Why Institutions Systematically Underperform Broadly Based Market Indexes

Abstract

The reason institutions underperform the indexes is that they are hiring the wrong manager and using the wrong incentives to motivate those managers. The interview/presentation process selects money managers with interpersonal skills that would help them succeed in most managerial positions, but that are either irrelevant or harmful for managing money. We provide a short questionnaire that can be used to select money managers. This questionnaire is intended to replace the interview process for selecting managers, but not to replace on-site investigation of back office operations. The monitoring process is also dysfunctional. By asking managers to justify unfamiliar investment, managers are discouraged from investing in obscure securities even if those investments would increase the risk adjusted returns portfolio. Instead, herding is encouraged where all managers are choosing similar stocks.