Week 6 - Goyal, A., and Wahal, S. (2008). The selection and termination of investment management firms by plan sponsors

Question 1

What is the main idea of this paper?

Answer 1

• Which pension funds delegate decisions (use of active funds and consultant)?
• What determines pension fund managers to hire/fire a particular AM?
• Does hiring/firing generate value?
• Headline risk: sensitivity to public scrutiny in the event of underperformance

Question 2

What are the main findings of this paper?

Answer 2

• Pension plans hire new AMs, when: (1) new inflows need to be invested; (2) asset policy change; (3) termination of previous AM
• Post-hiring performance of newly appointed AMs is basically flat
• Post-hiring returns are smaller than pre-hiring returns
• Larger plans select better AMs or negotiate better conditions (economies of scale)
• Headline risk sensitive sponsors have lower returns
• Consultants only add value for small pension funds, but are detrimental for the big ones
• Pension funds hire AMs for several reason, however, post-firing returns for non-performance based fires are close to zero, but the post-firing excess returns for performance-based firings are positive
• After the firing, the fired AMs performance exceeds the newly appointed AM’s performance
• Pension funds experience positive opportunity costs; sponsors pay transition costs (2%); consultants also benefit from the transitions
• (1) overconfidence: pension funds believe they can time the hiring and firing of AMs; (2) job preservation: they show that they are actually doing something; (3) termination decision improves performance: capacity constraints and greater effort

Question 3

What is the conclusion of this paper?

Answer 3

• Pension funds hire IMs after superior performance but their post-hiring returns are close to zero (headline risk)
• Firing due to many reasons
• Newly hired IMs after a firing deliver the same results as the fired IM
• Transition management firms earn high fees

Question 4

What is the Return chasing behavior of individual investors?

Answer 4

The average equity mutual fund investor tends to buy past outperformers and sell past underperformers.

Question 5

What does the term “dumb money” means?

Answer 5

Individual investors send their money to mutual funds which own stocks that do poorly over the subsequent few years.

Question 6

What does asset pension funds managers prefer when allocating their assets?

Answer 6

• Prefer delegation over internal asset management.
  -Reduces responsibility for potentially poor performance.
  -Use consultants to share even the responsibility for picking investment managers.
• Prefer active over passive asset management.
  -Job preservation incentives: Passive management makes a lot of jobs within the pension fund redundant.