Does the house always win?

While they are perhaps not as well-dressed – or cosmetically enhanced – as the Kardashians, there is a select group of celebrity fund managers who regularly outperform and are endlessly profiled in the media. Deemed to have the Midas touch, these individuals often control staggering large amounts of money too.

At the same time, many other successful funds are quietly run by competent teams without a spotlight on any one “star”. For the personal investor, it’s tempting to believe the hype and back the flamboyant individual. However, in the long term, research shows that a team approach could be preferable.

Team or individual?

According to behavioural finance professor, Michael Mauboussin, teams manage funds better than individuals with the optimum size for a team being three. He found funds run by three people outperformed solo-run funds by 0.58% a year on average, as CNBC reported. This doesn’t seem a great deal but, compounded over the years or on large investments, it can be significant.

Why should this be? It all boils down to the decision-making process. Common sense says that a single person can make quick decisions whereas a committee could drag its feet, encumbered by having to debate everybody’s view and perhaps never reaching agreement or action. But the danger of this view is that the individual could make bad decisions without any opposing voice whereas in a team there is more prospect of checks and balances.

This is particularly important for star fund managers. Asset managers are keen to sell their funds and any fund manager with a decent track record can find themselves propelled into the limelight. Feted by the marketing department, individuals are in danger of believing their own hype and that they can do no wrong.

As a result, they may also be subject to what, in behavioural finance, is called “confirmation bias” where a person only pays attention to information which supports their pre-existing thoughts and ignores any contradictory evidence. We wrote an introduction to behavioural finance a couple of weeks ago which you can read here. Interestingly, this tendency underlies the algorithms used by social media platforms to send users information which they are likely to agree with and filter out opposing views – so you can see how powerful it is.

Under these conditions, it may not be long before an unchecked manager’s mindset goes awry and the fund’s previously stellar returns turn into a black hole. A recent example is Neil Woodford who, after an exemplary career at Invesco, left to set up his own company which ultimately failed. The theory is untested but it’s possible that if Mr Woodford hadn’t been his own boss, things may have turned out differently.

Headstrong managers are one thing, but a slow-coach committee is another. In fact, contradicting Mr Mauboussin, older research from 2018 by Eitan Goldman, Zhenzhen Sun & Xiyu (Thomas) Zhou found that funds run by single managers tended to perform better than those run by multiple managers. They also noted that single managers took larger bets with less stocks, creating more concentrated portfolios and, interestingly, higher costs.

It doesn't matter, it's all about the house

With the experts divided, what is the best option for the end-user? Unfortunately there is no fool-proof method. While a large team and copious resources can help, they are no guarantee of investment success: there are team-managed funds which underperform and individually managed funds which outperform.

There may be a way through this muddle by concentrating on the quality of the asset manager rather than its employees, as Mr Mauboussin explains in a podcast with asset manager Schroders. He has found that a startling 70% of excess investment returns are attributable to the function of the asset management firm itself. Only 30% can be attributed to the genius of the individual manager. It’s sobering to consider that, if there aren’t enough Bloomberg terminals or water coolers to go round, your savings may be impacted.

Because different funds are trying to achieve a slightly different thing, there is no standard process for decision-making across asset management firms, or even individual funds. It all comes down to the specific fund’s process and philosophy. Sometimes one or two people make the investment decisions and sometimes teams make them collectively. In some cases, even a whole different department creates a list of stocks and fund managers are only allowed to pick their holdings from the officially sanctioned selection.

Understanding how each asset manager works is essential when a fund manager decides to move from one to the other – or set up on their own. Do you follow the fund manager or stick with their replacement on the original fund? It’s entirely possible that a fund manager at a big asset manager relied heavily on a team and the research department for their success and could therefore struggle with fewer resources and risk frameworks at a smaller firm or their own boutique.

If the fund has a clear and thoughtful philosophy and process, the best option could be to stick with the original fund and hope its new fund manager can continue to implement that and do a decent job. Alternatively, a failing fund could be rebooted with a new philosophy and process, fund manager or team, or in the case of investment trusts, by changing hands from one asset manager to another, which may, or may not, reverse its fortunes.

Herein lies a problem for the private investor because this kind of insider information is not always readily available. On the fact sheet, the fund manager (and sometimes co-manager) will be named. But details on the supporting team, if there is one, and the asset manager, may only be given passingly and in other areas. Outsiders, then, must glean whatever insights they can from promotional material, media interviews or company profiles.

There is a lot more to be done by platforms and asset managers to help the private investor understand how funds are organised and how investment decisions are made. While there may not be a silver bullet process that always works, in order to make an informed decision, you should at least know what that process is. And it probably doesn't hurt to know a bit about the house too.

Date of publication: 16th December 2020