It may pay to go for mediocre rather than stellar when selecting fund managers, according to last week’s post in Enterprising Investor by Joachim Klement, CFA.
While studies have shown that investors gravitate toward funds that have performed well versus their peers, Klement suggests that more sophisticated investors (such as pension funds) might be expected to apply more complex analysis. This isn’t always the case, however. According to Klement, expert fund selectors such as those hired by institutional investors are “under pressure to justify their fees and salaries…and this pressure can eventually become the dominating factor driving decisions to fire and hire mutual fund managers.”
A 2008 report published in the Journal of Finance by Amit Goyal (Emory University) and Sunil Wahal (University of Arizona) shows that, in instances where underperformers are fired and new managers are hired, “the fired managers on average tend to outperform newly hired managers in the three years after a change.”
What does this mean? Klement says, “If fund performance is mean reverting, then it might be a good strategy to select funds with several years of underperformance instead of funds with several years of outperformance.” Or, he suggests, choosing randomly may be a wise course. “Doing nothing and sticking to a selected fund for the long term — or just selecting funds at random and then sticking to them — can be a significant source of alpha in the long run. Of course, this requires something that many investors find very difficult to implement: patience and discipline.”