Career Risk and Herding Behavior

career risk fund manager

The career risk of trying to be different on Wall Street

"QWERTY" are the first six keys in the top left on most typewriters or computer keyboards. More than 90% of all keyboards have this QWERTY configuration. This inefficient key arrangement was originally created to make typing on a typewriter fast without having the keys stick together. Since the creation of computers, typewriters have become obsolete, however, this key arraignment still remains.

While most people who have studied this QWERTY configuration agree that it is not efficient, it is so highly embedded in every user’s skill-set and keyboard, that changing to a more efficient key arrangement would be too challenging to undergo for the mass population. It is claimed that changing to the more efficient "Dvorak" keyboard will take anywhere from three months to one year, and for 6-8 weeks the typist may not be able to easily type on either keyboard.

In 6-8 weeks of not being able to type, the user could easily lose their job for being too slow. Most people will not switch because it is easier to be just like everyone else than to take a chance that either they could improve their typing or get fired for being slower because of it. This is what can be called herding. Staying with the herd is safer than trying to do it alone and being seen getting it wrong. The fund management profession has a similar problem.

Are your fund managers sheep?

If you are correct in your predictions Wall Street has a short memory. When you are wrong Wall Street never forgets

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Career Risk

The financial service industry has a notorious problem which very few people outside the industry are aware of. This problem is generally referred to as career risk. Now, most of you reading this might think, "Who cares if some over-paid fund manager gets fired for not performing well enough?" While having your fund manager keep his job might not be high on your holiday wish list, you should realize that it is an enormous problem at Wall Street firms and that it is causing many funds to under-perform their potential.

It has become all too common that many financial service firms or fund managers have found it easier to try to mimic an index than to try to outperform it. The reason is no different than any other herding behavior. Staying with the herd is safe. If the herd is wrong, then at least you are like everyone else and the punishment is not significant. If a fund manager tries to separate from the herd and is right, then they will have some success. If they are wrong, they get fired. The risks of getting fired do not equal the reward of making a little more money and/or fame. If you are right in your predictions, Wall Street has a short memory. When you are wrong, Wall Street never forgets.

For instance, in 2008, the S&P 500 dropped 38.49%. Most mutual funds performed in a similar manner. While losing all that money is very unsettling, it is relatively acceptable to investors because everyone else lost as well. Let say for example that a mutual fund gained 1.0% in 2013 where the S&P 500 gained 29.6%. The manager would be fired immediately and would find it hard to find work after that, even if he made 15% when the S&P 500 lost 38.49 % in 2008. Most people compare their investments to an index like the S&P 500, so that is the benchmark for performance regardless if the fund manager performs better over a 10 year period.

A well-known example is Jeremy Grantham at GMO. In 1997, his firm suggested that the valuations of tech stocks were too elevated and that his clients should switch out of them. He was rewarded with 40% of his clients pulling their money from the firm. Subsequently after the 2000-2002 period when the market fell significantly, he gained back all the assets and then more, but the message was clear. If you are going to be different, you better be right. And it better not take too long to be proven correct.

Due to the marketing efforts of financial service firms and the news media which hum the same tune, it is very difficult to expect most investors to think outside the box, and be different. So next time you read a news article that says, "most mutual funds underperform their index." You will understand why so many fall into this category. Herding may work for sheep, but not for your hard-earned money.

7 Solutions to fund manager career risk influencing your investment portfolio​

1. Passive Index Investing

Index investing has a fanatical following of investors. Vanguard has built their company on the back of this idea. The concept is to diversify by investing in a mutual fund or ETF that mimics the index. If you are mirroring the index you should not under-perform it. A lot of academic studies have confirmed this thesis. Since most fund managers under-perform their respective index net of fees, this concept is worth considering.

If you are considering the passive index approach to investing, make sure you find the investment vehicle with the lowest fees. While some index mutual funds have very low fees, there are many ETFs with even lower fees. Consider all your choices before making a decision.

You should also consider the wide variety of indexes available to invest. There are indexes for fixed income, international fixed income and equities, as well as many more focused indexes like growth and value, market cap weighted, and sectors. A diversified portfolio should have a variety of asset classes with low-correlation to reduce the risk of your portfolio.

2. Focus on absolute returns, not relative returns

Absolute returns are getting returns regardless of the performance of the index.​ So if your absolute performance benchmark is 5%, if the Index is down -20%, you should get 5%. If the index is up 20% you should get 5%. While most investors don't consider this a viable strategy, many institutions, insurance companies, and pensions try to mimic this if possible so they can more accurately project their future returns.

This type of strategy is hard to do for an individual investor because it requires a lot of time focused on portfolio management. This type of strategy is typically used in hedge funds to achieve uncorrelated returns for their investors. One simple way to achieve this type of return is to invest in​ a bond. If you invest in a 5% bond, you can expect 5% annually. While the price of the bond may fluctuate, you get 5% each year it pays interest. 

3. Don't compare your portfolio to other people​

"Fear and Greed drive the financial markets. If you don't control your fear and greed, they will control your investing decisions."

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This is a common psychological problem among investors. ​Investors have a fear that they will not be performing up to par with their peers. This rarely ends well for the investor, but it is one of the more powerful emotions pushing investors to make bad decisions.

Every investor has a different financial situation. Each investor has unique goals, assets, liabilities, income and expenses​. How can you compare your financial situation with your neighbor?

Fear and greed drives the financial markets. If you don't control your fear and greed emotions, they will control you.​

4. Compare your fund manager over a full market cycle

Fund managers tend to have different strengths and weaknesses. Some perform well in certain types of markets and poorly in others. This can be due to their investing style or their inherent bias about the financial markets. Either way, if you are choosing a fund manager, consider how they perform in the type of market you are in now, not the market of last year or 5 years ago. 

A full market cycle includes both a bull market and bear market (recession). These cycles can last from 5-10 years long. During this period of time fund managers who can accurately spot inflection points in the cycle can do very well for their investors. If you want to fairly judge your fund manager, consider their performance over a full market cycle, not just the prior 12 months.

5. Understand why they under-performed their index

Under-performance of your fund manager is a relatively easy metric to judge. Either they were higher or lower than the index. Right? 

Did you ask why they under-performed?​ Don't feel bad if you didn't. Investors almost never ask why the fund manager outperformed the index. Fund under-performance can be due to a number of factors. Take the above example of GMO who accurately predicted a market decline. They under-performed their index leading up to the peaks of the last 2 bubbles, but the under-performance was due them reducing portfolio risk in expectation of a recession. They were correct in their assessment, but many investors pulled their money out early because they were not interested in why they under-performed. Ultimately, these investors made a bad decision based on their emotions.

6. "Self-direct" your investment portfolio​

Self-directing your portfolio will allow you to take control of your own destiny. For better, or worse, you will be in complete control of your decisions. This option is great for investors who have an expertise in a certain area. It could be technology, biotech, retail stores, emerging market bonds, options, or a variety of other investment strategies. While self-directing your portfolio is a noble endeavor, just make sure you are an expert in that area. If you are taking stock tips from your neighbor, you are probably not an expert. Focus on what you know best.

7. Invest outside the stock market​

There is no rule that states that you need to use a mutual fund or ETF to invest your money. There are virtually an unlimited number of investment types that you can consider. You could consider individual stocks, bonds, cash, options, CEFs, UITs, real estate, annuities, tax liens, horses, gold, private company stock, venture capital, franchises, etc. Its your money. You can invest it anywhere you want. However, whether you invest inside or outside the stock market, you should invest in what you know. Invest in your passion.

 


About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that they have an extensive understanding of the regulatory and financial considerations involved with self-directed IRAs and other retirement accounts. IAG advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources.

For more information, you can visit www.innovativewealth.com

About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and non-traditional investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.

Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article areexclusively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC.