Essay Review of “Murder on the Orient Express – The Mystery of Underperformance”
Once in a while I read something which crystalizes for me – with data and arguments better than I could hope to make – what I already suspected but hadn’t yet put into words.
Charles D. Ellis writes in Financial Analysis Journal[1] a research-based critique of the Financial Infotainment Industrial Complex’s myth of investment manager outperformance.
Using the literary conceit of Agatha Christie’s Murder on the Orient Express, Ellis plays detective Hercule Poirot to uncover everyone’s guilt – investment managers, investment consultants, fund executives, and investment committees – when it comes to paying unnecessary fees to managers who inevitably underperform ‘the market.’
If, like me, you kind of suspected all that, but wanted to see it demonstrated in black and white, I recommend the article. If you want the Cliff’s Notes version, hey, that’s why you come to Bankers Anonymous!
The Problem
As Ellis points out, everyone wants to own funds with investment returns in the top quartile; this is statistically impossible for more than 25% of investors in any year.
The further grim reality is that 60% of mutual funds underperform their benchmark every year, and that number climbs to 80% underperformance over a 20-year period.
Most troubling of all, Ellis cites research[2] which concludes that 24% of funds underperform their benchmark, 75% of funds match their expected market returns with no alpha[3], and 1% of funds actually offer risk-adjusted superior net returns, after costs.
So about 1% of actively managed funds are really “worth it.” Think you can pick that 1%?[4]
Ok, that’s the problem. Who’s to blame? Everyone in the Financial Infotainment Industrial Complex.
Investment Managers
How are they to blame for underperformance?
- They choose time horizons in their marketing materials specifically to show outperformance, ignoring those years which would show either ordinary market returns or underperformance
- They ignore the proliferation of thousands of highly trained experts in every aspect of investment finance who ensure that almost nobody has an edge on anybody else.
- They actively market their products precisely at the moment following short-term outperformance, despite their knowledge that performance almost always reverts to the mean in the medium-to-long-run.
Investment Consultants
How are they to blame for underperformance?
- Consultants get paid to retain clients, by not meaningfully underperforming the market. Consultants achieve this aim by emphasizing the importance of diversification, thereby ensuring that no single fund can noticeably impair the client’s portfolio, nor can any single fund make a meaningful contribution to alpha.[5]
- Consultants inevitably recommend funds with recent outperformance – which limits the pool of funds – and ignores the mean-reversion inherent in most managers’ performance over time.
Fund Executives
How are they to blame for underperformance?
- Fund executives often add a layer of extra fees by insisting on ‘separate accounts’ even when investing in long-only stock funds, when it makes little sense.
- Fund executives typically are at an information and experience disadvantage when dealing with their counterparts at investment manager firms. So they fail to ask pertinent questions or push back when necessary. I’ve frequently observed the psychological barrier that prevents less experienced financial professionals in the room from asking the right question. Investment managers know this and depend on this. Traditionally we think ‘fear and greed’ drive the market and that’s still true. But the ‘fear of appearing foolish’ drives the fee structure in many parts of the investment management world.
Investment Committees
How are they to blame for underperformance?
- Investment committees, like fund executives, usually act at an information and experience disadvantage when reviewing investment managers.
- Most investment committees have limited time and resources to do proper due diligence. As a result, they tend to focus on recent past performance, which has little predictive power for future results, and suffers from the mean-reversion problem of markets and strategies.[6]
- Investment committees mistake their role, imagining that it consists of investment decisions rather than governance decisions.
- Investment committees stick with historic policies long past their “sell-by date,” because of the group-think inertia.
The result
The logical result of the “Murder on the Orient Express” discovery that “everyone is guilty” is that managers of pension funds and endowment tend to pay too much in fees for investment management.
The Financial Infotainment Industrial Complex continually reinforces the idea that outperforming managers may be discovered at any time and that the goal of investment managers is to ‘beat the market.’
But when you pay extra to ‘beat the market,’ you end up, in the long run, paradoxically underperforming the market by, at least, the amount of your fees.
[1] What? You’ve let your subscription to Financial Analysis Journal lapse? Well, thank goodness you have me to point this paper out to you then. Here’s the Scribd link to the paper.
[2] Laurent Barns, Olivier Scaillet, and Ruiss Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas.,” Journal of Finance, vol 65, no. 1 (February 2010): 179-216.
[3] Sorry to get all Greek-lettery on you. “Alpha” means “performance above your benchmark” in investment terms. “Beta,” if you’re curious, means correlation to your benchmark. Beta is easy to achieve, and it’s what most mutual funds do despite claiming to deliver alpha. Getting alpha from an investment manager over time is hard, and rare.
[4] That sounds like a rhetorical question, but there actually is a correct answer. The answer is “no.”
[5] It’s not in Ellis paper, but this point reminds me that ‘diversification’ often prevents significant wealth creation. I’ve written this before, but truly wealthy people who made the money in their own lifetime, inevitably have extreme concentrations of risk in only one or two assets or businesses. Concentration of risks creates alpha, diversification creates beta.
[6] Ellis points out that research supports only the predictive power of recent performance for the bottom decile of managers. The worst 10% tend to maintain underperformance due to high fees and limited capability.
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