What investors get wrong when hiring and firing active managers

Quick read:

• Research shows that allocators tend to fire active managers who go on to outperform, and hire new investors who then underperform
• These tendencies hold true for institutional and retail investors, as well as across public and private markets
• A three-step framework can help mitigate these tendencies and instill discipline

What investors get wrong when hiring and firing active managers

Virtually all investors are familiar with the disclaimer “Past performance is not indicative of future results.” Turns out this tends to be the experience of many allocators picking active managers.

Existing research on how investors hire and fire underperforming active managers shows that investors tend to:

• Terminate active managers who go on to outperform,
• Swap these managers for new ones who then underperform expectations.

These tendencies were true for both institutional and retail investors, as well as across asset classes and management styles, according to studies¹ that looked at manager decisions over a period of more than two decades.²

Before and after: Returns of investment managers (8,755 hiring decisions over 10 years)

In other words, selecting active managers is an exercise fraught with potential errors. And in the current climate, with financial markets in a volatile state, and investors parsing inflation data and central-bank minutes week to week, buy-or-sell decisions may come with a shorter fuse. It’s all the more crucial that investors have disciplined processes when it comes to allocating to active managers.

These biases crop up in public and private markets. Takeaways from a private market study that looked at more than 100,000 capital commitments between 1990 and 2019 indicated:

• Private equity managers with no track record accounted for 50% of the capital commitments,
• Investors tended to chase performance, bet on local managers, and be swayed by the manager choices of peers.³

The study showed these habits did not lead to better outcomes, undermining the perception that performance tends to be more sticky or consistent in private markets.

So what stymies investors with manager hirings and firings? Research shows that these decisions tend to be influenced by two behavioral biases: recency bias and confirmation bias.

Recency bias

Relying solely on a manager’s short-term track record, expectations may crash against reality. According to research published in 2017, active managers hired due to recent outperformance were actually prone to underperform over the next three years.⁴

This was true across different performance metrics, from benchmark-adjusted returns to risk-adjusted ones. Looking at the data, managers in the lowest decile of various return measures in a three-year span—the so-called “losers”— consistently beat those in the highest decile, the “winners,” over the following period, the study showed.⁵

The same research also indicated that these patterns weren’t driven by factor cyclicality, or ebbs and flows in the economy that cause certain investing styles to do better than others. Even after adjusting for factors like value, momentum or size, the “losers” topped the “winners”.

So while the decision to hire an underperforming active manager may seem counterintuitive and even a career risk, we believe it shouldn’t be a decision investors shy away from, especially if there are other reasons to consider a particular manager.

Confirmation bias

Another common cause of misguided manager decisions may be confirmation bias. When investors assess their allocations, they may typically omit managers who have already been terminated.

This magnifies the confirmation bias. Fired managers may go on to outperform, but because investors may no longer be tracking their returns, they may not realize the eventual potential outperformance of the fired managers. Thus, without seeing the full picture, they may not realize the missteps they may have made in manager decisions.

Framework

All these findings leave us with the question of how to avoid such unintended oversights with active-manager selection.

In general, we found that using multiple signals is more powerful than one, pulling both quantitative and qualitative levers may be helpful, and instituting a detection system may help spot problems early—when cracks in performance may first start forming.

In response, we developed a three-step framework for allocators that aims to mitigate biases and instill discipline:

1. Have an ongoing quantitative system: Our monitoring looks for patterns like managers lagging relative to their own historical performance and to peers. This can act as an early-warning system and seeks to detect whether alpha may be tethered to true skill.
2. Do an ad-hoc evaluation. Ask managers questions about the causes of underperformance, steps taken seeking to reverse trends, and expectations for future returns. Some yellow flags may include process changes or key personnel changes. Red flags could be dramatic strategy shift or failure to adhere to risk management policies.
3. Make a sell/reduce/hold decision. Remember that a sell or trim decision often requires that investors recalibrate their other allocations and make a subsequent buy decision. Allocators also have to balance these decisions with implementation constraints, such as fees, liquidity and portfolio-management considerations.

Conclusion

The centerpiece of BlackRock’s mission is seeking to empower people to build savings, accrue wealth, and meet the financial goals that matter most through their investments.

We may not yet have seen the peak in market volatility, but 2022 certainly felt like the ushering in of a new era. As investors steel themselves for potentially more turbulence, it’s key that they avoid haphazard decision-making and try to disentangle true skill in active managers from mere trends. Past performance may not be indicative, but ongoing discipline may make a difference.