Dirty tricks of the fund managers’ trade

Some fund managers who can’t beat the market employ practices that are ‘not very pretty’

US funds spent 18 times as much money in 2005 as they did in 2009, following the market crash.  Photograph: Eric Thayer/Getty Images

US funds spent 18 times as much money in 2005 as they did in 2009, following the market crash. Photograph: Eric Thayer/Getty Images

 

Skilled fund managers aim to beat the market, but what about their less talented brethren? How can they attract investors’ money if they do not have the skills necessary to deliver the goods?

Luckily for them – and unluckily for their investors – a number of tricks can be employed.

Advertising and the horizon effect

Fund managers know this. That’s why they advertise when times are good and keep quiet when times are bad. US funds, for example, spent 18 times as much money in 2005 as they did in 2009, following the market crash.

Additionally, investors forget improved fund performance can come about not only by strong recent returns but by bad performance dropping out of the record. For example, a fund might have a poor five-year track record due to having suffered a lousy 2010. In 2016, that embarrassing year will no longer show up in the numbers, giving a misleading impression of improving performance.

A recent Cambridge study, entitled Past Performance May Be an Illusion, found investors are fooled by the so-called “horizon effect” and engage in “stale return chasing”.

The study found funds are most likely to launch an advertising campaign 13, 37 or 61 months after an especially bad month – “clear evidence of opportunistic behaviour”. Worse, they tend to jack up fees at the same time, hurting new and existing investors who must fork out extra money to hold the same fund.

“The study paints a picture that’s not very pretty,” says co-author Prof Raghu Rau. Funds are “using uninformative information in the form of stale returns to convince investors that they are buying quality or high-performing funds, when the current performance of these funds might be far less impressive”.

Trustworthy appearances

Additionally, people are less likely to withdraw their investments if their manager appears trustworthy, the study found, even if the hedge fund begins to perform poorly.

The study contains a reference to a 2010 article by Profor Securities founder Patrick O’Meara. The piece, entitled Hedge Fund Marketing: 10 Steps to Gaining More Clients, says, “Obtaining clients and keeping them satisfied is just as important as the funds’ performance.” A “face-to-face meeting with an investor is a big deal”; investors often go with “gut feel”, and the manager “has a lot of control” in this regard, the end result being that a client may even pick one manager over others “who may have a better track record, have more people, and manage risk better”.

Closet index funds

In reality, many active funds are closet index funds. They have no chance of beating the benchmark index, simply because they are too similar to the benchmark index. By doing so, they get to collect those hefty fees while ensuring they avoid the kind of disastrous underperformance that causes investors to withdraw their funds en masse.

Closet trackers are a relatively recent phenomenon. One major study found they were almost nonexistent in 1980, but by 2003 about 30 per cent of assets were invested in closet index funds. Last year, an investigation by Denmark’s financial regulator found almost a third of funds were index huggers, while fund firm SCP Private recently estimated 36 per cent of UK funds were closet trackers.

Growing awareness of the extent of the problem has increased calls for a clampdown. In the UK, some fund groups have begun publishing their “active share”, a score used to highlight how similar or dissimilar their fund is to its benchmark index. Irish investors might be wise to ask their fund groups for active-share percentages: anything less than a score of 60 means your money is invested in a closet tracker.

Copycat funds

A small number of funds resort to copying high-performing managers attracting large investor inflows, according to research by Prof Raghu Rau. They tend to target successful funds that are easily copied, for example, funds with low turnover that make representative quarterly portfolio disclosures.

Usually, copycat funds are poor performers attracting little interest from investors, indicating it is “an act of desperation”. In the short term, it works: performance improves for the copycat funds. Unfortunately for the funds (and their investors), it doesn’t last, with their performance going on to suffer over the coming years. Indeed, copycat behaviour is one of the “leading predictors” of subsequent fund failure, says Rau.

Window dressing

Some managers, for example, will buy high-flying stocks at the end of a quarter and sell holdings that did poorly, so clients think they had been holding the right names all along.

Another form of window dressing is portfolio pumping, when managers make aggressive purchases of stock they already own in the dying minutes of the quarter. Doing so drives the stock higher, thereby boosting the value of their existing position, making the fund’s performance seem impressive at just the right time.

Often, funds will get rid of these positions in the coming days. One study found that, on average, the stocks most heavily owned by hedge funds outperformed by 0.3 percentage points on the last day of a quarter, only to underperform by almost the same amount the next day.

Generally, skilled managers won’t bother with window dressing. Another study that examined the 1984-2008 period found those who engage in the practice tend to have performed poorly during the quarter. They continue to underperform in subsequent quarters and inflict higher fees on their investors.

In other words, managers who engage in window dressing should be avoided, as should those who indulge in misleading marketing, copycat behaviour or the various other tricks employed by the fund industry’s less scrupulous players.

The Irish Times Logo
Commenting on The Irish Times has changed. To comment you must now be an Irish Times subscriber.
SUBSCRIBE
GO BACK
Error Image
The account details entered are not currently associated with an Irish Times subscription. Please subscribe to sign in to comment.
Comment Sign In

Forgot password?
The Irish Times Logo
Thank you
You should receive instructions for resetting your password. When you have reset your password, you can Sign In.
The Irish Times Logo
Please choose a screen name. This name will appear beside any comments you post. Your screen name should follow the standards set out in our community standards.
Screen Name Selection

Hello

Please choose a screen name. This name will appear beside any comments you post. Your screen name should follow the standards set out in our community standards.

The Irish Times Logo
Commenting on The Irish Times has changed. To comment you must now be an Irish Times subscriber.
SUBSCRIBE
Forgot Password
Please enter your email address so we can send you a link to reset your password.

Sign In

Your Comments
We reserve the right to remove any content at any time from this Community, including without limitation if it violates the Community Standards. We ask that you report content that you in good faith believe violates the above rules by clicking the Flag link next to the offending comment or by filling out this form. New comments are only accepted for 3 days from the date of publication.