The institutional money management industry has a split personality. One half is highly concentrated and stable, consisting of large banks and insurance companies offering generic products. The other half is unstable, consisting of a large number of money managers offering active money management and specialized services. In many ways this segment is like the market for restaurants and beauty salons, with customers always in search of new favorites and the latest hot spots.
A combination of private interests and behavioral phenomena provide the basis for the existence of this active segment. Both frame dependence and heuristic-driven bias play major roles.
Frame dependence occurs as the sponsor divides responsibility for it’s portfolio across several active money managers. These managers are evaluated relative to benchmarks. The division of the portfolio gives rise to a mental accounting structure with particular reference points. This leads investors to react more strongly to outcomes that fall below a reference point than to outcomes that lie above it. Mental accounting also leads to the view that diversification means having variety across styles rather than maximizing expected returns subject to a fixed return variance.
An important aspect of active money management is scapegoating, or shifting regret to, the manager when returns are poor. Given the fact that active managers underperform strategic asset allocation, the amount of underperformance may serve to measure the value of scapegoating.
Scapegoating is one explanation for why investors select active money managers. Another is that investors are overconfident, believing the active managers they hire are likely to outperform strategic asset allocation.
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