Hiring and Firing Decisions of the so-called “Smart Money”

Over the years, many studies have examined the investment results of individual investor’s decisions.  These studies consistently conclude that individuals trade too frequently and chase returns, resulting in much worse performance than would have been earned by simply investing in a market-tracking index fund.

Less attention, however, has been paid to how portfolio moves by large institutional plan sponsors—pension funds, endowments and foundations—have impacted those funds’ performance. Plan sponsors collectively control billions of dollars, are managed by professional fiduciaries devoting considerable time and resources to selecting managers, and have access to consultants who are paid specifically to help their portfolios outperform.  In other words, plan sponsors should know what they’re doing.  For this, they are labeled the “smart money.”

Just before the stock market began its swift descent in October 2007, a team of researchers headed by Boston University professor of finance Scott Stewart looked into whether the smart money makes better decisions than the individual investor.  Specifically, they wanted to determine if plan sponsors make or lose money when they hire and fire money managers.

The conclusions of Stewart’s research may surprise you.  The study found plan sponsors actually destroy value when shifting assets among managers.  Fired managers outperformed those hired by 3% in the year following the hiring/firing decision.  Over the subsequent five years, “fired” managers beat “hired” managers by 1% per year.

In dollar terms, these figures are staggering.  The opportunity cost of plan sponsors’ decisions, on average, amounts to $20 billion in the twelve months immediately following a decision to change managers.  Over one five-year period, as much as $77 billion was lost due to firing managers who subsequently outperformed and hiring managers who proceeded to underperform.

Professor Stewart concludes, “The effort that plan sponsors are putting towards hiring and firing managers is not just a waste of time.  It is actually hurting them.”^[1] It seems the “smart money” may not be so smart, after all.

¹ Heisler, Jeffrey, Christopher Knittel, John Neumann and Scott Stewart.  “Destruction of Value:  An Analysis of Manager Selection Decisions by Institutional Plan Sponsors.”  Working Paper, September 2007.