Don't Act Like Stalin!

Concentrated, high tracking error, “high conviction” managers inspire both nervousness and fascination from potential investors. It is my belief that both responses are warranted. High tracking error managers have the potential to improve a portfolio because a diversified pool of several high tracking error managers has a much lower overall tracking error. Such a portfolio, assuming a decent hit rate in hiring talented managers, can have better expected returns compared to a portfolio consisting of less aggressive managers. Investors, however, have shown a strong tendency to chase performance in their hiring and firing decisions. This involves hiring managers after periods of unsustainably good performance and firing managers after underperformance, which may well have been due to either bad luck or a hidden style bias. History suggests that periods of extraordinary performance, whether good or bad, tend to at least partially reverse themselves in future. This means that an institution can surprisingly easily underperform over the period it holds a manager, even if the manager actually was talented and outperforms over the long run. The scale of the performance chasing problem is magnified when hiring very aggressive managers. For investors that can do a good job of finding and handling aggressive managers without falling afoul of performance chasing problems, such managers make a lot of sense For investors who have trouble avoiding making decisions strongly based on recent performance, very aggressive managers are more likely to hurt than help.