Despite enjoying their first positive net flows in three years, 2017 was another tough year for active managers. Not only were the inflows thanks entirely to the taxable-bond category, they were still minuscule compared with the money attracted by passive funds.
According to research firm Cerulli Associates, active mutual funds and ETFs netted $19.1 billion in 2017, while passive strategies pulled in more than 35 times that amount, $694 billion.
The active industry can respond in one of two ways: Cut charges to become more competitive, or improve performance to become more appealing. Plenty have taken the former route, including the likes of AllianceBernstein, Allianz Global Investors and Fidelity. Boosting performance is trickier than slashing costs, but would of course be better for asset managers’ profits – and for investors if it means funds can more reliably outperform their indices.
A new report by Nick Hoffman, Martin Huber and Magdalena Smith at management consultancy McKinsey proposes a way for fund groups to achieve this feat: systematically remove the biases that undermine portfolio managers’ performance.
‘Evidence from within and outside the industry strongly suggests that even the leading asset managers in top-performing funds could improve their investment performance by applying de-biasing techniques,’ the McKinsey team argued.
‘Our recent experience working with investment managers has shown that enhancing these techniques with analytics can improve performance significantly.’
Working on the bias
As an example, they pointed to a global investment bank that had reviewed its traders’ decisions on the weighting of equity positions.
This revealed a pattern of suboptimal execution due to endowment effects and confirmation bias, respectively the psychological tendencies to retain holdings despite changing conditions and to see non-existent patterns in information to validate assumptions. McKinsey added that a major asset manager had separately identified confirmation bias in its investment managers’ moves.
‘In the asset management sector, investment decisions are being analyzed in light of de-biasing experiences in other industries,’ McKinsey said. ‘A few leading funds have employed analytics in this effort, to improve effectiveness in diagnosing bias and its drivers. Working with analytics experts and behavioral scientists, they applied machine-learning algorithms to their historical investment data. They discovered clusters of suboptimal investment decisions that showed potential biases.’
At what McKinsey described as one ‘high-performing equities fund,’ for instance, performance decomposition analysis revealed that over the course of eight years superior stock-selection decisions were driving most of the returns. Stock weighting and the timing of stock sales, however, dragged on performance.
During the review period, stock picking contributed positive average annual total returns of 12.8%, but stock weighting and selling reduced returns by an annual average of 2% and 4.6% respectively.
Given this disappointing timing of the sales, then, the fund managers focused on this discipline for further investigation and discovered that three out of 10 stocks were disposed of too early or too late. To remedy this, the managers developed a detailed questionnaire to probe the ‘structural and emotional environment’ surrounding each trade.
One finding from this was that more often than not sales of high-flying stocks were made too early when the dominant emotions were pride and optimism.
Once these biases were recognized, the fund could implement quantitative metrics to highlight the environments in which they would occur. These ‘triggers’ for review included a 25% movement of a share price within a three-month window, the failure to add to a position during a 60-day period when the stock was drifting down, and a negative attribution to fund performance of over 50 basis points within a year. The resultant review could include several de-biasing techniques that have been employed by many other organizations and sectors.
These could be:
- Formal checklists to slow down decision making
- Devil’s advocates who challenge the manager’s views
- Pre-mortems in which the manager works back from the assumption that a disaster has occurred and attempts to tease out why
- ‘Red team/blue team’ sessions in which the manager observes independent parties arguing the investment case
The prize for instituting official processes such as these is significant, McKinsey said. ‘Our initial analysis suggests that, even under conservative assumptions, de-biasing will allow funds to undo this negative impact and reap the performance rewards. In looking at actual funds, we saw potential improvements of between 100 and 300 basis points.’
Regardless of whether active managers heed this advice to resist the rising passive tide, the lessons are applicable to all wealth managers. So, do you suffer from an anchoring bias to active over passive funds, for example, or has confirmation bias led you to underweight equities in recent years?