VII: Understanding Client Retention Principal-Agent Problems

Steven E. Landsburg, in The Armchair Economist: Economics and Everyday Life, wrote: “Most of economics can be summarized in four words: ‘People respond to incentives.’ The rest is commentary.” In this article, we explore principal-agent problems and potential client retention conflicts between investors and their advisors.

Principal-Agent Problems: What They Are and Why They Matter 

The principal-agent problem occurs when a principal (investor) hires an agent (investment advisor) to act on its behalf even when the agent’s interests may diverge from those of the principal.  

In the investment industry, typically the investor’s primary interest is realizing long-term growth in assets, while the investment advisor prefers a healthy and steady stream of fee income. This may not appear to be a problem, as investment advisors are hired to deliver long-term performance and should strive to satisfy their clients.  

Moreover, investors would not purposefully overpay or retain ineffective investment advisors. The problem, though, occurs when the investment advisor places its business interests ahead of the client’s investment interests. 

Because investment advisors realize that poor short-term underperformance can lead to their termination, they have an incentive to minimize the risk of short-term underperformance, even if this detracts from long-term performance. Thus, the business interests (maintain the client and collect fees) of the agent (investment advisor) may not always align with the investment interests (long-term growth) of the principal (investor). 

These subtle principal-agent problems are prevalent in the investment industry, but often unrecognized by investors and investment advisors. The investment advisors are not seeking to increase compensation through questionable tactics, but rather, simply maintain their clients. Advisors may structure portfolios that are over-diversified or too conservative and avoid long-term beneficial opportunities to mitigate short-term underperformance. Many investment advisors are unwilling to defend suitable, yet underperforming investment managers.

Additionally, advisors may create activity and complexity to justify their worth. Some subtle principal-agent problems driven by a focus on client retention may not be entirely avoidable, but investors should be aware of these issues to better understand the motivations of their advisors. 

Over-Diversifying Portfolios 

Investment managers who claim they are skillful stock selectors will nonetheless structure portfolios within certain constraints. These constraints include position sizes (e.g., no more than 5% in any one stock), sector weightings (e.g., +/- 20% vs. benchmark weighting), and portfolio optimization techniques designed to lower the tracking error (i.e., difference between the portfolio return and the benchmark return).  

Sometimes these managers are referred to as “closet indexers” because their portfolios are structured to perform in line with the benchmark. The problem is portfolios structured similarly to the benchmark generally perform in line with the benchmark return, but these managers charge active management fees, which are much higher than passive (indexing) management fees. 

Why do so-called active managers structure portfolios so similarly to the benchmark? The answer is simple — despite investors claiming to focus on the long-term, managers rarely are terminated for generating benchmark-like returns but are frequently terminated for significant short-term underperformance. Therefore, many managers structure portfolios not to generate the highest long-term returns, but to avoid meaningful short-term underperformance. Thus, their business interests (maintain the client) trump clients’ interests (exceptional long-term performance). 

Likewise, investment advisors and consultants also can design portfolios that are overdiversified. For example, an advisor may structure a portfolio that includes several actively managed equity mandates. Although each equity manager may construct fairly concentrated portfolios (and therefore are not “closet indexers”), the collective equity portfolio may resemble an index fund. Yet the investor is paying the higher active management fees. Although advisors and consultants claim they help their clients select top-performing investment managers, in this example, the advisor is mitigating the risk of not allowing any one manager to significantly impact the performance of the portfolio.  

Consequently, should one manager post disappointing short-term performance, the portfolio (and the advisor’s reputation) will not take a huge hit. In other words, consciously or subconsciously, the advisor is focusing on business interests even if the added complexity and fees detract from the investor’s long-term returns. 

Similarly, a consultant may recommend investments in over a dozen asset categories, touting the diversification benefits of each investment. But does the 20% allocation to fixed income really need to be divided into six different mandates? Do 2-3% positions, highly correlated to other positions, provide any substantial diversification benefits? While the consultant may truly believe in the recommendations and tout the marginal benefits, the consultant also benefits from not allowing any one investment to become too significant to the performance of the portfolio. Furthermore, the added complexity also encourages the investor to become even more dependent on the consultant, who must oversee and monitor the increasing number of managers. 

Avoiding Long-Term Beneficial Opportunities 

Just as investment advisors may overdiversify portfolios, they also can structure portfolios that are too conservative for their clients and fail to capture potential long-term beneficial opportunities. Research has demonstrated certain factors have historically earned return premia over time. There are reasonable rationales (mostly due to investor behavior and perceived risks) explaining why these return premia exist, and the evidence is persistent (i.e., long-term with in- and out-of-sample testing) and pervasive (i.e., consistent across regions and various asset groups). 

Examples include: 

• Size – smaller capitalization stocks outperform larger capitalization stocks
• Value – relatively inexpensive assets outperform relatively expensive assets
• Momentum – asset’s recent relative performance tends to continue
• Carry – higher yielding assets outperform lower yielding assets

Despite considerable knowledge about these factors, many advisors shy away from implementing portfolios to exploit these premia, but rather, focus on minimizing the tracking error of the portfolio. Therefore, portfolios are not tilted toward small cap or value stocks, and do not incorporate momentum or carry strategies, even if over the long-term these tilts would increase returns. Instead, the advisors structure portfolios more in line with the market portfolio to ensure closer performance to the benchmark. 

So why do investment advisors structure portfolios more in line with a benchmark instead of employing tilts that are expected to generate added return? Because they lack conviction, or believe their clients lack conviction, to maintain discipline when the factors underperform the market benchmark.  

These factors are expected to perform poorly at times, sometimes for several years, but over time, have proven to generate excess returns. Because investment advisors do not want to defend short-term underperformance and risk termination, they are reluctant to structure portfolios designed to provide better long-term performance. In other words, recommending a portfolio designed to perform better over the long run often has a greater probability of short-term underperformance, and therefore a greater probability of termination of the advisor. 

Failing to Defend Underperforming Managers 

Knowledgeable investment advisors understand that the managers they recommend or select will experience periods of underperformance, sometimes for several years. To realize the benefits of certain strategies, investors need to be patient, especially during difficult times. Investors cannot expect every strategy they own to outperform every year, or even every three or five-year period. Rather, investors must understand the expected frequency and magnitude of manager underperformance. By recognizing how often, and by what extent their investment managers are expected to underperform, investors can better maintain discipline during inevitable rough patches. 

This principal-agent problem occurs when these rough patches occur and investment advisors fail to defend underperforming managers. Instead of recommending patience and reiterating all managers and strategies experience periods of underperformance, some investment advisors will recommend firing the investment manager. This occurs, despite a well-known study by Goyal and Wahal¹ that demonstrated, on average, terminated managers outperformed the newly hired managers over the ensuing three years. Therefore, in most situations, the investor would have fared better retaining the manager instead of hiring a replacement.

So why do some advisors fail to defend underperforming managers? Mostly because they fear their clients will terminate them for recommending poor performing managers and compounding the problem by refusing to take action. Rarely do investors follow up and ask investment advisors how the terminated managers performed after termination. Thus, the investment advisor no longer needs to defend the investment manager’s poor performance and justify why the manager was hired in the first place.  

Even though terminating managers based on short-term performance usually results in lower portfolio performance, investment advisors who terminate managers based solely on short-term performance are placing their interests (maintaining their clients) ahead of the clients’ long-term interests. 

Adding Activity and Complexity to Justify Worth 

Jeremy Grantham, co-founder of Boston-based investment manager GMO, stated, “Everyone in the institutional world over-manages money for very good career risk reasons. We want to be seen as busy and earning our keep.” Investment professionals, like most people, believe more work justifies more pay. Hence, investment advisors can convince themselves they need to do more to justify their fees. Often this extra work has little impact on long-term returns, and in some instances, may detract from performance. 

Manager portfolio turnover increased over the last several decades. The average managed U.S. stock mutual fund’s annual turnover is nearly 100% today compared to 30% in the 1960s. Higher turnover leads to higher costs. Besides the observable commissions, there are hidden costs that are difficult to quantify, including bid/ask spreads and market impact. 

John Bogle, in “The Arithmetic of ‘All-In’ Investment Expenses,”² estimates transaction costs average approximately 0.50% for actively managed U.S. equity mutual funds. Do the stocks investment managers buy outperform the stocks they sell? And if so, are the added gains enough to cover the transaction costs? On average the answer is no, because the investment managers are essentially trading among themselves.  

So why do managers trade so much more than they did a few decades ago, even if the additional trading reduces performance? Because managers must justify their existence and believe their clients would question why they are paying nearly 1% in annual fees for a buy-and-hold strategy. 

Also, consider market timing. Some investment managers will hold large cash positions occasionally, thus, timing between stocks and cash. Some consultants will recommend overweighting or underweighting certain asset classes. Despite evidence that market timing is difficult to implement successfully, some managers and consultants will nevertheless seek to time the market. 

Why? To appear sophisticated and justify their existence. Similarly, investment advisors will introduce new managers and asset classes to validate their worth. The result of this principal-agent problem is often that this added complexity does little to improve risk-adjusted performance, but does allow the investment advisor to appear busy and hardworking.

Summary

Incentives drive behavior. Investment advisors prefer to retain clients, and therefore, are incentivized to structure portfolios to minimize the probability of being terminated. Some common practices, such as overdiversification, unwillingness to capture beneficial opportunities, failing to defend appropriate yet underperforming investment managers, and introducing added complexity, are prevalent, but not always well understood by investors. Being aware of these subtle principal-agent problems, as well as the motivations of investment advisors, should help investors recognize their own biases and mitigate concerns that short-term outcomes will outweigh adherence to long-term processes.