Monday, July 18, 2016

Competitive asset management and why focus on less popular managers

There is strong evidence that smaller hedge fund managers do better than larger managers. There is also evidence that managers that become popular with growing investment flows often disappoint with poorer investment performance. Finally, it is a fact that many managers underperform benchmarks and there is no persistence in returns. There should be a model that explains all of these phenomena.

There is a rational models on how these results can be achieved through the normal competitive market process. There is no needs to rely on poor management skill or behavioral biases as some have suggested.A competitive model can be used to explain similar behavior with hedge funds. This competitive model can be used to help frame how investors should choose managers. 

I am always surprised by why some academic papers capture thinking in the non-academic world and others do not. The Berk-Green model of asset management behavior found in "Mutual Fund Flows and Performance in Rational Markets" in the July 2004 Journal of Political Economy does a great job of providing a rational model of active management that has useful insight for explaining the lack of persistence and underperformance of managers. Their thinking is even more applicable to hedge funds to help investors choose the right managers.

In world where it is hard to determine skill, looking at performance is useful. Money will flow to the better managers, but in a competitive markets, these money flows will continue until returns are driven down to the industry average or benchmark returns.  It make sense for managers to continue to take money in even while returns are dissipated just as it makes sense for investors to give money to the better managers until returns are driven down to the market return.  Excess returns may exist but may not have persistence because the money flows will drive returns back to the industry average. A competitive market where excess returns are driven out through the normal process of supply and demand can answer a lot of money management questions.

Think about the key issues:

  • Small managers do better - flows or size have not forced profits lower.
  • Larger firms show less profits  - flows have driven returns to the average; however, the past track record keeps money in the fund.
  • Alpha is reduced over time - the competitive flows drive the alpha lower.
If a manager wants to continue to show good performance, he housed limits the size of the fund, although this is may not be rational in a competitive marketplace where he supposed to maximize firm profits. The investor has to look for the out of the way manager, and be willing to leave the fund when it gets larger. The only way to stay ahead of the competitive process is to constantly look for new manager talent and switch after they get too popular.

No comments: