VIII: Implementing Processes to Mitigate 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 the two previous articles, we explored principal-agent issues and potential conflicts of interests between investors and their advisors, specifically compensation related and client retention conflicts.

How can investors (i.e., board and committee members) alleviate potential conflicts and ensure their interests take precedence? First, they must spend time understanding potential conflicts, especially related to compensation structures.  

Second, they should recognize how concerns over short-term outcomes can overwhelm adherence to long-term processes, for both investors and investment advisors. Understanding how compensation structures and short-term concerns can influence investment advisors will assist investors in asking appropriate questions when conducting due diligence.  

Finally, investors should develop fundamental knowledge of the markets and investor behaviors, and with this knowledge, institute effective governance practices to ensure long-term investment growth is not sacrificed over concerns about short-term results. 

Understanding Potential Conflicts

Typical compensation structures for investment advisors are flat fee, hourly rate, asset-based fee, and commissions. Flat retainer fees may work fine and generally do not introduce any overt conflicts of interest. Hourly fees are generally acceptable for projects but could incentivize the advisor to create more work to collect a higher fee. Asset-based fees are common and align interests to the extent the advisor suffers from market value losses and benefits from growth in assets. Commission-based fees should be avoided due to the incentive for the advisor to churn the portfolio to generate additional commissions. 

Insight into other sources of compensation and other affiliations helps clarify if there are potential conflicts of interest. Does the firm have brokerage operations and receive commissions on advisor directed trades or favor investment managers who trade with them? Does the firm manage proprietary funds? Does the advisor host conferences sponsored by investment managers or provide services for managers and thereby have a bias to recommend those firms?  

Avoiding firms that answer yes to any of these questions reduces the chances the advisor will place compensation ahead of the investor’s best interests. 

When considering potential conflicts of interest, investors should understand the following about their current and potential advisors: 

• How is the firm compensated?
• Where does the firm receive other compensation?
• Are there relationships or affiliations with other firms?
• How are the advisor’s team members compensated?

Inquiring about how the advisor’s team members are compensated helps investors to understand their advisor’s motivations. For example, do the portfolio managers and research analysts receive a bonus based on calendar year returns? If so, they could become more conservative once they build a healthy excess return over the benchmark.  

On the other hand, they may take unnecessary risks late in the year if they are trailing the benchmark return. Bonuses based on rolling three- and five-year returns are preferable to calendar year returns and alleviate the incentive to focus on ultra short-term performance. 

Some individual advisors (i.e., the lead client service representative) simply receive a salary and have no performance incentives. Other investment advisors are compensated based on their clients’ revenues. Thus, they are incentivized to grow their business if they wish to increase their income, but are also incentivized to retain clients, lest their income decrease.  

Advisors usually find providing good service and retaining a client easier than gaining a new client. Therefore, this arrangement could lead to excellent client service if the advisor is well-compensated and manages a reasonable client load. If the advisor is not well-compensated and largely focuses on gaining new business to increase compensation, client service could suffer. Therefore, investors should understand their primary advisor’s client load and potential capacity. 

The investment industry is rife with conflicts of interest and even firms striving to be ethical can potentially face conflicts. Therefore, investors must understand where principal-agent problems can occur and seek to align incentives and compensation arrangements to minimize possible conflicts of interest. 

How Short-Term Outcomes Overwhelm Long-Term Processes

When considering how investment advisors may allow concerns over short-term outcomes to overwhelm adherence to long-term processes, investors should understand the following: 

• How concentrated are portfolios (number of positions, sector weights, and tracking error)?
• How many asset classes and managers are recommended?
• What are the firm’s views on portfolio tilts and are these strategic or tactical?
• What methods are used to rebalance portfolios?
• How often are managers terminated and for what reasons?

When hiring active investment managers, asking about the number of positions, views on sector weightings, and the historic and expected tracking error helps investors evaluate whether the manager is a “closet indexer” or a true active manager. Investors should not pay active management fees for index-like returns, and therefore, should avoid managers who place too many constraints on their ability to add value. 

Likewise, understanding how many asset classes and managers an investment advisor expects to recommend helps investors determine whether their portfolios will be over-diversified. Over-diversified portfolios add unneeded complexity and costs, thereby lowering returns.  

For example, investing with several managers in one asset category (e.g., five U.S. large cap equity managers) could lead to an index-like exposure but active management fees. Additionally, some advisors may slice an asset class too finely and invest with each area (e.g., U.S. equity — large cap, mid cap, small/mid cap, small cap, and micro cap). These asset categories overlap and are highly correlated; therefore, most portfolios do not need dedicated mandates for each area. 

Understanding where and how much an investment advisor is willing to tilt the portfolio to capture long-term return premia is informative. Because timing markets successfully is difficult, investors must be careful hiring advisors who employ tactical tilts. A better approach is to seek advisors who employ strategic tilts and have patience and discipline to maintain these tilts during underperforming periods. 

One way to evaluate discipline is to understand the advisor’s rebalancing philosophy. Advisors who rebalance portfolios when asset categories move out of acceptable ranges demonstrate conviction in a long-term process. By selling assets that performed well and purchasing assets that performed poorly, an advisor reveals a willingness to not let short-term market movements deter them from a long-term disciplined approach. Advisors who lack this discipline, however, often do the opposite and purchase more of what performed well and abandon strategies that performed poorly. Thus, the advisor avoids defending poor performing strategies to the client.  

Questioning advisors on how often managers were terminated and for what reasons allows the investor to understand whether the advisor is willing to defend suitable, yet underperforming managers. Managers may have been terminated for justifiable reasons. Examples include change in organizational structure, key personnel departures, legal issues, style drift, and significant increases or decreases in assets under management. More concerning, though, is if terminations were due to short-term underperformance, as this reflects a lack of confidence in the advisor’s manager due diligence process. 

Asking these questions, and other similar ones, can assist investors in better understanding the advisor’s investment philosophy and motivations. The objective is to determine to what extent the advisor is willing to focus on long-term processes over short-term outcomes.

Understanding Markets, Behaviors, and Instituting Effective Governance Practices

Devoting sufficient time to formulating a strategy and documenting the investment philosophy can help to ensure continuity and adherence to a long-term disciplined approach. The first step is encouraging investment committee members to develop a fundamental understanding of the markets and recognize how some investor behaviors can be unproductive.  

With that knowledge, the investment committee is less likely to allow an investment advisor to sacrifice long-term growth over concerns about client retention. Moreover, the investment committee will be prepared to focus on long-term processes and competently articulate an investment philosophy that meets the organization’s objectives. 

Why is a fundamental understanding of the markets important? Without it, investors are at risk of setting unrealistic expectations, at both the market and investment manager level. An appropriate asset allocation depends on realistic return assumptions. Retaining suitable fund managers during inevitable rough periods requires understanding the frequency and magnitude of manager underperformance. 

Additionally, when evaluating potential investments, often only the advantages are emphasized and investors are confounded when the results are less than advertised. By understanding not just the advantages, but also the disadvantages of different investment strategies, including the types of market environments in which the strategy is expected to perform poorly, investors are better prepared to focus on the long-term and not overreact to short-term outcomes. 

Therefore, investment committees should strive to have members with knowledge of market history or take the necessary steps to obtain that knowledge. Committees with a fundamental comprehension of the markets are more likely to maintain long-term discipline when subpar short-term results ultimately occur. Also, well-informed committees can more effectively evaluate their investment advisors and foster collaboration and adherence to long-term disciplines. 

Additionally, recognizing typical, yet unproductive, investor behaviors can prevent common mistakes, including allowing investment advisors to prioritize client retention over long-term growth. Typical investor behaviors (displayed by both investors and investment advisors) that can lead to unproductive decisions include reacting to recent events, herd mentality, displaying overconfidence, and valuing losses more than gains. 

An example of reacting to recent events is reducing stock exposure after a market decline. In most cases, a better approach is to rebalance the portfolio (increase stock exposure back to the target allocation) rather than lock in losses. Nevertheless, investors often are fearful and sell at inopportune times. 

Following the herd is common among institutional investors, as many compare their performance and asset allocation to their peers. Too much emphasis on peers can lead investors to misallocate their portfolios and stray from what is appropriate for their institutions. Furthermore, jumping on the bandwagon and investing in the hottest new fad may not always be appropriate. 

Some investors display overconfidence in their ability to allocate assets, select managers, and time markets. A humbler approach that acknowledges the difficulty in successfully executing investment decisions is preferable and likely to prevent irrational decisions due to overconfidence. 

Loss aversion is common among investors and refers to the inclination to strongly prefer avoiding losses to realizing gains. By accepting loss aversion as a real concern, investors can take steps to remove emotion from their decisions and focus on long-term processes. Committee members who clearly recognize unproductive investor behaviors are better positioned to avoid making common investing mistakes. They are also less likely to allow their investment advisors to veer from a long-term disciplined approach. Therefore, by spending time understanding common investor behaviors and ways to overcome these biases, investment committees can more effectively evaluate their investment advisors, as well as their own decision-making processes. 

With a good understanding of market fundamentals and investor behaviors, investment committees will be better prepared to institute effective governance processes. By devoting sufficient time to strategic issues, including investment philosophy, and not simply focusing on the portfolio and current market environment, boards and investment committees will be more effective in developing appropriate investment policies. These policies must articulate the importance of focusing on the long-term, and by documenting this in an investment policy statement, investors will be less likely to stray from the stated discipline. 

When developing the investment policy statement, investors should be sure to adopt long-term measurement periods. Three or five years is not long-term. Seven or ten years is preferable, but occasionally there will be ten-year periods where strategies may not work as planned. Nevertheless, adopting long-term measurement periods should minimize the temptation to react to recent events and short-term outcomes. Finally, the process of developing an investment philosophy and policy should assist in maintaining discipline and focus on the most important objective—ensuring long-term processes take precedence over short-term results. 

Summary

Incentives drive behavior. Compensation structures and client retention issues can influence investment advisors and lead to potential conflicts of interests. 

Boards and investment committees can minimize any conflicts by developing practical knowledge of the markets, recognizing typical investor behaviors, and instituting effective governing processes. Better comprehension of the markets and human behaviors will bolster investors in their evaluation of investment advisors, as well as their own decisions. Furthermore, this knowledge will promote the development of effective investment policies designed to focus investors on long-term processes.