Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Money, fast cars and investor returns
It may be intuitive but there is now evidence that investors with more testosterone and those who drive flashy sports cars tend to produce lower returns over time. They take too much risk.
We have Yan Lu, an American academic, to largely thank for those observational gems. From a position at the University of Central Florida’s college of business administration, she has led a group of academics in producing a body of separate research papers over the past five years which look at various correlations covering spending patterns, personality types and remuneration when compared with returns earned for clients by hedge fund managers and other investors.
Lu and her co-researchers have most recently turned their attention to public pension fund CIOs and their remuneration, which is arguably less frivolous than how they spend that money and much easier to control than their testosterone levels.
The latest paper, ‘Paying for Performance in Public Pension Plans’, demonstrates that higher-paid CIOs outperform their counterparts by 25bps (for second-quartile CIOs) to 47bps (for first-quartile CIOs) a year. That group of CIOs at 190 US pension plans in their study published earlier this year generated an extra US$108.59 million -US$201.59 million for their funds over the study period between 2001 and 2018.
Another interesting conclusion from the analysis of the data is that CIO incentive schemes, while more politically palatable for the schemes to present to governments and other stakeholders, did not by themselves lead to additional investment returns. The funds may be using incentives schemes mainly as a justification for higher remuneration.
Funds with overall higher remuneration correlate positively with CIO incentive schemes. There are various other correlations between total remuneration and the CIOs which are probably beneficial for performance. For instance, funds offering higher remuneration hire better educated CIOs and are more likely to retain their CIOs for longer.
In the latest study, the authors have drilled down into how better performance is achieved, looking at factors such as portfolio turnover (more tends to be bad because of increased costs), the inclusion of more speculative, “lottery stocks” (bad over time) and “disposition”, relating to the behavioural bias to hold onto poorly performing stocks because of the investor’s “sunk” cost.
The study concludes that higher paid CIOs tend to be better stock pickers by being less prone to excess trading and behavioural biases.
Lu’s co-authors were Kevin Mullaly, also from the University of Central Florida, and Sugata Ray from the University of Alabama’s Culverhouse College of Business. Ray was also collaborated with Lu (and Stephen Brown and Melvyn Teo) on the paper published in 2016 in which they analyse the cars driven by successful hedge fund managers.
That study found that hedge fund managers who own powerful sports cars take on more investment risk. Conversely, managers who own practical but unexciting cars take on less investment risk. It concludes that the preference captures the personality trait of “sensation seeking”, which in turn drives manager behaviour with investments.
“The incremental risk taking by performance car buyers does not translate to higher returns,” Lu and the other authors say. “Consequently, they deliver lower Sharpe ratios than do car buyers who eschew performance. In addition, performance car owners are more likely to terminate their funds, engage in fraudulent behaviour, load up on non-index stocks, exhibit lower R-squareds with respect to systematic factors, and succumb to overconfidence.”
Other examples of Lu’s work include the impact of marital events on hedge fund manager performance, how they choose charitable donations, what it means to get a lot of speeding fines and even facial structures. They can be found here.
