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Beware of Nervous Fund Managers

A Study Shows That Gun-Shy Investment Pros Do Worse, and Risk Losing Job

Robert Neubecker

When it comes to mutual-fund managers, the adage may be true: No guts, no glory.

Investment professionals who are too scared about losses tend to perform more poorly overall, hurting both their investors and their own careers, contends a soon-to-be published study.

As a result, fund companies should be doing more to screen prospective managers on the degree of their “loss aversion,” say the authors of the study, Andriy Bodnaruk of the University of Notre Dame and Andrei Simonov of Michigan State University and the Gaidar Institute in Moscow.

A caveat: The study is based on a survey of fund managers in Sweden, a country the authors have found to be fertile ground for their studies because it opens up managers’ private data, including personal tax records and investments, to the public. But Dr. Bodnaruk says the findings are applicable anywhere because they’re about human nature, not about where people live.

The Cost of Caution

Dr. Bodnaruk points to a flaw in hiring: “Managers are hired based on their past performance, experience in the industry, pedigree and other factors, but to our knowledge their ability to stomach volatility of their portfolio returns is never under consideration.”

And those jittery managers could be costing their investors. The study found that loss-averse managers underperformed their gutsy peers by 1.2 to 2.1 percentage points a year, “very large by industry standards.” And they have a greater chance of getting fired.

Individual investors, as opposed to the pros, care a lot about potential losses, and are even willing to overpay for stocks considered safe. The pros, on the other hand, are “supposed to be immune to behavioral biases due to their greater sophistication” and resources, write the professors.

The study is based on survey responses from 68 managers in Sweden. To measure the managers’ degree of risk aversion, the survey asked them questions about their willingness to participate in a single or several risky lotteries. Managers also were asked a sequence of questions about their willingness to gamble on lifetime income.

(The professors didn’t fool around in trying to hook the managers; the surveys were sent with a ticket for the popular Swedish lottery, and a gift card for the equivalent of $260 was promised to a randomly drawn participant.)

The result: 37% of managers showed high aversion to losses, 25% had low loss aversion and the rest in between. The better-safe-than-sorry crowd tends to work at funds “that are concerned about capital preservation,” such as bond funds, the study says; the risk-willing managers tend to be at funds with “aggressive investment policies” like international and hedge funds. Some of this evolves as people gravitate to their comfort zone, or get fired.

Earning Their Pay?

The professors’ call for more risk-aversion testing makes sense, says Todd Rosenbluth, head of mutual-fund research at S&P Capital IQ. With active funds, “if you’re not willing to take on risk, you’re essentially a closet indexer. In order for you to earn your pay, you need to take on those bets.”

“Investors are buying a fund based on what they assume the risk profile is, and they’re assuming the manager has the same risk profile,” he says.

In an earlier study, coming in the Journal of Financial Intermediation, the professors found fund managers don’t do any better than amateurs in personal investing decisions, except for investments in stocks that were also held by their funds. (In other words, where they have an information advantage.)

The uncomfortable conclusion of that study: “Expertise in finance does not improve investment decisions.”

Mr. Power is a Wall Street Journal news editor in South Brunswick, N.J. Email william.power@wsj.com.

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