BFS 2002

Contributed Talk

Hiring and Firing Fund Managers

Sam Wylie

We analyze the value of an investor's real option to delay the decision to fire a poor performing portfolio manager. It is shown in a Bayesian decision framework that the value of delaying the firing of a poorly performed manager, until some uncertainty over the manager's quality is resolved, partially explains empirical observations of investor tolerance of very poor portfolio performance results before changing manager (Sirri and Tufano 1998, Goetzmann and Peles 1997). Further, why mutual funds with shorter track records grow more quickly (Ippolito 1992, Chevalier and Ellison 1997). It is also shown that the real option value gives portfolio managers an incentive to inject noise into their performance results. Simulation results for the case of an investor with a 10 year investment horizon demonstrate that the real option value is economically significant, and highlight dependence of the value of active portfolio management on the cost of changing portfolio manager.