The executive summary of the Center for Applied Research‘s recent report The Folklore of Finance notes “The models for success in the investment management industry are broken.” The report highlights that although the asset management industry may be profitable, it is not successful by almost any reasonable measure. Authors Suzanne L. Duncan et al.point out that the industry is consistently failing at its primary responsibility — helping investors achieve their long-term goals.

The folklore of the investment management industry

The CAR report identifies three “myths”, long-held beliefs implicitly internalized by investment management professionals. Duncan and colleagues argue that it is this “industry folklore” that stands in the way of greater success in both generating alpha and assisting investors in achieving their long-term goals.

Folklore of Time

Investment Management Industry

The Folklore of Time refers to those beliefs and behaviors related to past occurrences and what may occur in the future. For example, both investment management industry professionals and investors focus a great deal on analyst forecasts (despite historically accuracy rates). Both  groups often also rely on past performance when making investment decisions, despite the fact that past performance is not an indication of future results.

Investment Management Industry

As an eye-opening example of the folklore of time, researchers analyzed the returns of 715 US stock mutual funds in the top 25% as of March 2010. Only two of the funds remained in the top quartile throughout the next four years (March 2010 to March 2014). This inability to generate consistent returns often create a situation where underperforming managers are fired, and replaced with managers with better performance. In many cases, the fired managers then often outperform and vice versa.

A second major problem related to the Folklore of Time is the industry’s unhealthy focus on the short-term. The problem has become so pervasive that most institutional investors today use a 1 to 3 three year time frame to evaluate the performance of providers when their clients are investing with 10-50 year timelines!
Investment Management Industry

Folklore of False Comfort

The Folklore of False Comfort manifests in four ways. The first relates to the industry’s tendency to rely on innumerable ways to classify, measure and document investment choices. Worse, these metrics are typically chosen without regard to whether they add legitimate value.

The second manifestation of the Folklore of False Comfort is the now pervasive overuse of consultants by institutional investors in the investment selection process.

Investment Management Industry

The third problem is the regulators and compliance departments who take false comfort in the idea that disclosures and disclaimers are a good way to increase transparency. The truth is that investors are not reading the disclosures. A study showed that around half of individual investors in North America say they spend more time reading catalogs than they do reviewing their investment statements.

The authors point to the distortion of the measurement of success as the biggest problem. “The fourth, and most damaging, materialization of the Folklore of False Comfort is its distortion of how investors measure success. We previously established the importance of long-term goals to institutional investors. Yet, only 22 percent of them define their success based on achieving these goals. The vast majority (63 percent) indicated risk-adjusted returns relative to a given benchmark as their top measure of success.”

Folklore of Knowledge

Investment Management Industry

The Folklore of Knowledge is really rooted in unconscious thought and human nature. Without realizing it (in most cases), investment managers take credit for their successful calls, but blame their failures on external factors. Investors similarly demonstrate a notable overconfidence in their own abilities.

Investment Management Industry

Duncan et al. conclude by saying that the current dysfunctional folklore of finance can be remodeled, but it will take a concerted industry-wide effort. “While the Folklore of Finance is the reason investment professionals and investors are failing to achieve true success, it is also the solution. The industry needs to generate a new Folklore of Finance that reinforces the values necessary to achieve true success. Folklore is difficult to influence directly. The industry’s focus on activities, on the other hand, can be shifted. By fostering the right ones, industry participants can soon bring about lasting positive changes. These changes will cause a reconsideration of beliefs, and a new folklore will begin to take shape”

Investment Management Industry