maybe smart money…isn’t so smart-maybesmartmoney

Maybe Smart Money…isn’t so Smart

QWAFAFEWDecember, 2007

Summary of Research Conducted on the Behavior of Institutional Investors

Boston University

Authors: Heisler, Karim, Knittel, Neumann, Stewart

HKKNS Boston University 2

What do We Believe about Institutional Investors?

Fill in the blanks!

1. They are different than individual investors because ___________.

2. They consider manager track records important for ____________.

3. They will _____ if they become disappointed with performance.

4. Their manager decisions ____________.


Three Research Studies Conducted at BU

1. Empirical analysis of institutional investment selection process

2. Empirical analysis of subsequent performance of investment decisions

3. Survey of institutional investor behavior and decision process


Empirical Study—Research Design

Examination of flows between managers

1. Test trailing performance, etc. to explain flow activity

2. Test subsequent performance toevaluate decision value-added

Effron database:Returns & Characteristics

on over 7000 Inst’l Products

Two Empirical Studies—Research Design


Effron Database—Asset Levels

Assets in Billions

78.6211.9

420.7 354.6570.2

2,445.7

4,433.9

104.6202.4

1,488.6

1,857.6

472.5

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

1985 1990 1995 2000

BalancedEquityFixed

FYI: Asset Flows represent 8% per year on average


Initial Analysis—Asset Flows Ranked by Performance

• Each year, sort managers by performance, then aggregate their subsequent asset flows– Total dollar flow– Active U.S. equity managers, ex-small-cap

Statistical results suggest…

Managers with the strongest active performance received substantially more of the asset flow.


Asset Flows by Active Performance—Results

Average Annual Dollar Flow, Best & Worst Performance Deciles,1989–2000

$(10.30)

$(2.43)

$5.85

$19.64

$26.87

$20.21

$(15.00)

$(10.00)

$(5.00)

$-

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

1 yr 3 yr 5 yr

Tota

l $B

Inflo

w


Full Analysis—Regression Model

• Applied Fixed Effects Regression analysis designed to capture subtleties using proportional dollar flow (“flow capture ratio”)

• Examines:– Relative importance of 1-, 3- and 5- year periods– Length of record, historical flows, and size of assets– Total vs. benchmark-relative returns, including S&P 500, Russell

style, and beta-adjusted style– Sign, level, and consistency of returns


Test 1—Trailing Returns

• Since Institutional investors focus on long term we expect 3 and 5-year historical active returns to be at least as important as 1-year return


Both active and total returns are important

Sign important for 1-year total

Level of 3- and 5- year returns are significant

Test 1—Trailing Returns


Test 2—Size, Visibility & Longevity

• Since institutional investors like security, we expect larger firms, longer track records, and historical “traction” should all be correlated with higher flows


Longer track records lead to higher levels of inflows

Larger asset size associated with lower inflows

Prior period inflows lead to higher levels of inflows


Test 3—Benchmark-Relative Returns

• Since institutions make their own benchmark decisions, we would expect returns relative to style indexes to be important


Active returns versus style indexes equally important to S&P500 relatives

Beta-adjusted style benchmarks are not important


Test 4—Consistency Measures

• Since institutional investors seek managers that outperform year after year, we expect excess return consistency to be important


Number of and pattern of out-performance year more important than cumulative returns

Value-added in all of 1, 3 and 5- year periodclearly the best

Freshness of underperformance key determinant


Test 5—Subsequent Performance (Second Empirical Study)

Key Question: Do institutional investors add value from changing manager allocations?

• If they are, their qualitative research is paying off• If they are not, perhaps they are focusing too

much on trailing performance


Managers who receive contributions tend to under-perform managers who experience withdrawals


Subsequent Performance—Results

• These results persist and are significant. t-stats are between 5 and 7.

Difference in Performance: Highest Flow Quintile Equity Managers minus

Lowest Flow Quintile Equity Managers(1989-2000)

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Pre-Flow Post Flow

Diff

eren

ce in

A

nnua

lized

Ret

urns

1-Year5-Year


Subsequent Performance—Dollars

• Collectively, plan sponsors are losing billions of dollars a year through their manager allocation decisions!

Equity Assets and Flows(billions, 1996-2000)

Loss of Value(billions, 1996-2000)

$4,316

$515

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

$5,000

Average Assets Average Flow

billi

ons

of d

olla

rs

$20

$60

$-

$10

$20

$30

$40

$50

$60

$70

Average 1-Year 5-Years

billi

ons

of d

olla

rs


Test 6—Source of Loss of Value

Key Question: Which decisions lose value?

• Are they good at setting asset allocation but not at manager selection?

• Do they add value at the category or style level but destroy value once it is implemented?


Investors lose value at the asset allocation (in the short term), category/style-allocation, and manager selection decision levels


Sources of Loss of Value—One-Year Periods, 1986-2000

• Note: Asset allocation is not significant over longer periods

Asset Allocation versus Selection

Equity Selection:Style/Category versus Manager

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Asset Selection

Pro

porti

on o

f Per

form

ance

0%

10%

20%

30%

40%

50%

60%

70%

80%

Style/Category Manager

Pro

porti

on o

f Per

form

ance


Research Study on Institutional Hire/Fire Decisions—Implications

• Institutional investors– rely on benchmark-relative performance, not simply total return

– are not overly focused on short term results

– pay attention to style, but do not necessarily adjust for style extremeness

– require more evidence for account changes than asset moves

– rely on consistency more than simply cumulative returns

• Institutional investors are not adding value from selecting investments, especially in manager selection

In summary, results of two empirical studies indicate:


2004 Survey Study

1. Test for confirmation of prior results2. Identify non-performance criteria

– Communication skills– Reputation– Consultant input

3. Test for perception on investment performance

Data: 100 large, public & corporate plans, summer, 2004

Third Study: Survey of Plan Sponsors


1. Results Confirm Prior Research 2. Results Identify Alternative Criteria

Topic t-stat

Historical ReturnsImportant to study returns, but not sole factor 11,8,0

Other Return MeasuresRisk important 10Consistency important 16Style-adjustment important 9

Other FactorsCommunication important 8Reputation not more important than track record 1Firm not more important than manager 1Tend to rely on own opinion, not consultant 3


3. Test for perception on investment performance

Topic t-stat

Disagree Performance Deteriorates 4Believe Manager Performance Good 10Disagree Performance Improves 4

Results suggest apparent inconsistency between perception and reality.


So…What’s Going On?

On Average, Perhaps Unsophisticated• Respondents agree they evaluate subsequent

performance of decisions (t=7)• And believe their decisions are appropriate and

effective (t=9)Yet the More Experienced See It

• Respondents with higher level of investment experience seem to appreciated performance reversals to a greater extent (but t=1.5)

• Respondents who believe supplier performance a problem, appreciate reversal (t=2.6)


Performance Chasing May be a Problem

1. 98% believe returns are important2. 85% require minimum of 3-yr record3. Anticipated changes in asset class

allocations correlated with trailing returns (3-yrs ending 12/03, t=1.7)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

-10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

3-Year Trailing Return

Incr

ease

/(In

crea

se+D

ecre

ase)

Regression Line


6.4%

4.8%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1 2

12.0%

10.0%

9.0%

10.0%

11.0%

12.0%

13.0%

1 2

Average Manager Turnover Percentage Disappointed with Supplier Performance

• Rank respondents by performance chasing tendency

• Explore relationship with turnover and manager performance

High Level of Performance Chasing

Low Level of Performance Chasing

High Level of Performance Chasing

Low Level of Performance Chasing

t = 2.4 Not statistically significant

Influence of Performance Chasing on Turnover and Performance


Summary of Other Survey Results

• Plans with consultants and higher education levels turn plans over to a greater extent

• More “functional” plans evaluate decisions to a greater extent, have fewer asset classes and higher turnover

• Tainted managers are terminated to a greater extent by public plans, yet only if performance is poor


1. Don’t follow fashion…seek valuation2. Know difference between deep value and

relative value3. If everyone wants you to fire manager, ask

yourself if you’re selling at the bottom4. Evaluate your process, not just your current

managers

Key Recommendations for Plan Sponsors?


Key Observations for Managers?

• Your clients may select you simply because your track record (perhaps versus style benchmark, without extremeness adjustment) looks good

• They may give up on you when short term performance is poor

• There’s a good chance this decision is a mistake• Key is know your client and develop good

communication with him/her


• Communicate frequently• Communicate more if performance weakens• Demonstrate, and then explain

– Why performance weak– Portfolio characteristics & performance consistent

with process– Performance tends to reverse

• Good followed by poor• Really good followed by poorer

Recommendations Regarding Communication

maybe smart money…isn’t so smart-maybesmartmoney

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