Squeamish Mutual Fund Managers Get Axed Quicker: Study

Loss Aversion in Fund Managers

As Nobel Prize winner Daniel Kahneman reported years ago, experimental and empirical evidence suggests that economic agents are more sensitive to losses than gains. That includes mutual fund managers. But if yours is a nervous nelly, dump them—now.

That’s the suggestion of a new paper from University of Notre Dame professor Andriy Bodnaruk and Michigan State University’s Andrei Simonov.

“Do institutional investors have loss-averse preferences?” the authors ask. “And if so, do these preferences for avoiding losses get reflected in their portfolio choice, performance, and career success? The literature traditionally maintained that loss aversion attributes primarily to individual investors; whereas professional asset managers are supposed to be immune to behavioral biases due to their greater sophistication, better resources, lower search and processing costs, regulation, etc.”

In their paper, they use investor level estimates of loss aversion of mutual fund managers to provide the direct evidence on its effect on investment decisions, performance, and career outcomes for institutional investors.

“We find that there is a considerable variation in the degree of loss-aversion among fund managers: about 37% of responding managers could be characterized as having high aversion to losses, 25% have low loss aversion with the remaining managers 38% falling into the middle loss aversion category.”

Managers with high loss aversion are more likely to be employed by funds that are concerned about capital preservation, e.g., fixed income and balanced funds, whereas managers with low loss aversion primarily work for funds which pursue aggressive investment policies, e.g., international funds or hedge funds, the add.

“We then demonstrate that managerial loss-aversion has significant effect on downside risk of funds’ portfolios …Higher managerial loss-aversion also results in lower performance: funds run by managers whose loss-aversion is high deliver between 9.6bp and 17.4bp lower monthly risk-adjusted returns (or between 1.16% and 2.11% per year) than funds which managers have low aversion to losses.”

Consistent with these results, they find that more loss averse managers are more likely to leave the asset management industry or to move to a smaller fund. The likelihood that high loss aversion manager has his or her contract involuntary terminated before the end of our sample period is 36 %; the corresponding probability for low loss aversion manager is only 5.88%.

“Our results also have important implications for the mutual fund industry,” they explain. “They indicate that managers’ personal attitudes toward risk are not fully mitigated by funds’ organizational incentives and have direct effect on the quality of their decisions and performance. This suggests that fund management companies may be able to achieve a better match between managerial decision making.”

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