How do so many active managers who underperform passive investment alternatives continue to attract and retain investors? In their June 2018 paper entitled “How Active Management Survives”, J.B. Heaton and Ginger Pennington test the hypothesis that investors fall prey to the conjunction fallacy, believing that hard work should generate outperformance. Specifically, they conduct two online surveys:
- Sample 1: 1,004 respondents over 30 with household income over $100,000 choosing which of two propositions is mostly likely true: “(1) ABC Fund will earn a good return this year for its investors. (2) ABC Fund will earn a good return this year for its investors and ABC Fund employs investment analysts who work hard to identify the best stocks for ABC Fund to invest in.”
- Sample 2: 1,001 respondents over 30 with household income over $100,000 choosing which of two propositions is mostly likely true: “(1) ABC Fund will earn a good return this year for its investors. (2) ABC Fund will earn a good return this year for its investors and ABC Fund was founded by a successful former Goldman Sachs trader and employs Harvard-trained physicists and Ph.D. economists and statisticians.”
Second choices are inherently less likely because they include the first choices and add conditions to them. The authors further ask in both surveys the degree to which respondents agree that a “person or business can achieve better results on any task by working harder than its competitors.” Using responses to these surveys, they find that:
- For sample 1, 63% of respondents choose the second statement as more likely, even though it is inherently less likely than the first (because it adds conditions to the first).
- For sample 2, 31% of respondents choose the second statement as more likely, even though it is inherently much less likely than the first (because it adds multiple conditions to the first).
- For sample 1 (2), average respondent agreement with the proposition that harder work generally produces better results is 3.70 (3.62) on a 5-point scale.
- For sample 1 (2), self-assessed level of investment knowledge had no effect (small negative effect) on the frequency of selecting the second choice.
- The authors interpret survey findings to mean that, despite considerable research indicating that active managers do not reliably beat passive benchmarks, promotional assertions of present hard work (including past hard work as credentials) attract many investors to active funds.
In summary, survey results suggest that many investors continue to invest in active funds because they believe that fund managers work hard and hard work pays.
Cautions regarding findings include:
- The main finding is an interpretation by the authors of interpretations by survey respondents of fairly simple questions. Follow-up interviews with some respondents may have corroborated the finding.
- It seems plausible that respondents may have interpreted the second statements as more plausible/complete/convincing than the first.
For a different perspective, see “The Diversity and Persistence of Quacks”. For a broad stream of research on the performance of active investing, see the investing expertise category.
