Jeremy Grantham has produced yet another truly outstanding essay in GMO’s Quarterly Letter to Investors for April 2012. Never reluctant to take on controversy, he focuses on the ways in which mutual fund managers have strong incentives to behave in ways that are often not in the best interests of investors in their funds. In the academic world, these perverse incentives are referred to as "agency problems."
A mutual fund manager makes decisions on behalf of his or her fund’s investors. In the parlance of economics, the manager acts as an agent working on behalf of the investors (the meaning here is similar to the use in the term real estate agent). The financial agent generates income by acting to assist the client and represents the interests of the client. There are invariably potential conflicts of interest between agents and clients. Agents often have incentives to make decisions that are in their own best interests but which are not necessarily in the clients’ best interest.
A Herding Mentality
In Grantham’s essay, he focuses on the most innocent of all agency problems in mutual fund management, but one that is enormously financially significant nonetheless. Grantham proposes, following famed economist John Maynard Keynes, that a fund manager’s biggest risk is career risk, the risk that he substantially underperforms compared to the fund’s benchmarks or to other funds that are classified as peers and loses his job as a result. If the fund loses a lot of money when all of its peers also lose a lot of money, that is less likely to result in a change of fund manager, than if a fund manager takes a conservative stance and misses out on a big market rally. This situation leads to herding among fund managers. There is less career risk for fund managers to make decisions similar to one another. Grantham asserts that market volatility levels are so much higher than the variability in fundamental variables such as GDP because of this herding behavior.
Standard Client Patience Time
Grantham describes a related agency issue that does not get as much as attention as manager herding. He calls this standard client patience time. This is the amount of time that a client is likely to stay with a fund manager if the fund’s performance does not meet the client’s expectations. A fund manager who makes investment decisions that are substantially different than his peers runs the very real risk of being wrong for some period of time.
How many of the fund’s clients will lose patience with the fund and sell their shares?
It is crucial to remember that a fund’s income depends on the total amount of money being managed and not directly on the performance of the fund. If investors dump their shares, assets under management drop, and the fund’s income drops. It is, in fact, fascinating that Keynes described this exact scenario:
What Keynes definitely did say in the famous chapter 12 of his General Theory is that “the long-term investor, he who most promotes the public interest … will in practice come in for the most criticism whenever investment funds are managed by committees or boards.” He, the long-term investor, will be perceived as “eccentric, unconventional and rash in the eyes of average opinion … and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”
The entire problem is beautifully summarized in the same paragraph of Keynes’ General Theory from which Grantham draws his quote:
Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
A Fund Manager's Core Dilemma
This single sentence perfectly summarizes the core dilemma for a mutual fund manager. If you, the fund manager, have a big allocation to Apple (AAPL) when most of the other funds in your category also have big allocations to Apple, and Apple stock drops substantially, you are probably okay from a career standpoint. The media will report that Apple disappointed investors in its latest earnings and you don’t get singled out. On the other hand, if you load up on a stock because you believe that the evidence is that this stock is incredibly undervalued and that bet does not pay off, then you look like a bad fund manager. And, if your bet on that stock turns out to be correct, some people will be impressed but many others will attribute your success to luck (which may or may not be the case).
The "Agency" Effect
The key take-away to remember here is that a fund manager is faced with an agency problem. He or she wants to make the best investment decisions, but also knows that investors have a relatively short patience time (investors hold mutual fund shares for much shorter periods than they used to) and that the evidence suggests that you have more to lose (assets under management or, at the extreme, your job) by following your beliefs if they go against the crowd than you have to gain if you turn out to be correct.
The agency problem that Grantham is tackling in his excellent piece, is something that every investor should care about and Grantham discusses examples from his own experiences managing money at GMO. You cannot fault investors with bailing on fund managers who are underperforming, nor can you fault the fund managers whose choices are influence by the desire to keep their jobs.
What Investors Can Do
What can investors do to minimize the effects of this agency problem on their portfolios? There are several solutions. The simplest default solution is simply to focus on a low-cost diversified portfolio of index funds. When you invest in index funds, you are not paying a manager to make decisions that will make or break his career. The much harder solution is to identify and invest with managers who do, indeed, follow their own convictions when it comes to the best investment decisions.
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