Picking Funds and Indices
A short review of the literature on manager selection
There’s a vast literature on factors that predict returns in the cross section of equities. But for most people, whether institutional or retail investors, the question isn’t how to pick stocks but how to pick funds and managers. And here there’s a remarkably scarce literature.
The most studied and most replicated finding on choosing funds and managers is the advantage of passive index funds over active managers. The most recent SPIVA (S&P Index versus Active) scorecard shows that the majority of active managers underperform their benchmarks on a net-of-fee basis over long investment horizons.
Yet few people choose to go 100% passive in their investments. Today about 54% of equity money is in passive indices, leaving the other 46% in actively managed funds. And even those that do choose a mostly passive investment approach have the problem of choosing indices: small cap or large cap, growth or value, international or domestic, stock or bond.
How then should investment managers choose indices or styles of investing? And, in the event an investor is looking to hire an active manager, what can we learn about how to do a good job working with active managers?
A great review of the literature on picking funds and indices comes from the brilliant and prolific Antti Ilmanen along with his AQR colleague David Kabiller and Swiss professor Amit Goyal. In their essay “Bad Habits and Good Practices,” they summarize the best studies on what investors can do to improve their decision-making.
The single biggest error investors make in choosing investing styles is pro-cyclicality. Using annual data on US pension funds’ asset allocations, researchers found that “a positive return in one asset class (domestic or international stocks or bonds) results in an increase in target policy weights of that asset class, not just in the same and subsequent year but for several years.”
Figure 1: Pension Fund Target Policy Weights Chase Returns over Several Years
Source: Goyal et al.
Unfortunately, the natural desire to allocate more money to better-performing asset classes turns out to be exactly the wrong instinct. While asset classes exhibit short-term (one-year) momentum, they tend to mean revert over the long term, as shown in the chart below.
Figure 2: One-Year Momentum and Multi-Year Reversal Tendencies in Asset Class Returns
Source: Goyal et al.
In practice, this means both that institutional investors tend to hire managers who have performed well over the prior two years and that the hired managers then tend to underperform the fired managers.
Figure 3: Plan Sponsors' Fire/Hire Decisions
Source: Goyal et al.
Allocators tend then to be pro-cyclical. They increase weights to asset classes with higher prior performance, give more money to managers who have been outperforming, and neglect the base rates on mean reversion in both asset classes and underlying manager performance.
In addition to these academic findings, Norges Bank published a fascinating report on their experience choosing active equity managers. Norges Bank has earned 1.8% excess return over 20 years in their external manager program—about $5B in excess profits—and invested with over 300 external managers. They have a robust internal research process complemented by extensive quantitative analytics on the characteristics and performance of their underlying managers.
Among other findings, they found that managers in more volatile markets generated higher excess returns than those in markets with less volatility and that managers with higher turnover outperformed those with lower turnover. Norges Bank primarily invests in active equity managers with concentrated (~50-stock) portfolios, with niche regional focuses as a result.
Perhaps most interestingly, they found that the crucial variable wasn’t hiring/firing decisions as much as deciding when to add to or trim from managers: their equal-weighted excess return of 0.7 percent was lower than the time-weighted excess return of 1.6 percent, meaning that funding/defunding decisions had a strong positive impact.
Combining the insights from these papers, it seems that the winning response is counter-cyclical investing: using strategic rebalancing as a mechanism to force selling of winners and buying of losers. And when choosing underlying managers, it seems necessary to develop a methodology that is not contingent on recent performance, making it possible to add to high-conviction strategies in the midst of bad times.