The fight for funds
Suleyman Basak, Professor of Finance at London Business School and Dmitry Makarov, Assistant Professor of Finance at Moscow’s New Economic School, explore how and why money managers make investment decisions. London Views reports on their research.
Given that investors respond to widely published fund rankings in media such as Investors Chronicle and Financial Times when making investment decisions, it is clear why fund managers want to outperform their peers. Managing a portfolio that soars to the top of a “best fund” list can attract many new investors; doing so is likely to increase the assets under management, and hence, the compensation of the fund managers. It also helps fund managers increase the size of their portfolios by garnering additional support from their companies in the form of greater advertising and promotion of the funds they manage in the hope of attracting more investors, thus providing the home company with an ever-larger base of assets. And, of course, for some managers, the reputation and status that go along with highly acclaimed success can be as strong a driver as compensation.
In the end, when looking at this part of the financial world, there is no escaping the truth of the often quoted statement by noted fund observer Mark Hurley that “the real business of money management is not managing money, it is getting money to manage”. In today’s difficult markets, investors are extremely wary of risk and tend to choose the managers with the most consistent performance over time (even if it may not be the highest performance at given intervals); thus, such aspects of reputation and status are more important than ever.
Heart’s desire
The question that emerges from such a quest for a fund’s (and its manager’s) success is how a manager’s desire to outperform others translates into an actual portfolio strategy. In order to answer this question, Suleyman Basak, Professor of Finance at the London Business School, and Dmitry S. Makarov, Assistant Professor of Finance at the New Economic School in Moscow, have been examining the strategic interaction between two risk-averse managers in a continuous-time setting through the lens of game theory. Their research is captured in a working paper available on Social Science Research Network (http://ssrn.com/).
Their research aim is to determine how a manager’s goal — to increase the value of the funds under her control by allocating assets in such a way that they bring the best returns relative to a given influential index — distorts the choice of which investments she makes with the assets under her control. This is an important consideration, for it raises the question of whether a manager’s desire for success causes him to take risks that are greater (or less) than the appetite for risk of the investors whose money he manages.
Basak and Makarov explain that the effects of strategic considerations are likely to be the strongest when a small number of funds are competing against one another, such as when several top-performing funds compete for leadership. To show how this works, they consider two risk-averse money managers (interpreted as either mutual fund managers, hedge fund managers or simply traders). To analyse the managers’ behaviour, they turn to game theory; that is, the branch of decision theory that is concerned with the interdependent strategic decisions of many participants. Many are familiar with game theory in diplomacy: zero-sum games often come down to compromises that are win-win situations for two nations as a result of both nations giving up something to gain something.
All in the game
In terms of fund portfolios, the authors examine the actions of the players using a more complex form of game theory, specifically the Nash equilibrium concept, in which each manager strategically accounts for the dynamic investment policies of the other manager and the equilibrium policies of the two managers are mutually consistent. In their analysis, they focus on top performers, those whose portfolio strategies attract a lot of attention from analysts and financial media, in part because this means that the risk aversions of these managers can be estimated from past performance data.
Their complex analysis begins by presenting the economic setup, which they describe as involving money managers seeking to increase the value of the portfolio of funds they manage by a certain date, such as the end of the year. They then provide the money flows justification for relative performance concerns before going on to describe the managers’ objective functions and characterise their best responses. After that, they analyse such issues as the non-existence, uniqueness and multiplicity of equilibrium; and finally, they investigate the properties of the equilibrium investment policies followed.
Since the investments of the two managers at any given time depend on their performance relative to each other, the authors conclude that managers’ equilibrium policies are driven by chasing and contrarian behaviours when either manager substantially outperforms the opponent and by gambling behaviour when their performances are close to the threshold. Depending on the stock correlation, the direction of gambling for a given manager may differ across stocks; however, the two managers always gamble strategically (that is, manipulate the risk exposure) in the opposite direction from each other in each individual stock.
Investing wisely
Basak and Makarov go on to note some promising directions for future research, such as cases in which money managers do not have knowledge of each other’s attitudes toward risk but can learn about them by observing their investment policies. They also think it would be of interest to extend the approach they have used to investigate the possible strategic interactions among CEOs, whose contracts often include a bonus for high performance relative to their peers. Moreover, they think that it would be useful to consider the questions they have looked at in a setting in which managers compete with each other, while at the same time competing against an outside group doing the same as a benchmark. Such studies would help provide additional information about how money managers make the choices they do.
Of course, the greater the body of such information available, the easier it would be to choose where to invest wisely. And in today’s difficult economy, in which so many people have lost so much due to falling markets, choosing the right investments is more critical than ever.