Santa Clara University

Looking at the Record — How Soon Can You Spot a Top-Notch Fund Manager?

Robert Hendershott
Associate Professor of Finance

“Past performance may not be indicative of future results.” Every investor has heard that one, yet almost everybody believes there’s some connection. Robert J. Hendershott, Associate Professor of Finance at SCU’s Leavey School of Business, is working on bringing that connection into sharper focus.

“In investing, we know there’s a spread in outcomes,” he said. “The question is how much of that is due to luck and how much to skill.”

Hendershott is close to completion on a paper tentatively titled “Using Past Performance to Infer Investment Manager Ability.” His research suggests that past performance can be a guide to the ability of an investment manager, but that a proper evaluation takes time — longer, in some cases, than investors might be willing to wait.

Robert Hendershott, Associate Professor of Finance, Leavey School of Business, Santa Clara UniversityHe directed his attention toward private equity funds for several reasons: They’re smaller than, say, mutual funds; they offer the investment manager more discretion and allow for greater risk; and the bottom lines can be dramatically different. The performance gap between a fund in the 25th percentile and one in the 75th percentile can be as much as 20 percent annually.

Because of that, investors want to back funds that finish in the top 25 percent. Fund managers who are in the top 25 percent rated by ability are more likely to get them there, but luck still plays a significant part. Even a crackerjack fund manager can be taken down by something like the sudden death of a powerful CEO or by backing a good company just as its industry goes into a slump, dragging down the good and bad alike.

Hendershott was able to calculate that if you took 1,000 private equity funds and looked at the top quarter (the best 250), you would expect to find that 146 of them or 58.4 percent were managed by top-quarter managers. That still leaves 41.6 percent of the good funds managed by the 13.9 percent of ordinary managers who happened to be lucky.

Time and additional experience are the compensators for this phenomenon. Winnowing the data down to get a practical handle on it, Hendershott determined that when a manager has had three consecutive top-quartile private equity funds, potential investors can conclude with 80 percent or greater confidence that the manager is exceptional.

Yet that raises practical problems. By the time a manager’s 1995 fund has been proved successful, it’s too late to invest in that manager’s 1997 fund. Once a manager has had three straight proven funds, everybody wants to jump on the band wagon. That could create problems by reducing the allocation available to new investors or by causing the fund to grow larger and move away from the strategies that made it successful in the first place.

In other words, Hendershott said, by the time past performance can be used as an effective screening device for fund managers, investors might be better off looking for the funds run by good but unlucky managers who didn’t meet the strict screening criteria.

And in the end, while past performance can help identify the top managers, it still can’t identify what it is that makes the top-rank managers really good. Hendershott used a sports analogy to make the point:

“What made Michael Jordan such a great basketball player?” he asked. “He was tall, but others were taller. He was fast, but others were faster. We know that there are Michael Jordans of the investment world who aren’t just lucky. They have something the other people don’t have.”


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