Do the Prudent Get Punished?
August 21st, 2007I live in New York City. I work in a business school. I received my secondary, and post-secondary, education at a business school. So I know a few Wall Street types. This is not to say I’m well connected among the Wall Street elite. I certainly am not. However, I do know my fair share of bankers, traders, private equity folks, and even the occasional hedge fund manager. I’m even lucky enough to count some of these folks as friends.
I think my friends are incredibly smart people. I often turn to them to exchange ideas about corporate activity, corporate performance, the market, and the economy. So I was taken aback by a comment I received in an e-mail from a friend last week about what has happened to highly-qualified, conservative money managers in his field. His opinion was that conservative money managers wrongly get money pulled from them during bubbles because they under-perform. He also claims to have witnessed it more than a few times in this current market.
I started to think about what he said, and the more I did, the more sense it made. We’d expect prudent managers to under-perform in boom times and over-perform in bust times on a relative basis. This is because they are less-willing to take on risk in bubbles when their imprudent counterparts are more willing to do so. However, in perfectly efficient markets, we would expect prudent and imprudent managers alike to have the same long-term mean performance on a risk-adjusted basis.
I’m not sure I’m willing to commit to such a strong-form efficient market hypothesis.
I do believe that inefficiencies exist, at its root, probably caused by some deviations from rational behavior on the part of economic actors. This is where the behavioral part of behavioral economics comes into play – the recognition that economic actors are not purely rational, but make decisions using certain cognitive heuristics that sometimes cause bias.
But that’s another story for a different day. Back to the story at hand.
There are some interesting implications to be drawn if prudent managers are punished during manias. If what my friend says is correct, then not only can we expect prudent managers to have money pulled from them in bubble years, but we can also expect them to be disproportionately fired during manias. This is probably because we tend to attribute out-sized performance to alpha in manias when, in fact, it’s likely beta. We see imprudent managers making out-sized gains and we think, "Wow, that manager must really know what he’s doing." Moreover, we start asking our prudent managers what’s wrong, wondering why they cannot earn like their imprudent counterparts. This is an irrational response.
What’s more disturbing is that the effect might not hold on the flip side. I certainly would expect imprudent managers who significantly under-perform during bear markets to have money pulled from them and to get fired. However, my sense is that in such instances we have much shorter memories when it comes to downside under-performance in bear markets, and the guys who under-perform and get fired probably aren’t out of jobs for too long. Instead of attributing the under-performance to alpha in bear markets, we attribute it to beta. Again, an irrational response.
This highlights one acute incentive problem that likely increases the amount of risk that even prudent managers are willing to take with their clients’ funds (a moral hazard of sorts). Specifically, because the funds under management do not belong to the manager, many seem to have taken the attitude, "If I win, great. If I lose, oh well." Should the money manager lose, the investor bears the greatest cost. The investor loses his money. The manager only loses his job, …and even then, probably not for long (and in the case of hedge funds, only after collecting their 2% vig of course).
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