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Thursday, May 24, 2007

The Oracle's Apprentice

How not to pick an investment fund manager:

‘The Apprentice: Omaha Edition,’ Starring Warren Buffett, by Austan Goolsbee, Commentary, NY Times: A number of years ago, in a moment of professional weakness, I bought exactly one share of Warren Buffett’s Berkshire Hathaway....

For a brief moment, I thought his track record might disprove the economist’s mantra that no one can beat the market in the long term so it’s better to just invest in index funds like one that matches the S.& P. 500.

The mantra comes from the rather compelling evidence that actively managed mutual funds cost too much and don’t always act in the shareholders’ interests. They churn stocks, for example — raising fees while also generating capital gains taxes for the investors. Their high fees sharply cut into investment returns in the long run. ...

Berkshire Hathaway seemed like a mutual fund but without the bad incentives. Mr. Buffett doesn’t care about churning stocks to get bigger fees. He doesn’t do things at the expense of his shareholders. He is the Oracle of Omaha, for Pete’s sake. If anyone can beat the market, it’s him.

Well, I still own that share, but it hasn’t worked out as well as I had hoped. My share has underperformed the S.& P. 500... My colleagues have mocked me incessantly, but I have remained a closet romantic, hoping that Mr. Buffett would renew his secret formula and prove my colleagues wrong.

Then I found out that the 76-year-old Mr. Buffett had asked for applications from people wanting to become his successor. ...[H]e announced his ... search strategy: rather than decide from old-style résumés and interviews, he planned to choose three or four top candidates and then give each $5 billion or so to manage and see how they do. The winner gets the job.

When I heard about this, the romance died. For all of Mr. Buffett’s reputation as the ultimate nonmutual fund, he may have just fallen into one of the biggest mutual fund traps of all — forgetting how incentives affect fund managers’ behavior. ...

Glenn Ellison of the Massachusetts Institute of Technology and Judith Chevalier of Yale have shown how important incentives are. In their classic paper “Risk Taking by Mutual Funds as a Response to Incentives,” for example, they showed that investors ... chase winners ... despite the evidence indicating that mutual funds that win in one year do not necessarily perform better in subsequent years. Funds with the highest annual returns get a huge inflow of money compared with funds that did almost as well but were not at the very top.

And since the amount of money a mutual fund makes depends on fees, not on the actual performance..., this gives the fund managers in the last quarter of the year some rather perverse incentives to take risks with the current investors’ money to try to influence the reported end-of-year return.

In a fund doing well but not stellar in the first three quarters of the year, the manager has a clear incentive to take big risks. If the risks pan out, the payoff in the last quarter can raise the fund’s return enough to get it into a top 10 list, say, and attract a huge number of new investors. If the risk doesn’t pay off, the return will be lower but the fees won’t be too much lower than they were before.

The study showed that managers responded rather directly to these incentives. The managers heading toward the top of the ranking increased their risk-taking significantly in the last quarter of the year whereas those in the middle played it extra safe.

So think about what incentives you create by handing four people $5 billion and telling them that whoever has done best in two years will get the most prized job in the investment world.

First place means a huge prize and second place means the same payoff as coming in last. Mr. Buffett has created an astounding incentive for managers to take risks, make a splash or otherwise make it to No. 1.

Ms. Chevalier, in an interview, said she found the approach surprising. “The shorter the evaluation period, the worse it is,” she said. “But no matter what, it’s still pretty bad. “It doesn’t sound like a good hiring strategy,” she continued, “It sounds more like an episode of ‘The Apprentice.’ ”

On the show, Donald Trump would fire someone from the team that earned less money, whether $1 less or $1 million less. That gave the contestants an incentive to do crazy things for the camera. But it’s no way to pick an investment manager. ...

    Posted by on Thursday, May 24, 2007 at 12:15 AM Permalink  TrackBack (0)  Comments (19)


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