Beyond Greed and Fear

by Hersh Shefrin

  Summary

  The first half of this chapter focused on instances of heuristic-driven bias and frame dependence. The second half focused on inefficient markets. In the first half, I discussed events pertaining to the Orange County Investment Pool. These events are replete with behavioral phenomena. At the beginning of the case, gambler’s fallacy, betting on trends, and overconfidence figure prominently. As the case progresses, conservatism, the illusion of validity, regret, and loss aversion come to dominate.

  Underlying the events associated with Orange County bankruptcy is a general issue—the longtime puzzle concerning the expectations hypothesis of the yield curve. In the second half of the chapter, I explained why the failure of the hypothesis reflects market inefficiency, largely stemming from underreaction to changes in the rate of inflation.

  Chapter 15 The Money Management Industry: Framing Effects, Style “Diversification,” and Regret

  Placing funds with an active money manager is typically a bad bet. Yet institutions continue to hire active money managers. Why?

  The short answer is that the individuals who serve on institutional investment committees exhibit frame dependence and heuristic-driven bias. When it comes to framing, committee members tend to think of portfolios as a series of mental accounts, with associated reference points known as benchmarks. Therefore, committee members tend to mistake variety in manager “styles” for true diversification. In addition, reference-point thinking leads people to give opportunity costs less weight than out-of-pocket costs of the same magnitude.

  In addition to frame dependence, members of institutional investment committees bear responsibility for the performance of the portfolio. Consequently, they are vulnerable to regret. Choosing active managers enables committee members to shift some of the responsibility for performance onto the managers, thereby reducing their own exposure to regret.

  As noted elsewhere, heuristic-driven bias stems mostly from reliance on representativeness. Specifically, representativeness underlies the mistaken belief in hot hands, an effect that leads sponsors to believe, mistakenly, that they have the ability to pick managers who can beat the market.

  This chapter discusses the following:

  • a case about a university endowment that illustrates how the portfolio is structured as a series of mental accounts

  • the effect that regret and representativeness have on the manner in which the endowment portfolio is managed

  • some general findings about the performance of active money managers in the tax-exempt money management industry

  Case Study: The Management of a University Endowment

  In 1998, eight active money managers managed the equity portion of Santa Clara University’s endowment portfolio. These managers used a variety of different styles, such as large-cap growth, small-cap value, opportunistic, and emerging markets. The equity portion made up about 75 percent of the portfolio. The remainder was in fixed income securities and cash.1

  Figure 15-1 is a pie chart that describes how the university’s allocation was allocated across money managers at the end of March 1998. The legend in the figure begins with the manager identified with a growth style. The percentage allocation to growth was 7 percent, and resides at the one o’clock position in the pie chart. Proceeding down the figure legend, and clockwise in the chart, we move to opportunistic, diverse, and so on.

  Responsibility for overseeing the university’s portfolio is entrusted to a sixteen-member investment committee. For advice and monitoring services, the committee uses Cambridge Associates, Inc., which advises many educational institutions. It offers advice on both asset allocation and the selection of specific money managers. In addition, it tracks managers’ performance and provides detailed reports to the investment committee.

  The investment committee meets on a regular basis with Cambridge once a quarter.2 Each manager makes a presentation to the committee at least once per year, in order to provide his or her “take on the market.” Usually two money managers make presentations at each of the quarterly meetings. The university’s vice president for finance also pays a series of visits to managers.

  How about goals? As far as long-term return is concerned, the committee set an objective range of 10 to 15 percent per year. The lower

  Figure 15-1 Portfolio Style Allocation

  The university’s portfolio is allocated across a variety of equity styles. Twenty-five percent of the portfolio is maintained in fixed income securities. end of this range corresponds to the historical return on equities. In view of the fact that 25 percent of the portfolio is allocated to fixed income securities that have averaged 8.8 percent a year since September 1989, this goal appears to be somewhat aggressive.

  How can a goal of 10 to 15 percent be achieved? Higher risk? Just plain good luck? Or superior money management performance? I find little evidence that the investment committee seeks above-average risks: The beta on the equity portion of the portfolio is approximately 1.0. Moreover, a major reason why 25 percent of the portfolio is allocated to fixed-income securities is precisely to achieve some risk reduction.

  Instead of counting on risk or good luck, the investment committee counts on above average performance from its money managers. Each manager’s performance is compared to the performance of a particular benchmark portfolio. Managers are grouped. Those in the same group are evaluated against the same benchmark. The precise benchmarks used at the university are described in table 15-1. The committee has a secondary goal. It looks for each of the managers to beat the corresponding benchmark by 1 percent a year.

  Table 15-1

  Behavioral Issues

  The first behavioral issue concerns the belief in active money management. Is there reason to believe that active money management delivers superior performance?

  The investment committee is guided by a set of principles. One principle concerns risk exposure. This principle stipulates that the way to minimize exposure to risk is to do two things: Allocate a portion of the portfolio to fixed income securities, and choose managers with different styles. Another principle stipulates that the way to superior performance is to choose managers who beat their benchmarks. The two together provide both prudence and superior returns.3

  In 1998, a vice president of Franklin Resources chaired the committee. By and large, the members of the investment committee believe in active money management. Only one member, the chairman of a local technology firm, has consistently argued for an indexed approach. But his has been a lonely voice. The other external members of the committee include an active money manager, a retired member of the California Supreme Court, a principal in a Chicago commodities trading firm, and a local real estate developer.

  Because the committee seeks managers who have the skill to beat their benchmarks, they attribute a below-benchmark performance as much to a money manager’s actions as they do to bad luck. Two years of below benchmark performance leads to a manager’s being put on notice. Shortly thereafter, if performance does not improve, the manager gets replaced.4 Is two years enough time to separate out the skill component from overall performance? In chapter 12 I discussed just how difficult a task that can be.

  How has the university’s active money management strategy worked? Between September 1989 and March 1998 the university’s endowment portfolio grew by 13.2 percent a year, within its 10–15 percent target range. During this period, the S&P 500 increased by 17.7 percent a year. In fact, the only domestic benchmark that had a return lower than 13.2 percent was the Russell 2000 Growth Index, which returned 12.1 percent a year. Interestingly, the S&P 500 had a higher rate of return and a lower return standard deviation over this period than any other benchmark. Its Sharpe ratio of 1.1 was higher than that of the Russell 2000 (0.5), the Wilshire 5000 Equity Index (1.1), and the Lehman Brothers Aggregate Bond Index (0.7).

  During the three-year period of March 1995 through March 1998, the University’s portfolio grew by 21.7 percent a year. Except for the Russell 2000 Growth
Index, all the other domestic benchmarks grew by more than 28 percent a year, with the S&P 500 returning 32.8 percent.

  I find it difficult to argue that this is superior performance. But was the fact that the university portfolio only returned 21.7 percent cause for concern? Apparently not. The investment committee does not use 32.8 percent as a reference point for comparison.5 It uses 10–15 percent, its long-term goal. And 21.8 looks mighty good against that reference point. The 6–10 percent difference earned by U.S. equities carried very little weight. Because of the reference point used to evaluate the outcome, this differential is treated as a foregone opportunity, not an out-of-pocket cost. As argued by Daniel Kahneman and Amos Tversky (1979) and Richard Thaler (1991), opportunity costs typically receive much less weight than out-of-pocket costs.

  Indeed, the committee is quite clear. Members were much more concerned with dampening a less frequent but serious market decline than in taking a chance on capturing the additional return. As one member of the committee put it: “We don’t really think about what we are giving up. Comfort level has a lot to do with it.”6

  In many ways, the decision approach followed by committee members conforms to the behavioral paradigm. The committee looks at the portfolio as being segmented into a series of mental accounts, one manager per account. Each account has its own reference point, its own benchmark.7

  Interestingly, the rapid increase in the value of the portfolio that took place during 1996 and 1997 gave rise to yet another behavioral effect. In early 1996 the value of the university’s endowment stood at $225 million. At that time, the president of the university indicated that he hoped the endowment would grow to $300 million by the year 2000.

  However, because the market was so strong during the subsequent two years, the endowment crossed the $300 million mark during the first quarter of 1998. Reaching that landmark early is akin to walking into a casino and being handed free gambling chips. Now do people tend to take more risk when they play with chips from the “house” instead of with their own money? As I discussed in chapter 3, Richard Thaler and Eric Johnson (1991) have found that they do. Thaler and Johnson call this tendency the “house money effect.”

  So, was there a house money effect at the university? Let me answer that question by asking another. Do venture capitalists take greater risks than the average money manager does? How about hedge fund managers? I ask this because shortly after its endowment hit $300 million, the university decided to add venture capital, hedge funds, and private equity placements to its asset allocation mix.

  How representative is the university’s experience as far as institutional money management is concerned? In a word, very. Take the house money effect. William Sharpe (1987) describes a typical attitude among pension committees by providing an illustrative quote for the case of overfunding: “We’re well funded; let’s put all our money in stocks—we can afford the risk.” However, he also discusses the extent to which the different approaches to money management—for example, strategic asset allocation (match the market) or tactical asset allocation (time the market, pick winners)—are inconsistent with maximizing expected return for a given level of risk.

  A Better Mouse Trap?

  In chapter 8, I discussed the case of RJF Asset Management, now Fuller and Thaler Asset Management. RJF has always promoted itself as using a behavioral strategy that exploits “mental mistakes” in the market. And since its inception in 1992, RJF has performed well. Yet, for all this talk about hot hands, RJF’s assets under management have grown slowly.8

  If you build a better mousetrap, will people beat a path to your door? RJF argues not. Doug Carlson of Cambridge Associates offers some reasons why.9 He points out that the composition of sponsor investment committees tends to be similar to those of the university above. Committee members get used to evaluating particular types of managers. In other words, they get used to thinking in terms of a particular frame. In addition, committee members come to hold strong opinions. Carlson suggests that managers who use uncommon approaches face uphill battles with sponsors; and RJF’s approach is definitely uncommon. Suppose a sponsor listens to the presentations of two managers with comparable track records. But one manager uses a common style and the other uses an uncommon style. When the sponsor gets ready to make a choice after the presentations, he or she will tend to choose the manager with the common style.

  These are behavioral issues, dealing mostly with familiarity and regret. Committee members hold a fiduciary responsibility, and they want to feel comfortable with their choice of money manager. They typically want to “understand” the money manager’s strategy. In particular, they recognize that if a manager’s performance is poor they will have to explain what happened to the board.

  Carlson indicates that unless they “feel a real need to break out of the box,” committee members will choose the familiar over the unfamiliar. Choosing the familiar lowers exposure to regret. Perhaps this is the Catch-22 of behavioral finance: Behavioral obstacles get in the way of behaviorally oriented money managers.

  General Findings

  Joseph Lakonishok, Andrei Shleifer, and Robert Vishny (1992) did a most illuminating study of the tax-exempt money management industry. They focus their discussion on the management of corporate pension funds, which parallels the management of university endowment funds. From their work, we learn the following about both kinds of funds:

  • Outside money managers are hired to manage large portfolios.

  • Consulting firms are used to select the money managers and monitor their performance.

  • The money managers so selected tend to use active strategies within the restrictions of an identifiable style.

  • The distribution of betas for the equity portfolios is tightly clustered around 1.0.

  • The equity portion of a representative fund underperforms the S&P 500. This underperformance does not take into account fees, or the fact that managers also hold cash. Hence, the returns to sponsors are even worse.

  Lakonishok, Shleifer, and Vishny use data obtained from SEI, which at one time was in the consulting business, like Cambridge Associates.10 The study covers the period 1983–1990. Lakonishok, Shleifer, and Vishny paint the following picture of the industry.

  Many corporate pension contracts are defined benefit plans. In this case, the pension assets are set aside to generate benefits promised to employees. Largely, any excess amounts generated relative to these obligations belong to corporate shareholders.

  The responsibility for managing corporate pension assets falls to the treasurer’s office. This is a major responsibility, and the treasurer’s office usually meets it by delegation, using consultants like Cambridge Associates as well as money managers.

  Why use active money managers rather than an indexed approach? Lakonishok, Shleifer, and Vishny suggest that the behavior of the treasurer’s office must be seen through the lens of self-interest. Overseeing pension assets constitutes a major portion of what this office is charged to do. Surely, the expertise to manage pension assets could be hired and brought in house. Yet, this typically does not happen. Why?

  Given the inferior performance of active money managers, the use of index funds would seem to be beneficial to shareholders. But it would also jeopardize much of the raison d’être for the treasurer’s office. Therefore, those people employed within the treasurer’s office, the outside consultants, and the money managers all benefit if the superiority of an indexed approach happens to be opaque. And they foster opaqueness by claiming to generate performance superior to the S&P 500, a style benchmark, or a risk adjusted benchmark.

  The money management industry appears to have two segments. The first segment consists of large banks and insurance companies that offer generic products such as index funds, guaranteed income contracts, and annuities. The second segment offers specialized money management for groups that do not believe in the superiority of index founds. Indeed, since people learn slowly, it has not been difficult for active money
managers to mask the superiority of index funds.11 Behavioral phenomena lead people to overattribute investment success to skill rather than luck. Therefore, the treasurer’s office acquires the responsibility of selecting superior money managers. This sets up the dynamic of the track record game, as the treasurer’s office sets out to chase superior track records.

  Is there persistence among active institutional money managers? Do top performers tend to repeat? The interesting thing is that they do, somewhat. Suppose we divide managers into four groups based on their track record from the previous year. If performance is completely random, what are the odds that the top performers from the previous year will continue to excel? In theory, the answer is 25 percent; in actuality, 26 percent of winners repeat. Even more interesting is the fact that the chances a manager will move from the worst group to the best is 32 percent, not the 25 percent predicted by random performance. Persistence is even stronger when viewed over periods of two and three years. For the three-year horizon, the expected benefit from going with past winners rather than past losers is about 110 basis points. But remember, managers travel, meaning they regularly migrate from one performance group to another. Thus, performance is somewhat persistent but mostly unstable.

  Because of the persistence effect, successful money managers will tend to have good track records. But they need something else—a good story to tell and a concept to sell. If returns have been poor, the employees at the treasurer’s office will have some explaining to do to the sponsor. Consequently, they will need to offer a convincing explanation for what went wrong. And to whom do they turn for an explanation? Money managers. Sponsors have a strong need for reassurance when returns are poor. The ability to provide effective hand-holding and communicate a clear story are the two most important ingredients of “service.”