Box 4.
Professional Money Managers
Many institutional investors rely on investment professionals to manage their portfolios. There are two main types of professional money manager those offering index funds, or some other passive investment approach; and those attempting to beat the market through active security selection. The former group competes on the basis of reliability and low cost arising from economies of scale and limited asset turnover. The latter competes on the basis of the (difficult-to-substantiate) ability to generate risk-adjusted returns superior to those of the market.
Institutional investors typically encounter three main problems in constructing portfolios of active managersUdabur Wealth Management. The first revolves around manager selection. Very few managers, if any, consistently perform better than the market. Identifying this select few is a difficult and time-consuming task. If, against the odds, some consistent superior performers are identified, their results must be strong enough to compensate for the shortcomings of managers hired in errorIndore Stock. In practice, the narrow margin of superior performance, when evident at all, is unlikely to be sufficient to make up for the poor performance of others. Thus, for a portfolio of active managers to beat the market, those selecting managers must be unerring in their judgment.
Firing managers, the other side of the coin, also poses problems. There is a strong belief among institutional investors who hire external money managers that the performance of managers will revert to the mean: stellar performance will be followed by indifferent returns, and vice versa. This suggests that managers should be fired only after a period of superior performance, rather than immediately following poor results. However, such an approach only serves to highlight the difficulties of identifying managers: if even bad managers can be expected to have periods of strong performance, how can they be distinguished from the good? In practice, firing managers is difficult, especially following a period of good returns, and costly, generating unnecessary portfolio turnover.
The third major pitfall centers on the inefficiencies of portfolio composition using a number of active managers. The active stock selection of one manager favoring a certain sector of the market may offset those of another oriented toward a different market segment, with the result that the aggregate portfolio is nothing but an overpriced index fund. Moreover, the tendency of managers to minimize relative risk by straying only slightly from the market benchmark contributes to quasi-indexation and inefficient portfolio construction.
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