By James Saft
(Reuters) - The idea that people succeed at work up to the point at which they are no longer much good apparently applies to fund managers too.
A new study bears out the truth in asset management of the “Peter principle”, a theory coined by Laurence Peter, an academic who studied hierarchies. The Peter principle holds that managers are promoted up to the point at which they are incompetent. That’s not to say that only the worst succeed, recent political evidence perhaps to the contrary.
It is instead the idea that just as industry tests business models to destruction (see: mortgage-backed derivatives), so do organizations test the abilities of their employees until they too are found wanting.
In a fund management context, this means you as an investor stand a non-trivial chance of signing on with a fund manager who, despite her track record of success, is now in well over her head. Ironically, there might also be some advantage in managers who, having demonstrated incompetence at a particular level, are now given only a diminished mandate.
While older studies did show a relationship between increase in size of a fund and diminishing performance, a November study by Richard Evans and Marc Lipson of the University of Virginia and Javier Gil-Bazo of Universitat Pompeu Fabra looked also at the way in which the scope of a manager’s responsibilities affects performance. The upshot is that there look to be diseconomies of scope, just as there can be diseconomies of scale in investment management.
Scope of manager responsibilities in this context includes not just size of assets managed, but the number of funds and the number of fund investment objectives a manager is assigned.
“We find that fund alphas are negatively related to measures of the scope of manager responsibilities,” the authors write. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2874975)
"Results suggest that better performing managers experience increases in scope that eliminate outperformance. In these tests we also find that worse performing managers experience scope reductions that improve performance to a degree that offsets underperformance. This reinforces our interpretation that the results are driven by manager activity.”
In other words, it may be that as managers prove themselves competent they are piled with more work up to the point at which whatever outperformance they’ve demonstrated is effectively arbitraged away by volume, by distraction and by difficulty.
The study looked at U.S. equity mutual funds between 1997 and 2015 and used a range of tests to try to establish the relationship between performance and the scope of manager responsibilities.
AGENCY ISSUES (AS USUAL)
It is not hard to work out why fund companies load up their better managers with more responsibilities: this is what organizations do. Fund firms presumably hope that whatever magic an active manager has demonstrated thus far can simply be applied to new and bigger mandates, thus winning the firm more business and profit. Fund firms also view larger responsibilities as a way to hold on to talent, as you can pay a manager more the more assets and functions she handles.
This is the kind of agency issue which is endemic in asset management. It is in the fund management firm (the agent’s) best interest to get more out of a given manager even if the principal, the investor, will be hurt. The individual fund manager has exactly the same issue: she may know she is spreading herself too thin but be unwilling to make the economic sacrifice which placing client interests above her own entails.
And unlike problems of size, which many financial advisors already acknowledge and may be on the lookout for, performance issues from managerial scope are not currently on their radar, nor do they require anyone outside the fund firm to do anything in order to happen.
Taking a step backward, evidence of the Peter principle in fund management is not just one more reason to be doubtful about the wisdom of choosing active asset management over passive.
Like doubts over whether managers can successfully handle bigger funds or if their outperformance can persist over time even with stable funds under management, this seems to point to a kind of efficient market hypothesis when it comes to active management. The market, at least as incentives are set up, seems to abhor outperformance and works in a variety of ways to arbitrage it away.
Chasing talent, which is what fund firms do by piling on tasks to their best managers, is foolish in the same way as it is fruitless to chase returns.
Well, foolish for investors.