Do sophisticated investors choose investment managers wisely? In their July 2020 paper entitled “Choosing Investment Managers”, Amit Goyal, Sunil Wahal and Deniz Yavuz investigate how institutional investors select investment managers for public equity and fixed income portfolios. For each actual selection, they construct a group of non-selected investment managers competing in the same geographic region, style and year (average 94 for equity and 72 for fixed income). They focus on two selection criteria:
- Investment manager past performance (returns and assets under management for each product offered as collected by eVestment).
- Relationships among institutional investors, investment managers and consultants (as collected by Relationship Science).
Using 6,939 investment manager selections (5,005 equity and 1,934 fixed income) by 2,005 global institutions delegating over $1.6 trillion in assets to 775 unique managers during 2002 through 2017, they find that:
- Past performance significantly influences probability of selection. An investment manager at the 75th percentile of past performance among peers has a 30% higher probability of selection than one at the 25th percentile. In other words, institutional investors believe in performance persistence.
- However, subsequent returns are lower for selected managers than non-selected competitors by a cumulative average 0.85% over the next three years. In other words, institutions exhibit no selection skill.
- Relationships also significantly influence probability of selection. Investment managers that have relationships with institutions have 15% to 30% higher probability of selection than other managers. Connections between investment managers and consultants who guide institutions similarly increase the probability of selection.
- However, when both selected investment managers and their competitors have relationships with the deciding institution, the former underperform the latter by a cumulative average 1.12% over the next three years. In other words, relationships do not help institutions pick the best managers.
In summary, evidence indicates that sophisticated investors pick investment managers based on past performance and social connections, but these factors do not help pick the best managers.
Other kinds of investors (such as individuals) may choose investment managers differently.
