Abstract:

Placing funds with an active money manager is typically a bad bet. Yet, institutions continue to hire active money managers. Why? The short answer is that the individuals who serve on institutional investment committees exhibit frame dependence and heuristic-driven bias. When it comes to framing, committee members tend to think of portfolios as a series of mental accounts, with associated reference points known as benchmarks. Therefore, they tend to mistake variety in manager “styles” for true diversification. In addition, reference point thinking tends to make people give opportunity costs less weight than out-of-pocket costs of the same magnitude. In addition to frame dependence, members of institutional investment committees bear responsibility for the performance of the portfolio. Consequently, they are vulnerable to regret. Choosing active managers enables committee members to shift some of the responsibility for performance onto the managers, thereby reducing their own exposure to regret. Heuristic-driven bias stems mostly from reliance on representativeness. Specifically, representativeness underlies the mistaken belief in a “hot hand,” an effect that leads sponsors to believe, mistakenly, that they have the ability to pick managers who can beat the market.

Keywords: styles; responsibility; winners; representativeness; framing; reference point; mental accounts; investment committees; diversification; money managers; regret; hot hand; passive money management; active money management

Document Type: Research article