Thursday, September 08, 2005

The Firing of a manager

One of the coolest things about finance, and in particular about teaching finance, is that almost any news item can be used to demonstrate various finance lessons. Indeed, just today Kimmunications gives us financial lessons we can take from the Hurricane Katrina disaster.

The story I wanted to point out however has received very little national coverage. Indeed, it really is not that big of story outside of Pittsburgh: The firing of Pirates' manager Lloyd McClendon. Huh? Bear with me.

The firing of a coach or manager (in any sport) can be used to demonstrate numerous aspects of finance. Possibly the simplest point is the decision process that owners (and General Managers) use to evaluate managerial performance. It is easy to understand why simple win-loss percentage may not be a good measure. (for instance the team may not have enough skilled players, may have had many injuries, or may just have experienced some bad luck.) The thought process necessary to remove a coach or manager is very similar to that necessary to replace a money manager.

Just looking at raw investment returns (which is analogous to looking at winning percentage) is not sufficient; it is a starting point only. A money manager may be doing a very good job but the fund's raw returns may be negative because of a down market, or the fund may lag peers because of a more constrained investment philosophy. Of course finance has tools to measure portfolio performance on a market adjusted basis, but none of these tools (Sharpe Ratio, Treynor Measure, and Jensen's Alpha are most common), is perfect and consequentially some good money managers are fired while some poor managers retain more funds under management than their performance warrants.

A second way that the firing of a sports coach/manager can be used effectively in a finance class is to use the tendency of sports' coaches to “clean house” upon being hired. This house-cleaning is common place in most sports as the new hire wants to bring his/her “own people” to the team. Scherbina and Jin (2005) find that new mutual fund managers are more likely to sell those “losers”, that had been acquired by the former fund manager.

While there is (and should be) debate as to why this behavior is common (did the former managers hold on to poor performers—both players and stocks-- because of a reluctance to make mistakes or because they had better information as to the true worth of the stock/player than the new manager?), it is consistent with the behavioral finance tenant of people being reluctant to admit their own mistakes.

One final problem in all of this is that it is difficult to test. In both sports and finance, poor performance generally precedes the firing. And in each case the performance improves following the firing, but what is more difficult to test (especially in sports) is whether this improved performance is merely a reversion to the mean (a new sector is hot, bad luck reverses, players' injuries heal etc), or if the new manager is the cause of the improved performance.

So with this in mind, you no longer need to feel guilty about watching ESPN or reading about sports, you're just looking for class material. ;)

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