BOSTON — Institutional investors that shun potential money manager candidates because of below-median returns could be lowering their odds of picking a long-term winner, research from investment consultant DiMeo Schneider & Associates LLC shows.
BOSTON — Institutional investors that shun potential money manager candidates because of below-median returns could be lowering their odds of picking a long-term winner, research from investment consultant DiMeo Schneider & Associates LLC shows.
A just-completed study by Matthew Rice, Chicago-based DiMeo Schneider’s chief research officer, shows that about 90% of managers with top-quartile results for the 10 years through Dec. 31 suffered through a below-median stretch of three years or more along the way.
Even pension executives who use five-year performance data to screen candidates risk culling a sizable number of strong, longer-term performers from their hunt: The study shows that slightly more than 50% of those top-quartile managers experienced a below-median rolling-five-year stint at some point during the 10 years.
The results present a stark choice for investors: “Be patient or be passive,” Mr. Rice said in an interview.
He said that the “vast majority” of institutional investors use above-median results for the previous three to five years as one manager search criterion.
If the same investors that insist on “buying” a money management firm that has done well in recent years, then “sell” that manager for trailing its benchmark in ensuing years, they are going to be locking in their underperformance, he said.
Morningstar data
Mr. Rice studied data from Chicago-based Morningstar Inc. for 1,596 mutual funds with 10-year records. He broke down results for 17 different asset classes: U.S. equities (large-, mid- and small-cap stocks for value, blend and growth), foreign stocks (value, blend and growth), emerging markets equities, real estate investment trusts, interim bonds, high-yield bonds and foreign bonds.
Every top-quartile small-cap-value, small-cap-blend and foreign-value-equity manager suffered through a below-median period of three years or more during the 10 years, the research showed. At the low end, 67% of the top-quartile foreign-growth-equity and 74% of interim-bond managers underperformed for a rolling period of three years or more during that 10-year span.
Top-quartile managers of mid-cap-blend equities, REITs and emerging-markets equities had the highest proportion of five-year periods of underperformance, at 72%, 71% and 70%, respectively. Mid-cap-value-equity managers had the lowest, at 25%, followed by foreign-blend-equity managers, at 35%, and interim-bond managers, at 38%.
The study shows that on average, 22% of top-quartile managers were in the bottom half of their peer groups during any given three-year period.
Based on the findings, even a pension executive talented or lucky enough to choose nothing but top-quartile managers for every asset class would have almost a quarter of the manager lineup suffering through a three-year period of underperformance at any given quarterly performance review, said Mr. Rice.
William A. Schneider, a managing director at DiMeo Schneider, said that institutional investors overemphasizing three- to five-year results when hiring or firing money managers could be “dooming themselves to failure.”
Interest piqued
The DiMeo Schneider survey, which Mr. Rice said should be available by the end of the month, has piqued the interest of pension executives who were asked about its findings.
“It’s a good question … a very good challenge” for pension fund trustees and executives alike, said David Minot, director of finance and investments for the $3 billion Vermont State Retirement System in Montpelier.
He said that while Vermont looks to evaluate a manager’s performance over a full market cycle of anywhere between three and seven years, a candidate coming in with below-median results for the most recent three to five years would face an uphill battle.
Pension executives say trustees and administrators can stick with a trusted money manager that stumbles, but the logic behind doing so has yet to permeate the manager search process.
“It’s one thing to stick with them; it’s another thing to hire them,” even if theory says it makes sense to do so, said Judith M. Johnson, the executive director and chief investment officer of the $1.4 billion Minneapolis Employees Retirement Fund.
It remains far easier to stick with a manager whose style has been out of favor than to hire one, or to make the case to a public board for a superior manager that has seen a bad quarter or two drag down its three-year results, said David Kushner, deputy director of investments for the $15.7 billion San Francisco City and County Employees’ Retirement System.
Ms. Johnson figures that consultants, wary of “account risk,” share some of the responsibility with trustees and pension executives for the sparse hiring of managers suffering through a spate of below-median performance.
But some do get the gigs. Stan Mavromates, chief investment officer of the $46.7 billion Massachusetts Pension Reserves Investment Management Board in Boston, said the board hired Baillie Gifford Overseas Ltd. in 2004 to run an international-growth-equity portfolio, even though the Edinburgh, Scotland, firm had trailed its benchmark, the Morgan Stanley Capital International Europe, Australasia and Far East Index, by 1.5 percentage points a year for the three-year period through December 2003, and by 0.1 percentage points for the five-year period.
Since August 2004, Baillie Gifford has delivered an annualized return of 22.6%, still below the EAFE index’s return of 23.6% for the same period, reflecting the continued relative strength of value over growth, Mr. Mavromates said.
