July 2019
Does your fund manager drive the 'right' car?
Anthony Corr, redpoint Investment Management
It’s the journey, not the destination.
The authors looked at fund returns, fund flow, portfolio risk, management and performance fees, high water marks, lock up periods, redemption periods and leverage. They found no distinguishable statistical [2] or economic difference between performance car owners and non-performance car owners for all of these attributes apart from one, the variability of returns. This in turn impacts the important risk-return performance metrics, the Sharpe ratio, defined as the ratio of portfolio return less cash return compared to portfolio volatility. The Sharpe ratio was found to be statistically and economically lower for sports car owners, as is the information ratio, defined as portfolio excess return versus portfolio tracking error. It seems that hedge funds run by performance car owners tend to have similar long term outcomes but with more variability along the way.
I feel the need, the need for speed.
Performance car ownership is linked by the authors to the psychological trait called sensation seeking, more commonly called thrill seeking. The conjecture is that sensation seekers are willing to accept riskier activities simply for the sake of the experience. The implication is they run their money in a similar way to other hedge fund managers, but with a proclivity for riskier portfolios. This is indeed supported by the performance analysis. The authors go further however to see if the hedge fund businesses are also run in a riskier way. They find that performance car owners are statistically more likely to wind-up their hedge fund, be subject to regulatory action and lawsuits, and carry more operational risk. They also appear to engage in riskier trading behaviour. US equity hedge funds (at least) managed by performance car owners have higher fund turnover, more frequent trading, more holdings in smaller companies, a higher active share [3] , and favour stocks with high recent returns.
Birds of a feather
The paper tests and re-tests the hypothesis in a number of ways. For example they perform the analysis on high vs low torque cars, high vs low horsepower cars, ‘sports’ vs non-sports cars. They look into investor motivation and find that sensation seeking investors tend to be attracted to sensation seeking hedge funds, that non-sensation seeking incentives tend to encourage nonsensation type activity. There are also some robustness tests to see whether gender, personal wealth, age, previous success and other factors might explain the results. They find no statistical link between these.
So the message from the article is, if you have a long time to invest it doesn’t matter what car your fund manager drives. However, if your timeframe is shorter you may think a little differently. In short, if you’re looking for thrills, go ahead and chase the overtly successful fund manager with the red Ferrari. On the other hand, if it’s risk adjusted returns you’re after, make sure your manager drives a dull boring car.
Footnotes
[1] Brown is affiliated with Monash Business School and New York University, Lu is at University of Central Florida, Ray is at University of Alabama and Teo is at Singapore Management University
[2] In lay terms, a statistical difference occurs when the difference between two outcomes (e.g. the average portfolio return of sports car owners compared to non-sports car owners) is so great, that the probability the difference was observed by chance is improbably low, when taking into account the variability of the data. There is always a small possibility you are wrong. You’d be forgiven for thinking a coin is loaded if it turns up heads ten times in a row. This is an improbable outcome, a 1 in 1,000 chance, but it can occur.
[3] Active share is the fraction of the fund that differs from the S&P 500 index.
[1] Brown is affiliated with Monash Business School and New York University, Lu is at University of Central Florida, Ray is at University of Alabama and Teo is at Singapore Management University
[2] In lay terms, a statistical difference occurs when the difference between two outcomes (e.g. the average portfolio return of sports car owners compared to non-sports car owners) is so great, that the probability the difference was observed by chance is improbably low, when taking into account the variability of the data. There is always a small possibility you are wrong. You’d be forgiven for thinking a coin is loaded if it turns up heads ten times in a row. This is an improbable outcome, a 1 in 1,000 chance, but it can occur.
[3] Active share is the fraction of the fund that differs from the S&P 500 index.
Important information : This communication is provided by Redpoint Investment Management Pty Limited (ABN 83 152 313 758, AFSL 411671) (Redpoint). The information in the communication is of a general nature only and is not financial product advice. The communication is not intended to offer products or services provided by Redpoint or its affiliates. Opinions constitute our judgement at the time of issue and are subject to change. Neither Redpoint nor its employees or directors give any warranty of accuracy or reliability, nor accept any responsibility for errors or omissions in this communication.