Bond managers are more likely to be fired early in their careers if they underperform, while equity managers are more often allowed a second chance.
As a result, many of the most experienced equity managers underperform, and are likely to have been underperforming for quite some time, an in-depth study from Citywire Investment Research has concluded.
Our research found ‘best of breed’ bond managers are left as the underperformers tend to be terminated earlier in their careers. Therefore if you pick an experienced bond manager, you are more likely to get alpha than by picking a more experienced equity manager.
Bond managers tend to take on more risk as they gain experience and continue to generate alpha. The longer-term survivors grow the confidence to take on more risk, while establishing themselves and developing a strong reputation.
The equity experience
The opposite can be said for equity managers. Asset management firms are more forgiving of underperforming equity managers, which means they are able to take risks earlier on in their careers to gain returns without facing the repercussions for underperformance bond managers face.
But this level of risk-taking diminishes as their careers progress, as do their returns. This means the most experienced managers in equity sectors tend to underperform and take the least risk.
Equity managers can also become hindered by a larger asset base, which means they enter capital preservation mode and reduce volatility as a result to keep assets in the fund stable.
In effect the managers become closet trackers and stop taking the risk they once would have earlier in their career.
However, bond managers with large assets under management increase the level of risk they take, and in general are not hindered by overseeing more assets but continue to produce alpha. One explanation for this could be the confidence gained by the ‘best of breed’ bond managers showing through.
One theory, which may explain why underperforming equity managers survive, is based on the research of Nick Chater, professor of behavioural sciences at the Warwick Business School in the UK.
He studied doctors and the ability to diagnose cancer. His observations found if immediate feedback is not given, doctors do not actually get any better with experience.
But what they do get better at is delivering the information and developing skills in storytelling. They can provide a great narrative of why something has happened but that does not mean they have become more adept in spotting cancers.
There are analogies to be drawn between Professor Chater’s research and what we see in the mutual fund industry, especially among more experienced equity managers.
Equity fund managers may not be getting any better with experience, but what is getting better is their storytelling ability, which keeps investors on board.
To read the report in full please click here.