduce negative alpha (i.e. underperforming the market) or to minimise regret risk, manager selection will likely have a positive impact, perhaps even enough to justify the resources commensurate with the task’s difficulty. If the expectation is to produce positive alpha, financial advisers and their clients are likely to be disappointed.

How, then, can advisers operate at the optimal position in the impact–effort matrix?

The challenges advisers face

In seeking to meet their clients’ financial goals, advisers face two sizeable headwinds: clients’ investing biases and the difficulties in identifying skilled managers who are able to reliably produce alpha for their investors. Let’s review briefly what the academic literature has found regarding these two challenges.

Retail investors are generally susceptible to a number of biases. Most notably, their returns-chasing behaviour leads to poor buy and sell decisions and disappointing investment outcomes. Barber and Odean (2000) found that the average retail brokerage investor underperformed the market by about 1.5% a year. What was even more telling was that investors who made the most buy and sell decisions had the worst performance, underperforming by 6.5%! This hazardous tendency manifests itself meaningfully when it comes to picking mutual funds and other managed products.

Hsu, Myers, and Whitby (2015) showed that investors earned about 2% less than the mutual funds they invest in because of a bias toward chasing performance (i.e., buying high and selling low). Their research also demonstrated that larger performance gaps exist in high-expense-ratio funds (again more likely to be held by retail investors) versus low-expense-ratio funds. Hsu, Myers, and Whitby concluded that less-sophisticated investors, often those who invest in retail funds, underperformed by a greater margin (i.e., suffered a larger return gap) than those who qualified for institutional share-class funds.

Advisers face tremendous challenges in overcoming such client biases. Mullainathan, Noeth, and Schoar (2012) found evidence that suggests advisers have difficulty de-biasing their clients, and as a result engage in ‘catering’ behaviour, seeking to please existing or new clients by being supportive of returns-chasing behaviour. Linnainmaa, Melzer, and Previtero (2016) also found that the average adviser has difficulty overriding retail investors’ biases, often exacerbating them with recommendations of frequent trading and expensive, actively managed products.

A behavioural bias that favours more of what recently has provided comfort and profit and less of what has produced pain and loss often leads advisers to recommend the managers their clients want—those with the best trailing performance. Thus, clients can find themselves treading the ‘hamster wheel’ of manager selection, continuously replacing poor performers with good performers. Evidence shows this form of performance chasing, however, likely puts advisers and their clients on the outside track to future excess returns.

Cornell, Hsu, and Nanigian (2017) documented mean reversion in mutual fund performance, finding that, when measured by trailing three-year performance from 1994 through 2015, top-decile managers underperformed the bottom-decile managers by 2.3% a year. Arnott, Kalesnik, and Wu (2017), controlling for fund expenses, showed a similar monotonic drop-off in the subsequent performance of prior winners.

The evidence makes it pretty clear we shouldn’t use historical performance as our primary manager selection criteria. Well, maybe we should - just in the opposite direction!

Advisers should focus more on three soft ‘Ps’

Advisers who acknowledge the pitfalls of a pure performance selection criterion could spend more of their due diligence efforts on the so-called soft 'Ps': philosophy, process, and people. Indeed, the institutional investment consulting community has relied heavily on non-performance factors for decades to make manager selection decisions. Jenkinson, Jones, and Martinez (2016) found that consultants’ recommendations correlate partly with the past performance of fund managers, but more so with non-performance factors, suggesting that consultants’ recommendations do not merely represent a returns-chasing strategy.

But the additional insights gained by non-performance factors has not led to an ability to, on average, select ‘winners’. On a value-weighted basis, Jenkinson, Jones, and Martinez found no evidence that the managers’ products recommended by investment consultants outperformed the products the consultants did not recommend. On an equally weighted basis, they found that recommended products underperformed other products by approximately 1% a year, leading them to conclude that non-recommended funds performed at least as well as recommended funds.

Benefits beyond the pursuit of benchmark-beating performance can be realised through careful and well-resourced manager selection. Behavioural finance frequently references individual investors’ willingness to forgo higher wealth accumulation in favour of non-monetary emotional benefits. We assert as much in Research Affiliates’ core investment beliefs that investor preferences are broader than risk and return. Additionally, benefits of a well-documented manager research effort can mitigate regret risk in performance ‘blow-ups’ (particularly with negative press headlines for public entities) and provide a layer of - real or perceived - fiduciary insurance; for example, by performing an extensive due diligence review before recommending a manager, the adviser or consultant best positions themselves to explain a poor-performing manager.

Nonetheless, the literature suggests that financial advisers shouldn’t expect, nor communicate to clients an expectation of, market-beating results via manager selection, at least not with the current (sometimes overwhelming) investor bias of making buy and sell decisions based on performance metrics.

Is zero alpha a win?

Perhaps the biggest value an adviser can add is to save clients from themselves by eliminating their negative alpha. If, as is frequently the case, the starting point is 200 basis points of negative alpha from horrible timing on fund hires and fires, then taking this to zero should be considered a relative win for both client and adviser. Evidence suggests this is a realistic and achievable goal.

Jenkinson, Jones, and Martinez (2016) found that the returns of consultant-recommended funds were roughly in line with non-recommended products, and Goyal and Wahal (2008) found that “post-hiring returns are higher for decisions in which a consultant was used in selecting the investment manager.” Our interpretation is that consultants’ qualitative judgment and research slow down clients’ returns-chasing behaviour. Given the sizeable literature showing the return gap between investors’ returns and their funds’ returns, perhaps the more constructive goal of manager selection is to ‘do no harm’ when replacing poor performers. Perhaps a worthwhile ‘win’ from manager selection is zero alpha!

Seeking positive alpha is hard from two perspectives. It’s hard for fund managers to beat passive benchmarks, and as we’ve demonstrated, it’s hard for fund selectors to pick the winning fund managers of the future. Advisers can feel pressured to please returns-chasing clients. When their mandate is to replace recent bottom-quartile funds with recent top-quartile funds, advisers start at an inherent disadvantage in producing positive alpha. Reframing the goal of manager selection as the positive impact of reducing negative alpha and educating clients so that their expectations are in line with this goal can justify the effort expended by financial advisers on manager selection.

 

John West CFA is Managing Director, Head of Client Strategies and Trevor Schuesler CFA is Vice President, Client Strategies at Research Affiliates. This article is general information and does not consider the circumstances of any individual.

 

RELATED ARTICLES

The most vital question ever put to me as a portfolio adviser

Fund managers versus funds: fraternal or identical twins?

Using past performance is a risky way to invest

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Latest Updates

Planning

What will be your legacy?

As we get older, many of us start to think about how we’ll be remembered by those left behind. This looks at why that may not be the best strategy to ensure that you live life well and leave loved ones in good stead.

Economy

It's the cost of government, stupid

Australia's bloated government sector is every bit as responsible for our economic worries as the cost of living crisis. Grand schemes like the 'Future Made in Australia' only look set to make it worse.

SMSF strategies

A guide to valuing SMSF assets correctly

SMSF trustees are required to value all fund assets, including property, at market value when preparing the fund's financial statements each year. Here are some key tips to ensure that you get it right.

Economics

Australia is lucky the British were the first 'intruders'

British colonisation's Common Law system contributed to economic prosperity, in contrast to Latin America's lower wealth under Civil Law. It influenced capitalism's success in former British colonies, like Australia.

Economics

A significant shift in the jobs market

The expansion of the 'care sector' represents the most profound structural change to Australia's job market since the mining boom. This analyses how it's come about and the impact it will have on the economy.

Shares

Searching for value in tech stocks

Just because a stock is cheap doesn't necessarily make it good value. This uses case studies in the tech sector to help identify when stocks trading on 30x earnings may be inexpensive and when others on 10x may be value traps.

Investing

Are more informed investors prone to making poorer decisions?

Finance Professor Michael Finke recently discussed the double-edged sword of taking an interest in your investments, three predictors of panic selling, and why nurses tend to be better investors than doctors.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.