How do managers manipulate returns? Let me count the ways…
Yesterday I noted how fund managers are conflicted. They want to look good so their firm can attract funds to improve their fee income. One way to look good is by gaming the system—fudging their returns. You’d think there would be rules about this sort of thing. But often, there aren’t.
One way to manipulate performance is through incubation and mergers. Several new funds are established with different strategies. Initial investments are limited; hot new IPOs get allocated. What looks like investment skill might just be the trading clout of a big firm working for a small fund. Successful funds get marketed; failures are quietly closed. Really successful funds may be merged into the firm’s flagship funds, where their enhanced performance makes the mother ship look good.
This is a kind of “bait-and-switch.” Mangers also manipulate more technical measures. Many of these metrics are designed around a theoretical normal distribution curve. But fund managers can use options and other derivatives to skew their results, giving them apparently higher scores. These strategies can be legitimate—but often are used just to look better. As the British banker Charles Goodhart once noted, “Once a measure becomes a target, it ceases to be a good measure.”
At the core of performance manipulation is a desire to look good. But the heart of money management is a desire to be right—to anticipate the market’s moves by understanding its dynamics. Investors need to know the difference.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!