Fund managers expect investors to focus on the numbers, and to be soothed by stories when performance dips. But, investors should not be so readily swept along by how fund managers view the world. Behavioural finance provides some clues to the psychology involved and underlying meanings. Fund manager behaviour - both on a regular day-to-day basis and under stress - is surprisingly predictable. Investors need to understand the patterns, and signs to look for.
Biases are usually put into two groups; those involving feeling or emotion, and the ones that represent mistaken analysis and reasoning, cognitive errors. But it is not simply a case of emotion always being bad, nor that reasoning can be perfected by just thinking harder or better. Some gut feeling is helpful – it can be a very quick and effective guide on whether to trust someone or not. It often expresses unconscious learning we have from previous experience. Emotional biases are not easily eliminated, but we should recognise them.
Improving reasoning needs the help of a framework to make the process more systematic, to avoid giving undue weight to information that grabs our attention. That frame could be a standardised set of comparables that we should analyse, not just the numbers thrown at us.
Companies know that a disappointment in profits or earnings per share can be softened by throwing in some random positives, such as “organic growth”, “new orders” or “online sales”. We may easily overlook the lack of comparability in the additional information, and the difficulty of ascribing any real meaning to the numbers. In turn, fund managers are adept at picking out juicy anecdotes about their portfolio or recent market patterns, knowing it can distract investors and appease.
It is human nature to like stories. Joining up data into a narrative is the way we make sense of the world. But, it can mislead, dropping our guard when we should actually be questioning assumptions and assertions. The stockmarket is fertile ground for stories. It is a noisy environment; share prices bounce around daily, and short periods of a few months can be little guide to investment skill.
It is easy to join up short term numbers and imagine trends. Fund managers often use this when claiming a turnaround in performance, splitting up performance periods in an unusual, but favourable way. That can allow a few months of underperformance - however shocking - to be presented as an anomaly, whilst the previous data confirms the underlying skill of the manager. Or, the market background itself can be blamed, as in “shares have lost touch with fundamentals”. Managers may reassert their conviction in their strategy, though psychology shows individual confidence in a decision has little validity.
In this way, an underperforming manager can still be the hero of the story, by being smarter than the market, more cynical and contrarian. There are investors who like that in a manager, and can tolerate lengthy periods of disappointment. Investors should first question the choice of benchmark and how it compares with other market moves. It is usually easy to outperform an underperforming benchmark, and vice versa. It is important to get assessment periods and benchmarks straightened out at the start.
Unfortunately, much of what is called “due diligence” is just reporting the narrative of the fund manager, rather than dispassionately examining the facts in an objective process. Terms like “overbought” and “oversold” are easily bandied around. Instead, investors should be questioning whether risks have increased, if a manager’s style is changing, and how redemptions are being handled.
Behaviour by hedge fund managers, particularly those running macro funds with a lot of global discretion, is in a category of its own. Often as drawdowns deepen, the manager detaches himself from the month-by-month numbers. Sometimes the fund distributor is sacked. Effectively shooting the messenger, this can help to further insulate the manager from client concerns. Reports arrive later in the month, often with references to past glory days in the fund rather than the uncomfortable present. The investment strategy may become more risky and complex. One better month can often be spun as a major turnaround, and the manager develops a perspective on performance that is entirely at odds with clients. And, bizarrely, some of these reports have the manager refer to themselves in the third person, as if they are a mere actor in a modern tragedy, thrown around by outrageous forces. All of this has been seen in some reports in recent months, so difficult has the background been for macro hedge managers. Elements of the hedge stories can be seen in most reports of disappointing performance by conventional managers.
Fund managers typically operate in teams, and there have been many studies of group behaviour. These point to the risk of group-think and a difficulty in accepting challenge. It seems reassuring that teamwork is involved. But the value of that depends a lot on how it is organised; whether the team is stable and has applied consistent methods, drawing on diverse inputs. Groups work best when they use counter-arguments, document decisions and assign probabilities to outcomes. A framework is needed to address the risks of herding and overconfidence.
Biases impact most areas of investment work. Good process can fix some of this, but not all. Investors need to understand the issues, and recognise the behavioural pitfalls. Learning to spot stories is a good starting point.
A version of this article was published on ftadviser.com on 08/11/2017.