“You’re getting sacked in the morning”

Football fans like me will be familiar with the chant often heard on the terraces "You're getting sacked in the morning”, aimed at the manager whose team is performing poorly. Taking action based on this knee jerk response to poor performance may, however, be damaging in the long term.

Imagine winning £250k from a £50 bet, a 5,000x return. One lucky punter almost did, before he opted to cash out for £72,335, during the 2016 Premier League title run in. Such outsized winnings were popping up all over the East Midlands when Leicester City produced, arguably, one of the greatest anomalies in British sporting history. The man to lead them to glory was Claudio Ranieri, who won English football’s biggest prize with his unfashionable team, only to be sacked a couple of months later.

Such roller-coaster rides for managers have become commonplace in modern football, with the average tenure for an English football manager reducing from 3.5 years in 1992 to 1.3 years in 2016.

At first glance, a career evaluating hedge funds seems vastly disconnected to a passion for football; however, when it comes to the turnover of managers there are important overlaps from which both worlds can learn. This thought piece aims to draw some comparisons between my career and my life-long passion, football, after noticing similar trends in both of late - specifically, the short-termism of hiring and firing managers.

My role as a hedge fund analyst at Aurum allows me to cover a wide array of funds, from start-ups to mature businesses, spanning several strategies (quantitative, multi-strategy, global macro, event driven, fixed income and equity long/short). I am of the opinion, supported by our research, that a reversion to the mean of under performing managers is more common than many presume. Having a sound original thesis and understanding of the limitations of managers prevents reactionary trading and turnover, helping to achieve long-term goals. It seems to me the same is true of football.

After his departure, the outpouring of support for Ranieri came from across the footballing world including from within Leicester City, begging the question, why sack him? In this instance, it seems there wasn’t a huge amount of fan pressure, more likely a lack of understanding from the board as to what could be expected from this group of players. Leicester were certainly heading towards the relegation zone, but what had really changed from previous seasons? Leicester’s recent history has seen them perennially flit between leagues. Without undermining Leicester, getting relegated and promoted is what they do. Had the owners stopped to consider what had really changed, without using last season’s heroics as a benchmark, would they have let a manager with such an impressive CV go?

It is true that bringing in a new coach often gives the team a boost in the short-term, as evidenced by Leicester! However, I question whether it actually translates to long-term success. Indeed, analysis by Dutch economist Professor Bas ter Weel also shows that these short-term bumps in performance are misleading. Professor ter Weel’s work focuses on the Dutch Eredivisie from 1986-2004 and states that "Changing a manager during a crisis in the season does improve the results in the short term," as seen at Leicester "But this is a misleading statistic because not changing the manager would have had the same result".

The graph below depicts his work, and highlights that a reversion to the mean often occurs in all circumstances, whether a manager is fired or not.

In addition, statistical research performed by Andreas Heuer of the University of Muenster, Germany, claims to be able to “show with an unprecedented small statistical error for the German soccer league that dismissing the coach within the season has basically no effect on the subsequent performance of a team.”

But what does this have to do with hedge funds?

Both the Premier League and hedge funds are high pressure, big money environments, where managers are subject to high levels of scrutiny. In both arenas, a poor run of results is likely to result in the human urge of their backers to do something about it, for fear of inaction being seen as a sign of weakness. Yet is doing something always better than doing nothing? Not according to Messrs ter Weel and Heuer.

Constructive or not, there is a behavioural urge to ‘satisfy’ the home crowd. These emotional tendencies can foster decision-making that strays from an initial thesis, even if the facts of the case have not changed.

There will always be a pool of exciting new hedge funds boasting a few months of stellar performance. A universe of thousands of hedge funds guarantees such statistical anomalies. Sometimes these are just that - statistical anomalies. At other times such superior returns can be generated at a small asset size, though subsequently degrade as the fund grows. Investments that are based on attractive short-term performance, rather than a holistic portfolio and philosophical view, are less likely to succeed long-term.

The statistics show a tendency to revert to the mean for football, but what about for hedge funds? A number of years ago, we performed a review of Aurum’s historical trading, which considered the performance of funds before and after they were bought or sold. Our analysis showed an amazing similarity to the work performed by Professor ter Weel, with a similar ‘V’ shaped graph highlighting reversion to the mean.

We noted a tendency to redeem funds following 9-12 months of poor or lacklustre performance. What we found when we fully analysed the subsequent performance of those redeemed funds was a very clear reversion to the mean immediately after the redemption. Not only that, but when we studied the pre-investment and post-investment performance of the new purchases, we found a bias toward funds with stellar performance. Aurum was drawn to the new ‘stars’ of the industry but, lo and behold, these stars tended to revert downwards towards the mean subsequent to purchase.

Whilst one might have expected this to a degree, the level of mean reversion surprised us. Indeed, by overlaying the return profile of new purchases (blue line) against the performance of redeemed funds (red) we found that there was almost an identical overlap in the return profiles.

As with football managers, taking the tough decision to show faith in an underperforming fund had very similar results to replacing them with the seemingly easy choice ‘superstar’ fund. Portfolio turnover was not as additive as had been imagined.

Since performing this analysis we have begun to highlight biases and behavioural shortcomings in our research process and have taken steps to mitigate the risk of falling for these classic psychological traps. One such measure is the addition of a Risk and Return Expectations (“RARE”) report. The RARE report forces us to set upfront expectations (with upper and lower bounds) for any proposed investment, helping to identify reactionary short-termism when faced with a period of poor performance, which we were perhaps vulnerable to in the past. 

RARE dashboard for long term return expectations

In general, we believe that we as humans, with our behavioural flaws, can often lack the ability, or desire, to analytically critique our performance. You only need to look at the success of Daniel Kahneman’s book “Thinking Fast, Thinking Slow” to understand how poorly our brains account for our actions. There are perception versus reality voids which require us to put in place rigorous processes and challenge mechanisms to prevent ourselves slipping into these behavioural traps.

After seeing the evidence against short-term fixes, we believe the key to success in both football and hedge fund investing is to have a philosophy and a long-term goal that percolate through all decision making. Just as important is setting clear and realistic expectations from the outset.

Looking at the most successful football teams in recent history, the majority have had a philosophy that runs throughout the club from top to bottom, from the physio to the star striker. Barcelona is one of the standout examples, investing in youth, bringing through young coaches from within and playing a certain brand of football instilled by Cruyff in the mid-70s. Bayern Munich is another. In the 90s, Karl-Heinz Rummenigge and Uli Hoeness set out to restructure the standard of football played at Bayern. Building on the club’s academy coaching, they formed the foundations for a period of success not only for Bayern but also German football. The Bayern motto, Mia san Mia, translates as ‘We are who we are’, and governs Bayern in their underlying philosophy, focusing on excellence, perfection, attention to detail, unity, diversity, innovation and a promotion of youth from within. 

To apply this approach to hedge funds, investors should be clear what their goal is, confirm that the manager fits with their philosophy, understand the possibilities and limitations of the manager and invest with a long-term horizon (which means being prepared for those inevitable periods of underperformance). Setting initial expectations for both the upside and downside helps investors to stay the course rather than falling into the typical reactionary traps – Leicester City!

To quote Keynes “when the facts change, I change my mind – what do you do, Sir?” Assuming a sound thesis through a high quality due diligence process means that we can watch the numbers but ultimately if the facts have not changed then, to Keynes’s point, why should the course change? This is why Aurum applies significant resources and effort to the investment research process. That said, if the facts change, so will our opinion, but what we do not do is fall into the trap of short-term reactionary behaviours driven by a small number of statistically insignificant data points.

We understand the compelling urge to react; doing nothing in times of poor performance can be perceived as a sign of weakness or even a lack of leadership. Sticking with your original investment thesis if the facts have not changed, however, can ultimately prove beneficial. Some crowds welcome reactionary answers to problems – but often the illusionary effects of change can be short-lived, as demonstrated in the football world by ter Weel’s work. All too often the shining stars revert to the mean and, as is often forgotten, the ousted ‘losers’ come back to form. The cost of churn is high and the opportunity cost associated with it can often go unnoticed.

Rather than out with the old and in with the new, Aurum recommends applying behavioural checks and balances to decision-making. Shoot first, ask questions later, is not the way. We are aware of fool’s gold and constantly ask the hard questions of managers and ourselves– especially when the ‘easy’ decisions appear to present themselves. Long-term capital appreciation is built on solid foundations, processes and self-analysis, rather than dancing to the song of the numbers.  Aurum has found that self-awareness and self-analysis have proved invaluable for stable and consistently performing portfolios.  

Whilst it might seem odd for a hedge fund investing advocate to quote Warren Buffett, I strongly agree with his quote “games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard”. Both the hedge fund industry and the Premier League may have something to learn from Warren.