By Mary Childs Oct. 9, 2018 5:00 a.m. ET Takashi Hososhima Sugata Ray conducts the most fun research. From his post teaching and researching at the University of Alabama, he studies disparate influences on asset management and market microstructure. He has looked at the effect of personal real estate transactions and “marital events” on the productivity and risk tolerance of hedge fund managers. We caught up about his most recent paper with Stephen Brown, Yan Lu, and Melvyn Teo, coming out soon in the Journal of Finance. The paper looks at the relationship between risk-taking and the purchase of a sports car. It has already won the Q Group’s Jack Treynor Prize, which “recognizes superior academic working papers with potential applications in the fields of investment management and financial markets.” And the paper has received third place at the CQAsia Academic Competition, and made a splash in the finance world. Barron’s: What did you find? Ray: We’re looking at this trait called sensation-seeking. Some people enjoy sensation-seeking, and some are sensation-avoiders and prefer to not seek novel experiences. You can probably determine among your friends who is a sensation-seeker, but unless you know someone very very closely, it’s hard to pick that up. As quantitative researchers, we are looking for something we can observe externally, [something] relatively objective. The thing we found data on was cars. It also has this dual effect of acting like catnip: A lot of people in this field seem to be very interested in the cars they drive and other people drive. But other things could be used as flags. Sugata Ray We found this data source vin.place. They cull records from a variety of publicly available sources. You get a lot of detail on the car: model, year, brand, make, VIN [vehicle identification number]. We start searching for some hedge fund managers, and found a good chunk of them. Then we merged this data with the commercially available hedge fund data, like TASS, HFR, Morningstar: returns, when they were formed, how much they charge, so on and so forth. Do those cars the managers drive have some predictive power, allowing us to gain some insight into how their funds are going to perform? The answer ends up being yes. We looked at things like sports car versus non-sports, torque, 0 to 60 times — things you associate with fast and speedy cars, we designate as sensation-seeking flags. Someone who’s buying a zippy sports car is likely to have the intention at least of enjoying driving a zippy little sports car, and is likely to enjoy the sensation that comes from it. The sensation-seeking flags were correlated with higher risk-taking in the funds. Not just that. Investors didn’t get additional returns for it. All hedge funds managers take risk; that’s one of the ideas behind hedge funds. But these guys were taking risks that weren’t adding any returns. As a consequence, the funds had lower Sharpe ratios, a measure of return per unit of risk, one thing both managers and investors want to improve. The funds also end up having higher measures of operational risk, things like ADV violations. ADV is this form fund managers have to file; violations include things like: Were you penalized by a government agency or the judicial system? Were you sued by investors? Etc. All of these measures of risk are higher. For no additional yield. OK, these things are bad. How do these sensation-seeking fund managers persist? We show some evidence that sensation-seeking investors, in particular the managers of funds of hedge funds, are also sensation-seekers who also drive sports cars. They tend to be the ones investing in the sensation-seeking hedge funds themselves. It goes one level back, to sensation-seeking investors who put up with the additional risk at little to no additional return. If you flip all this: Driving a minivan is as sensation avoidant as you can think of. These guys take lower risk, and their returns are no worse, so they end up being a better bet in terms of Sharpe ratios. Unfortunately, we don’t find that investors adequately appreciate how good of a deal it is. It’s not the case that sensation-avoiding investors flock into sensation-avoiding funds. That was the one area in which, perhaps, our findings will help improve some asset allocations. In other words, investors should seek out sensation-avoiding minivan-driving fund managers? My goodness. Yeah, if you want to distill it to a sentence. Tell us about your other recent work. Our marriage and divorce piece was ultimately about attention. In the industry, it was pretty well-known that if a manager is going through a divorce, really bad things happen to their funds. We got court records on marriages and divorces of fund managers and looked to see what happened to performance. As expected, a couple of years after the divorce, managers underperformed, and it’s pretty significant underperformance. But the same thing happened for marriages. No one expected that. It makes sense: You’re kind of distracted. It’s a good distraction, that’s for sure, but you are distracted. You start seeing patterns of behavior that you’d expect from someone who’s distracted: more investing in index stocks, you’re not going out there and finding creative new investment ideas; it’s, like, let’s buy Apple. You start seeing a much higher percentage of the assets deployed into index names. The correlation of the funds’ returns with the index starts going up. You start seeing higher susceptibility to behavioral biases. An example of this is the disposition effect, the tendency most of us have to want to realize gains and hide losses. When you lose $50 at blackjack, this is the tendency that makes you want to stay and try to break even, because you haven’t lost it until you leave the table. Fund managers who are going through both marriages and divorces start showing significantly higher susceptibility to the disposition effect: They are much more likely to start selling winners and holding losers. This susceptibility is linked to underperformance. We did not document it in that paper, but we did conduct tests to show that. The other paper, still a working paper, is on charitable donations. Unless the donor wishes to remain anonymous, charities will publish names of donors at different band levels. We looked through [data collected by Noza] and got the donations of hedge fund managers. When you think hedge fund manager, “charitable” is not the first thing that comes to mind. Their profession is to make their investors richer, and get a little cut for themselves — to make money. Giving away money is at odds with the profession they’ve chosen. That being said, a lot of them make a lot of charitable gifts. We started thinking perhaps, just perhaps, not all these gifts are entirely altruistic; perhaps some have some strategic component. So when is it that these fund managers make these gifts? We focused on $7,500 or more. We find something very surprising. Fund managers who are doing badly — in terms of the funds performances, of their funds inflows — are much more likely to make these large gifts. That’s at odds with everything we know about donations. Most people donate when, financially, they’re doing well; you don’t pick the year you’ve been fired to donate. After the donation, compared to fund managers who are not doing so well who did not donate, the donating fund managers end up mitigating a boatload of outflows that the non-donating fund manager experienced. They keep more of the money in house. It looks like perhaps there’s some evidence that these guys are doing this strategically, to try to mitigate the outflows, to keep money that would have otherwise gone out the door and get another chance to improve performance, or at least charge another year of fees. Wow. Are there any other personal-life indicators of future performance? Another is on the houses that these guys buy. There are court records to get home buying and selling data; it’s visible to a neutral observer. Can that shed light into how your fund performs in the future? For most people, including hedge fund managers, real estate is a significant chunk of their portfolio. Do they make changes in their professional asset allocation in line with this? A manager could have two ways to complement their investment portfolio; to say look, I’m dialing up the risk on my personal investment front, maybe I should dial back the risk on my professional investment risk, so it evens out. The manager could be thinking, well, I think the world is about to go into a really good boom phase, we’re in the middle of a beautiful bull market, so I’m going to dial up the risk on my personal investment and I’m going to also dial up the risk on the professional investment front. We found the latter. When managers are buying leveraged investment properties, they are also dialing up the risk in their hedge funds. We also found, for primary residences, evidence of the distraction story: The funds tend to suffer in terms of performance going forward. Don’t they have a list of the most stressful events in life: moving, marriage and divorce, loss of a loved one? You buy a bigger house, you buy a more expensive house, you are more distracted. Did you look at childbirth as a determining event? It’s something we wanted to look at, but it’s hard to get data on people having children, at least until many, many years after. The main source of people data is LexisNexis, and LexisNexis doesn’t provide data on minors, so you can only be doing analysis today on 20 years ago. What’s next? [It’s] a work in progress, but in popular media, people seem to think there’s some correlation between poker and fund management. One hypothesis could be these managers who play poker are better managers; we do find that, cross-sectionally at least, managers who have been winning poker tournaments, for whom we have data, seem to outperform other managers. But then we find something very interesting: When a fund manager wins a poker tournament, this tends to attract more investor money. But winning this poker tournament does not predict any future outperformance; investors might be reading a signal into this, but really the best signal is still the past performance of the fund. Why hedge funds, not mutual funds? The strategies are so much less constrained and the manager has so much more discretion. At least in my opinion, it’s more of a pure laboratory to see some of these things manifest. Did you get any feedback that sparked a follow-up look? A fund manager wanted to become more comfortable with taking risk. I guess a lot of fund managers grapple with this. You get very stressed when you take risk. How do you make yourself more risk-seeking? He talked about all sorts of potential options, but one was: If I started driving a sports car, would that actually start wiring my brain differently? There is some suggestive evidence this is the case. In a famous experiment, random people were asked to test-drive a car, and afterwards they [answered] certain questions. The people who test-drove luxury cars answered very, very differently, in terms of entitlement and a variety of things, than the people who test-drove ordinary cars. So it does potentially change the person. We looked at the risk of a fund prior to a purchase of a sports car or a regular car, and whether the purchase of a sports car added any meaningful signal over and above the risk before. Risk is measured very noisily, where you have a certain number of data points on returns, you see how they swing up and down, and OK, that’s my risk. This signal [from] the car is a meaningful signal, regardless of which way you are predicting. It doesn’t seem to be the case that they’re changing their risk behavior — this is being revealed. That is who you were all along. We just couldn’t see it as clearly before we saw your car purchase. Shouldn’t your friend wait till you find a signal that increases risk-taking and returns? I’ll keep looking. Thanks, Sugata. BIO BOX CV: Assistant Professor, Economics, Finance, & Legal Studies, Culverhouse College of Business, University of Alabama. Previously: University of Florida; PhD from the Wharton School at the University of Pennsylvania, 2009, Finance Hobbies: Pinball, and trying get his children interested in pinball. https://www.barrons.com/articles/sugata-ray-hedge-fund-research-1539025367
Indeed, @dealmaker is one of the good ones... If you want to read the full paper, it's here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2882983
Data Mining at its best. Taking risks is not a bad thing, taking unwarranted and unsubstantiated risks is.