Should Fund Managers Care About the Behavior Gap?

In their book, Quantitative Value, authors Tobias Carlisle and Wes Gray discuss the importance of creating an investment process that systematically reduces irrational behavior. Intelligent people are constantly looking for ways to minimize their own weaknesses. Automating good decisions is one of the best ways to pull this off.

There was one example in the book that showed just how much damage poor behavior can inflict on investor performance. Through 2009 Ken Heebner’s CGM Focus Fund was the best performing U.S. stock mutual fund of the decade. This was the hot mutual fund at the time that everyone was talking about. The performance of the fund was phenomenal, but there’s a catch — investors weren’t brought along for the ride. Here’s Gray and Carlisle on what happened (emphasis mine):

Over the decade, the fund had gained 18.2 percent annually, beating its closest rival by 3.4 percent per year, which is exceptional. The typical investor in Heebner’s fund, however, lost 11 percent annually. […] Heebner’s fund surged 80% in 2007, and then investors poured in $2.6 billion. The following year, the fund sunk 48 percent, and investors yanked out more than $750 million.

That’s a behavior gap of almost 30% per year. When asked about this enormous difference between investment and investor returns, here’s what Heebner had to say:

A huge amount of money came in right when the performance of the fund was at a peak. I don’t know what to say about that. We don’t have any control over what investors do.

This brings up an interesting dilemma for fund managers. How much responsibility should they take for their investor’s behavior? Shouldn’t they care about how their shareholders perform? Obviously, this is an extreme case, but I don’t think that fund managers should be so indifferent about investor performance.

Investors make their own decisions and there’s no way to stop irrational behavior in everyone, but asset management organizations have to educate their clients. There are ways in which funds can help educate their investor base. Communication of the investment process and potential opportunities or risks can help. This could include things like periodic outlooks, performance review letters, conference calls or webinars. Many fund shops have even set up their own blogs to share their thoughts and research on a regular basis.

Whatever the tool used, clear communication should be a priority for those investment firms that would like to distinguish themselves from asset-gathering marketing organizations. The investment firms that I like to work with are always excellent communicators. They’re honest and forthright with their investment process and views on the markets. This includes owning up to mistakes when they’re made and not making excuses for poor performance. Great analysis is worthless without the communication skills necessary to explain it.

The education and coaching aspects should be a priority for all investment organizations — financial advisors, fund managers, pensions, consultants, etc. — that invest funds on behalf of their clients. Nothing is perfect and you can’t save everyone from themselves, but it’s a helpful way to spread your message, gain the trust of clients and affect change in their behavior.

Quantitative Value

Find Tobias (@Greenbackd) & Wes (@alphaarchitect) on Twitter.

Further Reading:
Managing Someone Else’s Emotions
The Difference Between an Investment Firm & a Marketing Firm
Q&A With Alpha Architect’s Wes Gray Part I and Part II



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What's been said:

Discussions found on the web
  1. Jim Haygood commented on Jan 12

    ‘Automating good decisions is one of the best ways to pull this off.’

    Dalbar studies, and the example you cited, indicate that chasing performance is nearly ubiquitous.

    Probably this phenomenon is what allows mechanical timing to work. After all, if every individual sold when stocks go below their 12-month moving average, institutions with static allocations would have to hold all those stocks during bear markets.

    But even among individuals, surveys suggests that the majority are closet, ‘seat of the pants’ market timers, even when they adamantly claim they’re not.

    Fund companies can encourage ‘buy and hold,’ but too many of their customers think chasing 5-star mutual fund ratings is a formula for outperformance.

    You can give them books about mechanical timing … but they just chew the covers off them.

    • Ben commented on Jan 13

      True, easier to say than to pull off in real-time because many investors over-ride even the best model. People have a habit of tinkering too much.

  2. Aidan Sweeney commented on Jan 15

    Hi, I had a look at that book on Amazon. It’s sold out but should be available again in two months. Thanks for sharing.

  3. MoneySheep commented on Jan 18

    I just read your article today, but in the last few days I had been thinking about investor behavior traps, because a sales guy of a “portfolio manager” had been calling me to invest with them.

    From what had been going on, I concluded that they (financial advisers) don’t want to advice me on investing behavior/process that will help me, they just want my money so they can charge repetitive fees, and be a slave to them.

    Then I started to think, I really should educate myself, they are not going to hand it to me. Just like going to the university, they care more about get tuition than giving education. It is a commercial institution. If you get an education in the process you are lucky.

    In the end, “Investors make their own decisions” as you stated above. The problem is that investors seek a fund manager because they need help, but the fund manager is not helping. You are on your own. I conclude that it is best just to buy broad market ETFs.

    • Ben commented on Jan 18

      For the most part, yes, there aren’t enough people out there looking to give good advice and help people change their behavior. But they do exist. I know many of these people. Email me if you’re interested in hearing more.