During due diligence meetings with fund managers, do you ever ask about their personal lives? Are they going through a divorce? Are they worried about putting their children through college? Are they laboring under massive credit card debts?
A sense of conversational propriety probably precludes such an inquiry, but the evidence that a manager’s performance is influenced by their personal circumstances is mounting.
Last year, for example, Citywire reported that fund managers operating in US counties that suffered natural disasters went on to reduce the volatility of their portfolios by economically significant degrees. And now a forthcoming paper in the Review of Financial Studies considers the impact of real estate crashes on managers’ behavior and detects a similar phenomenon.
Betting against the house
Veronika Pool and Noah Stoffman of Indiana University, Scott Yonker of Cornell University and Hanjiang Zhang of Washington State University collected data on the value of 598 US equity fund managers’ homes across 447 unique zip codes. Looking at the bursting of the real estate bubble in 2007 and 2008, the authors documented ‘robust evidence’ that managers who experienced a larger decline in their personal wealth subsequently reduced the risk in their portfolios relative to other managers of similar funds in the same location.
The same pattern emerged when they examined changes in the level of risk taken by fund managers based in San Francisco around the 2001 drop in house prices in that city. ‘This is consistent with shocks to personal wealth inducing an increased distaste for risk, which then translates into lower risk-taking in the fund,’ Pool and her colleagues argued.
‘Mutual fund investors may wonder whether they could be harmed by the behavior we document,’ they continued. ‘Our results do indicate that in this particular instance, Sharpe ratios increase for those managers who suffer a wealth shock. But this is just one realization of possible outcomes; for example, a positive wealth shock could lead to shareholder harm. More generally, investors are harmed when their portfolios can deviate unexpectedly from the investment mandates of their funds.’
Another new study, however, shows how property crashes can lead a different segment of the investment community to even more malign actions. Stephen Dimmock of the Nanyang Technological University in Singapore and William Gerken and Tyson Van Alfen, both at the University of Kentucky, compiled a database of more than 400,000 US financial advisors and their addresses, derived from their Form U4 filings with Finra.
They too discovered that large declines in a practitioner’s house price – calculated from Zillow numbers, which Pool and her colleagues also used – had an impact on their decisions. In this case, it made them more likely to misbehave. Instances of misconduct, defined as formal complaints filed against an advisor by a client, increased by 42% for advisors whose homes lost 10% or more of their value during the financial crisis.
Does this happen because desperate advisors try to cheat their clients, or because advisors are so distracted that they mismanage their clients’ accounts?
Dimmock and his colleagues separated acts of misconduct into what they called ‘active’ and ‘passive’ categories by parsing the text fields in the advisors’ disclosure statements. Active misconduct included cases where advisors deliberately exploited clients for financial gain through misrepresentation, unauthorized trading or activity, fee- or commission-related misconduct, excess trading, or fraud, while passive misconduct would include cases of inattention harming clients, through advisors’ negligence or the omission of key facts. Both forms of misconduct were found to be more frequent when advisors’ house prices plunged.
Fund managers would probably abhor being likened to the brokers who populate Finra’s registers and who are subject to different incentive and oversight regimes, but the broader point is that a financial professional’s behavior is undoubtedly shaped by their personal life. And even if the housing market does not seem at imminent risk of collapse, bear in mind another source of distress and loss highlighted in passing by Pool and her colleagues. While the divorce rate for the US population at large was 44% in 2015, it was closer to 50% for their pool of fund managers.