Underperformance of Actively Managed Portfolios: Some Behavioral Insights

Abstract

Two glaring anomalies in investment management are apparent: (1) after fees, active portfolio managers do worse than market indices, and (2) clients continue to pay for services they don’t receive. The purpose of this paper is to offer explanations of these anomalies from a behavioral perspective. We explore some of the cognitive biases that perpetuate active management and subsequent underperformance, including herding, disposition, and endowment effects, as well as conservatism and status quo biases, overconfidence, and agency problems. Investors’ continued use of active managers despite persistent disappointing returns is attributed to being victims of framing effect, hot-hand fallacy, lack of knowledge as well as intimidation or insecurity, and status quo bias. We propose some ways that portfolio managers and investors could improve their decision making.

Keywords:

• Active portfolio management
• Index investing
• Underperformance
• Behavioral finance
• Cognitive bias

JEL CLASSIFICATION:

• G11
• G12
• G22
• G32
• G41

Notes

1 See, for example, Sharpe (1966), Jensen (1968), Fama and French (1993), Gruber (1996), Carhart (1997), Wermers (2000), Fama and French (2010).

2 The focus of this paper is on the behavioral aspects of a specific irrationality or anomaly - that professional money managers persistently promise what they are not able to deliver and investors continue to invest with them. For a broad literature review and discussion of market anomalies in general including behavioral basis of financial crises, see Gärling, Kirchler, Lewis and van Raaij (2009) and Gärling (2011).

3 See Jensen (1968), McDonald (1974), Chang and Lewellen (1984), Grinblatt and Titman (1989, 1993), Cumby and Glen (1990), Eun, Kolodny, and Resnick (1991), Brown and Goetzmann (1995), Malkiel (1995), Gruber (1996), Daniel, Grinblatt, Titman and Wermers (1997), Wermers (2000), Pastor and Stambaugh (2002), Cohen, Coval, and Pastor (2005).

4 The 2018 update is no different: see Huver (2018).

5 Martijn Cremers runs a website that can provide active share information of U.S. mutual funds. The website is updated annually and can be accessed at https://activeshare.info

6 See Taylor (2004); Ennis (2005); Bogle (2005b); Cremers and Petajisto (2009); Ellis (2011); Petajisto (2013); Ellis (2014).

7 See Elton, Gruber, Das, and Hlavka (1993) and Carhart (1997) for quantitative estimates of the degree and impact of cost.

8 Investors’ behavior is covered mainly in the fifth section, Why Investors Keep Putting Money into Actively Managed Funds Despite Fund Managers’ Underperformance. However, as expected, most of the biases apply to decision makers both as investors and as portfolio managers.

9 Those that have been empirically tested can be identified by their corresponding references.

10 See Kahneman, Knetsch, and Thaler (1990, 1991) for experiments that demonstrate these cognitive biases and further explanations of how they are accounted for by loss aversion.

11 For example, Barber and Odean (2001); Fenton-O’Creevy, Nicholson, Soane and Willman (2003); Malmendier and Tate (2005); Malmendier and Tate (2008); Schrand and Zechman (2012); Deshmukh, Goel and Howe (2013); Pikulina, Renneboog and Tobler (2017).

12 Montier (2006) found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance and 100% of them ranked themselves as average or above average; no one was below average! In this respect, they are like the drivers in Sweden (Svenson 1981) or the residents of Garrison Keillor’s (1985) Lake Wobegon community.

13 Jensen and Meckling (1976).

14 Framing is part of the overall area of choice architecture, which includes regulation, framing, and nudges; see Thaler and Sunstein (2008); Thaler, Sunstein and Balz (2013).

15 WJS Limited Partners; TBK Limited Partners; Buffett Partnership Ltd.; Sequoia Fund Inc.; Charles Munger Ltd.; Pacific Partners Ltd.; Perlmeter Investments Ltd.; Washington Post Master Trust; and FMC Pension Fund.

16 Gilovich, Vallone, and Tversky (1985) investigated the hot hand in basketball. By analyzing the shooting records of the Philadelphia 76ers and the Boston Celtics, as well as experimental data from Cornell University teams, they found no evidence of hot-hand (or “streak”) shooting. They attribute the hot-hand fallacy to people’s inability to perceive and understand random events as such.

17 A full discussion of the pros and cons and practicality of these suggestions and especially taking account the interactions among different biases is the subject of another paper.

18 When asked what he would eliminate if he had a magic wand, Daniel Kahneman replied, “Overconfidence” (Shariatmadari 2015).

19 Hedge Funds Lower Fees as Fed Raises Rates, https://www.hedgefundresearch.com/news/hedge-funds-lower-fees-as-fed-raises-rates

20 Herbert (1980); Kirby (1983).

21 See Buffett (1984); Tweedy, Browne Company (1992); Fama and French (1998); Chan and Lakonishok (2004).