Finding outperforming managers

Transcription

1 Finding outperforming managers Randolph B. Cohen MIT Sloan School of Management 1 Money Management Skeptics hold that: Managers can t pick stocks and therefore don t beat the market It s impossible to pick winning managers because there is no persistence in performance Truth: Managers can pick stocks but fail because of institutional factors Winning managers can be identified in advance but doing so requires much more than simply looking at past average returns 1

2 Equity managers underperform S&P % 10.00% 14.63% 15.40% 5.00% 0.00% Net return S&P 500 index Can it be that no one can pick stocks? Start with top talent Then give them superb training Then put in place maximum incentives for hard work and performance Then it is claimed that these managers don t pick stocks any better than someone throwing darts at a Wall Street Journal page! This makes no sense Reason: it s not true 2

3 Managers can pick stocks 17.00% Gross and net performance of equity funds 0.79% 16.00% 15.00% 0.79% 0.20% 0.20% 0.68% 0.10% Fees Trading costs Cash drag Net return 14.00% 14.63% Typical equity fund 14.90% S&P 500 index fund The Price is (Almost) Right Cohen, Polk and Vuolteenaho (2009) Many stocks deliver strong risk-adjusted returns over short periods i.e. value stocks are a bit underpriced But risk-adjusted long-term returns are weak Few stocks are underpriced by a lot 3

4 Why doesn t edge cover fees? Benchmark hugging Research consistently shows institutions make the right calls But timidity reduces their returns Long-only fees charge a lot for active management Comparing fees $100 in a typical large-cap U.S. mutual fund costs $1/year (or more) Correlations with benchmark often very high Equivalent to $90 indexed plus $10 of long-short bets Fees on decomposed investment: $.09 for the index 10 b.p./year So $.91 buys only $10 of active management Equivalent to 9.1% manageent fee 4

5 Cumulative returns Can we find a subset who ll outperform? Just because the industry as a whole doesn t beat the index doesn t mean there aren t great managers to be found But past performance is no guarantee of future performance No persistence in fund performance 40% 30% 20% 10% 0% -10% -20% -30% 32% 12% 11% 17% 13% 12% -8% -23% Past return Future return 5

6 Why is there so little persistence? A good manager should still be good a few years later But, track records can mislead This disguises true persistence Performance attribution difficulties Example: leveraged buyout funds Buy small companies with average beta 1.25 Lever the portfolio 4-to-1 CAPM fair return would be T-Bill + 5*(Market T-Bill) If T-Bill = 5% and market premium = 7%... 40%/annum is a fair return! If the asset is illiquid might demand more Many PE firms underperform this benchmark 6

7 Steady as she goes Many funds invest in illiquid securities Establishing valuations is a challenge If securities are marked low in up months, high in bad, results will be smoothed Volatility and beta can appear far lower than they are likely to be in the future Asness et. al. (2001) present evidence that such behavior may be widespread These problems can lead to explosive scenarios that are potentially devastating to investors The pyramid Consistently overmark illiquid securities Three major benefits: Creates good track record in the short run Increases fees collected Sells existing investors (including General Partners ) fund holdings to others at high prices Key is that the fund keeps growing Otherwise disaster is likely 7

8 Window dressing Standard window dressing story: buy winners at the end of the year to dress up the portfolio This makes little sense If performance is bad, why would the fact that you had lousy performance while owning good stocks? Smart window dressing means actually making performance look better Buy safe stuff then can imply numbers were X, and look we did it it without buying risky assets Musto (1997) shows this is common among money market managers Where did the returns come from? Some strategies pay off a small amount often but have a large loss rarely Famously selling put options has this property Following such strategies can create a spectacular track record right up until the surprise bad event occurs Such a track record is hard to distinguish from that of a manager who is generating consistent alpha Especially confusing because put-selling strategies are in fact often good strategies 8

9 Cumulative returns Hatching, matching and dispatching Investors are only shown returns of living funds Thus all fund companies (hedge funds, mutual funds, funds of funds) may find it optimal to start many funds, then show investors the results of funds that were lucky Past returns investors observe are likely to be higher than what they should anticipate in the future The extreme of this is incubation But continually adding new products and marketing the winners works too The money management industry in a nutshell year 5 year 10 year S&P 500 Fund 9

10 The roach motel Bidding up the fund s own positions At the end of any given month, managers have incentive to buy more of what they already own, and not necessarily at the lowest possible price Musto, Carhart, Kaniel and Reed (2004) has evidence of this behavior Managers can outperform net of fees Hedge funds do appear to outperform Data is messy, but: Even HF skeptics, using Data cleaned of survival and selection biases Recent data to exclude good old days Data that excludes many top performers Still find 6% gross and 3% net alpha Compare fraction of alpha taken by HF and MF managers 10

11 FUND OF HEDGE FUNDS VS. S&P 500 VALUE OF $1 INVESTED DEC 31, 1999 TO DECEMBER 31, value HFRI FOF COMPOSITE S&P How to Generate Big Alpha Liquid securities are accurately priced Ordinary stock picking faces challenges What other approaches may work? 11

12 Catalysts Activist investors attempt to create a catalyst Brav, Jiang, Partnoy and Thomas (2008) 7% activist announcement effect This increase does not reverse Corporate cash flows improve Opportunities of this sort are likely limited Illiquid Assets Investment anomalies appear stronger in inefficient, illiquid, overlooked markets Evidence suggests illiquid securities are sometimes greatly mispriced An opportunity worth pursuing But, risky if weight is too large 12

13 Insurance Selling puts Merger arbitrage Others?? Leverage Find small edge in liquid assets Then, lever holdings until alpha is substantial Common in fixed income and global macro Adds volatility, but this may be manageable Can perform like insurance selling Appropriate sizing is key here as well 13

14 Velocity Make a small edge but do it over and over Normally this fails due to transaction costs Traders can get good side of the spread Can also be automated (HFT) Usually a prop desk strategy Will you be allowed to invest? Goldman Sachs Pretax ROA (%) Trading and Principal Investments (2002 Q1 to 2009 Q4)

15 Macro and micro Micro bets have little edge Macro may be very different story Are macro funds in this business? Value of $1000 (LONG S&P 500 short NIKKEI 225) 12/31/1989 to 12/31/

16 Concentration Few stocks have very large mispricings But, some opportunities exist Buffett supposedly said: I have only one good idea per year Can we expect a lot more from others? Example: School Ties What happens when investors know CEOs? Cohen, Frazzini and Malloy investigate 16

17 Best Ideas Cohen, Polk and Silli (2010) Determine which new thought highest-alpha Use manager holdings Ex-post performance of those best ideas Best ideas outperform by far Best idea, second best, etc: Six-Factor Alpha 0.60% 0.40% 0.20% 0.00% -0.20% -0.40% -0.60%

18 Sharpe Ratio Portfolio Sharpe Ratio Optimal Active Policies Under a Constant Active Allocation Rule % 5% 10% 15% 20% 25% 30% 35% 40% 45% Percentage in the Best Idea 10% Active Allocation 20% Active Allocation 30% Active Allocation 40% Active Allocation 1.20 Sharpe Ratios of Equal-weight Portfolios of Active Managers Number of Managers Managers Maximizing Own-Portfolio Sharpe Ratio Managers Maximizing Global-Portfolio Sharpe Ratio (no short selling) Managers Maximizing Global-Portfolio Sharpe Ratio 18

19 Related/confirming evidence Concentrated portfolios: Baks, Busse, Green Focus: Kacperczyk, Sialm and Zheng Active Share Petajisto and Cremers Differentiation (SDI) Sun, Wang, Zheng Size and performance Smaller mutual funds outperform Hedge funds: evidence is mixed What is going on? 19

20 Conclusions A strong case exists for a substantial allocation to hedge funds and similar alternative strategies Since liquid assets are accurately priced, managers have to choose from a short list of ways to generate substantial alpha Each method has potential problems, creating challenges for portfolio construction 20