January 13, 2013 3:56 am

Beware the dangers of overinflated egos

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The verdict is out. Again. Another round of academic research from UK professors suggests that for US fund managers, overconfidence is like a ghastly virus. Those who catch it, risk making poor investment calls and reporting some shrinkage in their investment returns in the year following the publication of a fund’s annual report.

Indeed, Arman Eshraghi, a researcher at the University of Edinburgh’s Business School, and Richard Taffler, a professor working at Warwick Business School, argue that over-optimism among fund managers based across the Atlantic Ocean is rife. And as a result, investors are seeing a slowdown in returns on active funds run by overconfident fund managers.

Managers with a growth bias tend to be more affected by the trend than value investors, according to the research. And as one might expect, fund managers with strong past performance are more likely to catch the overconfidence disease than those with less successful ones.

“When you outperform your benchmark you tend to become overconfident,” Mr Eshraghi says.

Mr Eshraghi and Prof Taffler arrived at the conclusion that “excessive levels of overconfidence interfere with sound investment decision-making and thereby diminish future investment returns” – after using the so-called Carhart finance model – a performance assessment tool – to study the connection between the over-optimistic mood of fund managers and the returns of some 4,600 actively managed US funds between the years 2003 and 2009.

And the two also argue that money can be made by shorting funds looked after by overconfident fund managers and buying ones run by those deemed to be “normally” confident.

Their report Fund Manager Overconfidence and Investment Performance: Evidence from Mutual Funds stems from research compiled by Mr Eshraghi last year to complete his PhD at the University of Edinburgh. Prof Taffler served as his thesis adviser.

“The whole idea is that overconfidence affects your investment decisions and, by extension, your investment returns,” explains Mr Eshraghi.

“We found that by potentially knowing this in advance, it would assist hedge funds in gaining alpha. You could buy those funds whose fund managers are optimally confident and sell those funds whose managers are overconfident.”

But a question lingers. How was confidence measured? Mr Eshraghi’s response seems less than convincing. He assesses US fund managers’ over-optimism or lack thereof by analysing the nature of the narrative they write in their annual reports with the help of a software programme called Diction. “If you are very upbeat and happy about your performance you often use positive adjectives and other upbeat words. The software measures that and produces automatic scores for over-optimism,” he says. “The algorithm uses a series of 33 dictionaries (word-lists) to search text passages for different semantic features such as praise, satisfaction or denial.”

This method seems unlikely to be foolproof. And even Mr Eshraghi admits that the distinctions that distinguish overconfidence from normal confidence levels are subtle and in some cases difficult to discern.

“There is no single way of defining overconfidence,” he says. “The differences between normal confidence and overconfidence can be slight.”

The pair say that a number of subtle factors affect a manager’s confidence. Indeed, investment managers are swamped by so much information and face so much competitive pressure that they tend to rely on subjective judgment, intuition and their gut feelings to make decisions. Their jobs are difficult and they face the threat of dismissal if the returns they earn are not “up to snuff”.

“On average, fund managers are more confident than normal people. They have to believe in themselves in order to survive in this uncertain environment and deal with the stress and anxiety of buying and selling stocks,” says Mr Eshraghi. “You have to be confident in order to survive in a harsh environment.”

The professors do note that fund managers do not always engage in excessive trading due to overconfidence. Rather, they might have to increase their turnover after a rise in fund inflows following strong past performance. “Fund managers indeed trade more after good past performance and their higher trading is driven by individual portfolio performance,” they note.

As one would expect, the performance of under-confident managers is just as poor. “Their funds tend to implode for some reason, they just can’t sustain their performance,” notes Mr Eshraghi.

No continental European or UK fund managers were studied given the difficulty of obtaining company reports. Mr Eshraghi notes it was easier to assess the level of confidence of US fund managers as annual reports there are “freely” available.

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