A few days ago a friend's email had me pondering why professional money managers seem more willing to risk their client's money than individuals are to risk their own. Now, it might seem obvious to you that a person is more concerned about risking their own property than someone else's, but to me this conjecture doesn't hold up to evidence from personal experience.
For example, imagine that your friend lends you their car. Aren't you more cautious driving that vehicle than you are even your own? (I hope the answer is yes, otherwise please don't ask for a loaner.) Likewise when watching a friend's child, aren't you just a little more attentive and protective than usual?
So, why are professional money managers willing to take on higher levels of risk than individuals with their own money?
As the gerbil in my head ran on his rusty wheel, I began to muse...
There must be something in the way money managers are incented that causes them to alter their ethical bias away from protecting their client's fortunes toward risking it. I submit that the cause is the way that manager performance is measured. If you read investment prospectives you'll notice comments like "marketing beating performance for the last 10 out of 15 years". You might see marketing material with statements similar to, "twice the returns of the S&P 500 since inception". Of course it only mentions that inception of the fund was two or three years ago in the small print at the bottom or on the back of the advertisement.
Is it possible that money managers are measured like sports teams, by wins and losses? Is it possible that their careers depend on people looking at the number of times that they've beaten or fallen short of the average market or index returns? If their perofmance is measured by wins and losses instead of cumulative returns then they could be incented to choose a slightly riskier strategy than someone investing for the long-term.
The table below is an example of a "successful" money manager. The returns in the first column were generated by a random number generator and a slight (3%) upward drift. In other words the money manager is choosing riskier investments than the index but still getting the natural benefit of inflation.
The second column is the annual return for the money manager. The third column is showing his "wins" or "losses". A win is a year with an annual return greater than 3%, the average market in our example. A loss is any year when the manager's return is less than 3%, in other words a year when he does not beat the market.
Notice that our money manager is a winner! He beats the market 12 out of 19 years. He is beating the market 63% of the time! If this were baseball, that would be equivalent to a .632 batting average. He'd be worth millions.
However, look at the last column. The lowly individual investor in an index fund that is just treading water. He is beaten by the money manager 12 out of 19 times. In professional investing circles he is a loser. But, look at the final totals. The money manager with his .632 batting average has a cumulative return of only 65% whereas the individual loser has a more impressive cumulative return of 75%.
I did not assign these values for the purpose of proving my point. Instead I generated multiple examples randomly and then selected one for illustrative purposes. The problem here is not with the numbers. The problem is with how we track performance for professional investors. Too often the industry pushes the "wins" count, or batting average, instead of cumulative returns. Why?
I have some theories and will express them later, but for now here is the table. If you'd like a copy of the spreadsheet for your own modeling, please drop me an email. Special thanks to Shawn for initially sending me the email that got me musing.
J. Sweeney
