• A human instinct to want to win and beat the market may be behind the popularity of active fund managers
  • Loss aversion and a desire to win back losses may be why many investors stay put when fund managers underperform
  • Regret aversion and fear of making a wrong proactive decision also at play when people let their losses run

Why do we stay when a fund manager underperform?  According to the SPIVA scorecard produced by the S&P Dow Jones Indices, over the last 15 years almost 84% of actively managed Australian equity general funds underperformed the S&P/ASX 200.

Furthermore, the S&P persistence index Australian persistence scorecard has shown that any success can be short lived. Only a minority of Australian high performing funds persisted in outperforming their respective benchmarks or consistently stayed in their respective top quartiles for three or five consecutive years.

Yet fund managers continue to be a popular choice, despite claims of smart-beta strategies having the upper hand.

Place for both active and passive investment

Deakin University behavioural finance expert and Morningstar analyst Erica Hall told Stockhead there is a place for both active and passive management.

“Both active and passive strategies can play a role within portfolios, the approaches will perform differently during market cycles,” she said.

“Indexing provides broad market exposure at a low cost with clear investment objectives, and typically won’t deviate from the tracked benchmark, mirroring each holding at the benchmark weighting, whereas active managers can and do deviate from the market benchmark.

“They have the freedom to invest in sectors and securities not contained in the benchmark and take on higher conviction positions based on their own research.

“Stronger active managers can generate superior risk adjusted return over the long term, but they are hard to identify in advance.”

Human instinct to want to win

In addressing particular behaviour issues around why investors go with active managers, Hall said it often comes down to a human instinct to want to win. She said a passive investment will provide market returns less cost, but for some investors that is not enough and they want to beat the market return – or at least try.

“Index funds match the market benchmark and if the market falls so will their investment, and conversely if the market rises, so will their investment.

“Active managers aim to beat the market and will hold investments that they believe can generate the right risk return outcomes to meet their stated objectives.

“Therefore, underlying holdings are different to the market benchmark at different points of time. This can work in their favour or against them depending on market conditions but over the long run the better managers should be able to generate alpha over and above the benchmark.”

Why investors stay when fund managers underperform

Hall said the ‘disposition effect’ is one of the perplexing investor behaviours and explains the phenomena that investors are more likely to hold onto investments that are in loss and sell investments that are in profit.

“The logical thing to do would be to do the opposite, let the profit run and cut losses,” she said.

Why do investors behave in this way? Hall said it goes back to the concept of loss aversion and prospect theory, discovered by Kahneman and Tversky in 1979, who found generally people would be prepared to take on more risk to avoid a loss (risk seeking) and were risk adverse in the face of profit.

“They also found that we feel the pain of a loss more acutely than we feel the pleasure of a gain and a loss is estimated to be at least twice as painful,” Hall said.

“So, investors will tend to do what they can to avoid the real pain of being in a loss-making situation.

“Typically, investors are harvesting their profits whilst they can in case it disappears and hanging onto their losses in the hope that they will turn around and generate a profit.”

Status quo bias is likely at play

What is status quo bias? Hall said it’s where you want to maintain things just how they are. And because once you have made the decision to invest it requires an effort to make a change, it can be easier to just to keep the status quo.

She said status quo bias interlinks with loss aversion and regret avoidance and may also explain why investors stay when fund managers underperform.

“If investors make a decision to sell a losing investment, that decision takes effort; and worse, once they sell, if that investment then rises and becomes profitable, they will feel regret.”

As humans we have a natural inclination to avoid painful feelings. Hall said interestingly we feel worse through achieving poor outcomes from making an incorrect proactive decision than if we achieve the same poor outcome but due to our inaction.

“All in all, we don’t want to make a wrong decision because that hurts more than not making a decision at all,” she said

“If we made the call, we have to take responsibility for it but if we did nothing it’s the market or the fund manager but it’s not on us.

“Doing nothing and getting a bad outcome is preferable than doing something and getting a bad outcome, so regret aversion is likely at play when people let their losses run.”