Testing fund selector prisoners on game theory

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On empirical evidence alone, sales flows are telling us that the consensus already believes traditional alpha is a ‘zero sum game’ but also that ‘SmartBETA’ and portable alpha – through absolute return funds – may have potential.

However, what if we are looking at the active-passive choice all wrong, what if we are looking in the wrong places?

The reality is that the risk of choosing active management invites the risk of choosing bad managers. Most funds are chosen by relatively inexperienced advisers and brokers. Do professional fund investors fare any better? A study by Diane Del Guercio of Oregon University hints that fund selectors may be complicit in the poor aggregate performance of active funds. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1935109)

Why might advisers choose the wrong managers?

In my paper Core-Satellite Conundrum (InvestmentEurope, No. 58, p45) I alluded that fund buyers may be falling for game theory by taking safe ‘bets’ into the same well known funds. In other words fund buyers may be opting for ‘safe’ core options on an assumption of negative outcomes and inability to identify superior choices with any certainty (see below).

core v satellite

Fees may also have an impact as passive disrupters set ever lower fee scales, platforms continue to war on each other and large scale fund players lower their charges in order to squeeze smaller firms.

Together these have tended buyers towards existing names, over potentially superior new entrants. In other words buyers have become prisoners to established supertanker funds: better to be wrong together than wrong alone.

One way to break out of this bias is to review those core positions and invest into a broader range of active boutiques.

Can boutiques better supertanker managers?

Day-to-day, I observe that boutique managers more often operate like private equity managers. They buy companies not stocks, they finance businesses where they see growth, they hold for longer and they are less likely to buy familiar stocks held by everyone else.

Many boutique managers are self-invested and owners of their own businesses, which builds in alignment between investor and fund manager. Unfortunately few advisers and investors recognise the merits of such an approach, many prefer well known stocks and confuse familiarity with opportunity. To that end fund buyers have exhibited some game theory in their choices.

Factor investing: ‘Smartbeta’ or snake oil?

Factor investing has many proponents like Sharpe, Fama, French and Gabriel Burstein; but also its detractors, namely John Bogle of Vanguard and James Montier of GMO.

There is a low cost turf war between traditional index providers and factor index providers. The argument is whether the ‘zero sum game’ view for active management would also be true for SmartBETA over the long run. As one model outperforms, another will underperform – if we are to believe Sharpe – leaving only cost arguably addressed.

Ironically, active managers also have the ability to change the tilts – ‘beta factors’ – in their portfolio to escape the same mean reversion, even if empirically few do so successfully. In game theory, SmartBETA may appear an attractive compromise to fund buyers wishing to beat the benchmark but unprepared to take a large bet against it.


Many studies simply do not take into account active fund selection, variability of time horizons, alternative strategies or portfolio diversification.

The big difficulty is that we have not yet disentangled the active-passive debate from one of charges and there are few to no universal studies proving the effectiveness of active fund selection among professional buyers.

I am collating the views of other fund selectors and looking for empirical evidence that active fund manager selection has benefited investors. I encourage fund buyers to share their experiences and for academics and data gatherers to address the issue.

Take part

The survey remains open, have your chance to have a say at: https://www.surveymonkey.com/s/MDHG8ZT


Jon Beckett is UK research lead for the Association of Professional Fund Investors, author and senior reviewer for the Chartered Institute for Securities and Investments and member of the Z/Yen Long Finance think tank

Jonathan Boyd
Editorial Director of Open Door Media Publishing Ltd, and Editor of InvestmentEurope. Jonathan has over two decades of media experience in Japan, Australia, Canada and the UK. Over the past 17 years he has been based in London writing about funds and investments. From editing the newsletter of the Swedish Chamber of Commerce in Japan in the 1990s he now focuses on Nordic markets for InvestmentEurope. Jonathan was awarded Editor of the Year at the Professional Publishers Association (PPA) Independent Publisher Awards 2017. Shortlisted for the same in 2016, he was also shortlisted in 2017 and 2015 for the broader PPA Awards category Editor of the Year (Business Media).

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