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  • Jul 13, 2014
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The Week Explained: Overconfidence

PUBLISHED : Monday, 28 January, 2013, 12:00am
UPDATED : Monday, 28 January, 2013, 7:21am

Hedge fund managers often regard themselves as the masters of the fund management universe.

So how do these financial wizards shape up? Results are now in for last year's hedge fund managers' performance from the Chicago-based Hedge Fund Research. They show that overall returns from hedge funds were a modest 6.2 per cent, compared with the 11.4 median return reflected in the FTSE All World equity and the Barclays Global Aggregate bond indices, as reported in the Financial Times.

Over the past five years hedge fund managers failed to reach the industry's normal target of returns of 3 per cent to 4 per cent above Libor, reported the FT with reference to Hedge Fund Research data.

There are many explanations for this lacklustre performance but one of the more compelling comes from research by the Edinburgh and Warwick business school academics Arman Eshraghi and Richard Taffler*. They surveyed actively managed US equity funds in the period 2003-09 and found that, "excessive overconfidence is associated, to a large extent, with diminished future investment returns in the 12 months following publication of the annual report. This effect is robust across different investment styles, although it appears to be stronger among growth-oriented funds. A closer investigation reveals an inverted-U relationship between fund manager overconfidence and subsequent investment performance."

What the academics are saying is these fund managers got far too cocky about their abilities following a run of success, which led them to make poor subsequent investment decisions.

Eshraghi and Taffler developed three proxies for measuring overconfidence. This involved using diction software to find language in the fund manager's reports for identifying optimism, excessive certainty and self-reference. The concept of optimism is generally understood as being "language endorsing some person, group, concept or event or highlighting their positive entailments".

The researchers looked for high use of words known as self-reference, namely expressions such as I, me, mine, us and ours.

They also searched managers' reports for language indicating ambiguity or pessimism.

There are some problems here, not least the fact that managers' reports hardly represent the sum total of their thought process and there is a danger that writing style can be confused with substance. There is also the issue of how to tell between normal confidence and overconfidence.

However there are clearly some valuable indicators here and the methodology used by the authors makes their findings quantifiable.

Investment psychology is not an exact science; at best it provides valuable insight not only into why markets have performed but also into how they are likely to perform in future. As an example Eshraghi and Taffler suggest that a practical use for their research is to short funds run by overconfident managers.

Optimists may believe local fund managers are less prone to overconfidence than the US-based managers in this study. However, the hedge fund managers I have met at gatherings were not overly burdened with self-doubt.

One reason why the study focused on America is that US fund managers are more likely to make their investment reports public. It would be helpful if more of that happened here because it would give investors searching for fund managers a better opportunity to understand the people who might be looking after their money.

Interestingly, the European Union is working on a directive to govern the work of occupational pension funds, which, among other matters, compels fund managers to provide a full account of the past performance of their products. It's no surprise that fund providers are fighting this tooth and nail.

* Fund Manager Overconfidence and Investment Performance: Evidence from Mutual Funds

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