In a new research paper, Shahin Shojai, global head of strategic research at Capco, and George Feiger, chief executive of Contango Capital Advisors, along with a third author, Rajesh Kumar, evaluate academic contributions to the field of asset management and find them wanting, at least in terms of how the real world works.
“We find that while the theoretical aspects of the modern portfolio theory are valuable they offer little insight into how the asset management industry actually operates, how its executives are compensated, and how their performances are measured,” the authors write in “Economists’ Hubris–The Case of Equity Asset Management.”
They question whether any portfolio managers look for the efficiency frontier in making asset allocation decisions. Why? Because it is just about impossible to locate in reality. Instead, the authors say, managers “base their decisions on a combination of gut feelings and analyst recommendations.”
Shojai and Feiger assert that performance evaluation methodologies are unable to compare managers’ performances in a way that is useful to investors. Since portfolios cannot be meaningfully compared, they suggest that “selecting portfolios that simply perform better than their peers, irrespective of their so-called risk, might not be a bad idea.” They maintain that the use of faulty performance evaluation models has resulted in many successful managers being wrongly discounted, with possible negative consequences for their ability to attract assets.
How would Shojai and Feiger evaluate manager performances? They would compare a manager against himself. Using the concept of inertia, they would compare asset managers’ end-of-period performance with the results they might have achieved if the initial portfolio had been held without transactions during the period used to determine their compensation. They say this would provide clients with a reliable performance comparison tool.
“By incorporating the inertia concept, portfolio managers who are unable to generate genuine alphas might be prevented from using trading revenues to make up for performance related income shortfalls, since they would find that they are also paying for them indirectly. Finally, it might put an end to the use of excessive trades in return for soft commissions.”
This new paper is the fourth in the Economists’ Hubris series. Previous articles examined whether academic contributions in the areas of mergers and acquisitions, asset pricing and enterprise-wide risk management systems were of practical use.
Michael S. Fischer ([email protected]) is a New York-based financial writer and editor and a frequent contributor to WealthManagerWeb.com.