AgPa #61: Minivans versus Sports Cars

Sensation Seeking and Hedge Funds (2018)
Stephen Brown, Yan Lu, Sugata Ray, Melvyn Teo
The Journal of Finance 73(6), 2871-2914, URL/SSRN

Tell me about the car you drive and I tell you who you are. In the hope of not offending the car enthusiasts too much, this week’s AGNOSTIC Paper relates the performance and characteristics of hedge fund managers to the type of car they drive. As announced in last week’s article, this is a funny example for the important soft factors that investors should consider when selecting an asset manager.

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

I think we can all agree that our human psychology occasionally impacts financial decision making and most of the time, unfortunately not for the better. We already touched on some examples for that in AgPa #8 and AgPa #22, but the research in this area is nowadays so large that it would require a separate blog to cover it in detail.

The authors of this week’s paper focus on one particular example for this which is sensation seeking. They explain it as “a personality trait clinically defined as the seeking of varied, novel, complex, and intense sensations and experiences, and the willingness to take physical, social, legal, and financial risks for the sake of such experiences.” (Brown et al. 2018, p. 2872).
In English and somewhat exaggerated : sensation-seekers do non-rational or even stupid things because they enjoy them. Of course you can now argue that having joy from something rationalizes sensation seeking. I agree with that for some leisure activities like dangerous sports. In the professional space, however, I think you don’t want to rely on sensation-seekers and this week’s paper shows that at the example of hedge funds.1As hedge funds are “just” dealing with money, maybe another example to make it clear. Do you want to have a sensation-seeking surgeon or pilot? I would rather go with the boring safety-obsessed guy…

Following prior research and various insights from psychology, the authors argue that the type of car someone drives is a reliable proxy for sensation seeking. And as it turns out, they found a way to get data on the cars of some US hedge fund managers and put together a very cool dataset.

Data and Methodology

The authors use a publicly available database to identify the car purchases of US hedge fund managers between 2006 and 2012. From my perspective of a European citizen that is used to strict privacy laws, it was really amazing to see how much personal information you can get from public sources in the US. The authors mention, however, that people have the opportunity to opt-out from this database so there might be a little selection bias in their data. After identifying the purchase, the authors subsequently classify cars into Sports Cars, Minivans, and Other Cars based on the body style. They also obtain further information like horsepower, torque, passenger volume, price, and a safety rating.

They match this information with data on hedge funds from various professional data providers (Lipper, Morningstar, Hedge Fund Research, Barclay Hedge). The total sample consists of 1,144 hedge fund managers who purchased 1,774 cars between 2006 and 2012. 163 of those vehicles are Sports Cars, 101 are Minivans, and the rest are Other Cars. That is obviously only a small subsample of the 4,505 hedge funds that existed during this period in the US. More data is of course always better than less, but I think despite public data sources it is still not easy to get data on cars of individual persons and the authors certainly did the best they can.

Before we continue to the results, maybe a brief comment to those of you thinking “Well, that’s nice story-telling but a sample of roughly 250 cars doesn’t say anything”. I understand this concern, but as often, we are free-riding on the checks of the scientific community at this point. The paper is published in the Journal of Finance which is one of the best journals in the world. The authors also provide a whole bunch of further analyses and tests to make sure that their results are not spurious. Overall, I am therefore pretty sure that the mechanisms they identify are applicable to the real world.

To test the differences between sensation-seeking and non-sensation-seeking hedge fund managers, the authors use car ownership as indicators. Managers who drive Sports Cars are the sensation-seekers, and those who drive Minivans (in fact probably one of the most uncool car type available) are the non-sensation-seekers. They also repeat their analysis with horse power, torque, passenger volume, and safety ratings for more robust results.

Important Results and Takeaways

Sports car drivers take more risk and deliver lower performance

In-line with the idea of sensation-seeking, the authors find that managers who own Sports Cars take on significantly more risk than managers who own other car types. Even after controlling for other variables that impact a fund’s risk and return, Sports Car drivers’ funds had on average a 2.3%-point higher annualized volatility than the remaining hedge funds. On the contrary, Minivan drivers take on significantly less risk than other fund managers and in particular less than Sports Car drivers. These results are generally similar for the other indicators (see above) and support the idea of sensation seeking. Managers who purchase Sports Cars seem to be also willing to take more risks in their jobs.

The more interesting question for investors, of course, is whether this risk-taking is compensated. Achieving higher returns by taking more risk is okay, but just taking risk without getting more return seems stupid or indicates a lack of skill. From the way I framed the previous sentence, you probably already expect what is coming…

The authors find that Sports Car drivers generated Sharpe and Information Ratios that were on average 0.38 and 0.33 lower than for managers who drive other car types. Similarly, Minivan drivers delivered Sharpe and Information ratios that were on average 0.54 and 0.40 higher than for the other funds. Given that the overall stock market has a historical Sharpe ratio of about 0.4 to 0.5, these results are very substantial! And of course, the results also suggest that sensation-seekers are either unskilled because their risk is not compensated by higher returns, or that they take it for other reasons than making more money. Needless to say, you don’t want either of those as an investor…

Further supporting those results, the authors also find that sensation-seekers trade significantly more than other managers and deviate their portfolios more aggressively from benchmarks. For Minivan drivers, once again, the pattern is exactly the opposite.

Funds of sports car drivers come with more operational risk

The authors next examine the relation between car ownership and the operational risk of the fund. Operational risks capture potential problems beyond the investments of a fund manager. Hedge funds are businesses like all others and need to operate profitably and compliant with rules. Even the smartest hedge fund manager doesn’t help you when she cannot manage her company and need to close it after a few months. In fact, the authors even quote research showing that operational risk is more relevant to explain past fund failures than the risk of the investments.

I know it is getting boring, but the authors find that funds of Sports Car drivers exhibit significantly more operational risk. For example, a Logit regression with various control variables suggests that the probability of fund termination increases by about 4.7%-points when the manager owns a Sports Car. Sensation-seeking fund managers also report significantly more violations of rules and standards in regulatory disclosures. These results again support the idea of sensation seeking and suggest that such managers are indeed willing to take more risk in various areas of their professional life.

Sports-car-driving investors want sports-car-driving fund managers

So far, we have found all these negative outcomes for sensation-seeking hedge fund managers. The question therefore arises why investors do not spot the problems and still invest with them. The authors present and test a very simple idea. There is no reason why sensation seeking should be limited to hedge fund managers. Since it is a psychological bias, it should affect the whole population. The authors thus hypothesize that some hedge fund investors are themselves sensation-seeking and want to have managers who deliver on their preferences.

They use their database to conduct the same analysis with Fund of Fund (FoF) hedge funds and find essentially the same results. Sports Car driving FoF managers also take significantly more risk while the reverse holds for the Minivan drivers. More importantly, sensation-seeking FoFs invest significantly more of their portfolios into the sensation-seeking managers’ hedge funds. The authors thus conclude that although they produce worse results, sensation-seeking hedge fund managers found their spot in the industry and attract clients with the same psychological bias.

Conclusions and Further Ideas

This week’s paper reminded me of Rolf Dobelli’s book The Art of the Good Life. In the chapter about Prevention, he provides a funny though-experiment. Suppose you have two captains of a ship. Captain A steers the ship and crashes with an iceberg. The ship sinks but the captain heroically saves all passengers. Captain B checks her instruments for potential dangers well in advance and avoids the iceberg by a wide margin. What will happen? The public will celebrate captain A as hero while no one talks about captain B who actually did her job much better but less sensational.

I think this week’s paper shows that the situation is very similar for asset managers. The evidence clearly speaks for the safety-obsessed Minivan driver who avoids unnecessary risks upfront. Yet, it is surprisingly hard to stick with a boring process that just works. It is just not the way our brains work and we probably all have the sensation-seeker in us to some extent.

So what can we as investors learn from this week’s paper? Of course, after reading this post you should definitely ask your asset managers what type of car they drive. All jokes aside, the type of car stands synonymous for investigating your managers’ psychology. If you believe in the empirical evidence, you want to invest with the boring guys who don’t take unnecessary risks and just execute their process. A great example for this, as so often, is Warren Buffett who took on a few simple ideas but executed them without major stupidities over more than six decades.

In addition to that, the authors recommend to look for managers who co-invest with their investors. They argue that such aligned incentives should reduce sensation seeking among managers and find corresponding evidence in their data. In my experience, however, this is no full protection as it is always surprising to see the stupid things some people do with their own money.

Finally, I cannot end this post without saying something about my own car. Funny enough, I just recently purchased my first car ever at the age of 26. It is a more than 10-year old Opel Corsa with less than 100HP and >150.000km mileage.2Here it is…
This is probably even less sensational than a Minivan

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1 As hedge funds are “just” dealing with money, maybe another example to make it clear. Do you want to have a sensation-seeking surgeon or pilot? I would rather go with the boring safety-obsessed guy…
2 Here it is…