This post often touches on the structural challenges the investment management industry faces, which lead to inefficiencies in managing portfolios or bottle necks in decision-making when examining governance. There are lots of these issues and individually they are discussed at length and in detail across the numerous investment journals. So I was really pleased to recently come across a paper that took a more holistic view of some of the key issues, particularly around alignment of interest. The paper is entitled ‘Fiduciary duty in dysfunctional markets’[i] , published by Ricardo Research with a summary version published in top1000funds.[ii]
The paper looks at the relationship of the key players in the institutional investment market, from the asset owner through to the individuals/groups that manage the money on their behalf. They discuss the “potential for misalignment of interest between principals and agents…” and how principals can “..design effective incentive and accountability systems that help mitigate these issues.” Unfortunately, too often the measures put in place to ensure accountability lead to unforeseen behaviours that influence the process, to the detriment of what is being sought. The paper discusses the use of benchmarks and constraints around those, which can lead asset managers as agents to face a conflict of interest around managing their own business interests against acting in the best interests of their clients.
The authors delve deeper into the issues, characterising what they see as two forms of investing – ‘cashflow and price-only investing’, the former taking a longer-term assessment of a business’ operations; the latter concerned with the near-term changes in stock prices. They further break down the price-only investors into two camps – those that are explicitly exposing the market feature of momentum and those whose motivations are driven by the constraints mentioned earlier. Within this group are those managers termed ‘closet indexers’ whose investment process is driven by the risk weightings of the index where portfolios only deviate by a small margin. Not only is this not good for clients – why pay active fees when you receive effectively passive performance – but the authors argue it is not good for markets. In an efficiently operating market participants should identify mispriced companies and act accordingly. Where there are other factors that interfere in this process, such as benchmarks driving decisions, then the correction of such mispricings may not occur.
The article goes into much more detail about the market impact and how the principal-agent issues are causing negative consequences to the system and the objectives of asset owners. The authors propose ways for asset owners to achieve a high standard of fiduciary duty, including explicitly deciding whether their managers are adopting cashflow or price-only strategies; allocating more to cashflow strategies and putting in place appropriate monitoring systems that will not, of themselves, impact their agents’ behaviours.
This brief post cannot do justice to the well-articulated piece to which it refers, and a read of the full paper is to be recommended. But it is encouraging to see such an investigation into the motivations of the players along the investment chain, demonstrating how important it is to put in place a governance arrangement that allows agents to provide the best outcomes, unfettered by constraints that may produce unintended consequences.