Aurora Borealis
1 May 2014 CFA Institute Journal Review

Throwing Good Money after Bad? The Impact of the Escalation of Commitment of Mutual Fund Managers on Fund Performance (Digest Summary)

  1. Gregory G. Gocek, CFA

Extending the behavioral finance concept of anomalous decision making to the context of buying decisions, the authors examine how a significant proportion of equity fund managers in Taiwan tend to escalate their commitments to unprofitable positions, which results in portfolio underperformance relative to nonescalating peers.

What’s Inside?

The authors research a potentially overlooked behavioral bias by institutional investors, namely their irrational buying decisions related to escalating commitments to stocks that have underperformed since they were first purchased. Their study focuses on Taiwan during 1997–2002 because data on monthly holdings are available over this period. Approximately 40% of all fund managers in Taiwan persist in buying losing stocks even though they receive no benefits from price reversal and do experience an 80–120 bp detriment on their returns relative to managers without this bias. This inferiority is attributed to poor stock selection with their biased persistence, leading them to ignore potentially valuable alternatives.

How Is This Research Useful to Practitioners?

As fiduciary standards grow more stringent, a professional investor’s fatal flaw may be the belief in superior insight that is contradicted by reality. Research shows that doubling down on losing positions out of loyalty to accepted management practice can have harmful effects on client wealth, but it is still excused as the unforeseeable outcome of volatility from adverse market conditions. The authors’ evidence serves as a cautionary tale to professional investors on the hazards of rigidly adhering to favorite investments or approaches.

The authors’ findings initially signal a possible good outcome for those managers who persist in buying losers, namely the effect of the cash holdings of their nonescalating peers. That nonequity portion of portfolios appears to be the most tangible source of the nonescalating managers’ outperformance, which would mean that the 40% of Taiwanese fund managers were not necessarily trailing because of inept stock picks. Further investigation eliminates plausible alternative explanations for the divergent performance, including market-timing skills, fund flows and redemption needs, and lower trading costs. Ultimately, escalating commitments are linked to poor investment choices.

How Did the Authors Conduct This Research?

The authors use two major databases to analyze the trading of 250 open-end Taiwanese mutual funds from August 1996 to June 2002. Institutions in Taiwan are required to provide detailed reporting monthly, unlike the typical quarterly frequency elsewhere (e.g., in the United States). This difference facilitates a closer assessment of trading to gauge actual holdings.

Escalation of commitment is defined as the propensity to include a greater proportion of stocks that are declining in value than increasing in value over a given month. The authors rank the funds by escalation of commitment scores and group the results into portfolio quintiles, with monthly holding period returns for each quintile tracked over the six-year horizon. These were then compared with a series of benchmark equity portfolios that include all listed stocks. Measures covering 3-, 6-, and 12-month periods quantify fund performance under escalation of commitment, the effectiveness of reversal strategies, and the contribution to returns from active management.

The use of Taiwanese data over a short time frame provides tracking advantages to closely monitor trading, but the resultant downside is the potential limit on the applicability of the findings. Characteristics unique to this specific market and period, such as greater propensity for risk taking, may be at work. Also, given that a long-term value style would seem to be more likely to involve stocks initially proving to be losers, the allowed review time frame (one year or less) may be insufficient to provide a fair test of ultimate profitability.

Abstractor’s Viewpoint

The authors aim for a suitable goal in focusing a behavioral finance perspective on new types of decisions (the reinforcement of likely self-defeating purchases) made by supposedly rational actors (professional money managers) but in contexts potentially conducive to biases (on the exchanges of emerging economies where market efficiency has been shown to be a weaker fit). Their reference to comparable investment anomalies by corporate finance managers comes across as an aside rather than as a considered judgment, although they do acknowledge the greater methodological challenges that interfere with the study of project finance. Further research seems warranted.

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