Career risk trumps investment risk
As someone who has worked most of his career on the buy side, I know that career risk is real and overrides many investment considerations.
In the world of investment, a career on the buy side reveals that career risk takes precedence over investment risk. However, gauging how fund managers navigate this career risk can be challenging, especially when dealing with private investment funds. The analysis of separately managed accounts (SMA) in Italy provides a fascinating insight into this predicament.
Access to SMA data is scarce, as they are inherently private, but it serves as an ideal testing ground for examining career risk due to their straightforward structure.
A single fund manager is responsible for one client, the pension fund, with a clear objective: to manage the portfolio in a specific manner. This unique relationship allows researchers to isolate the factors influencing the decision to replace a fund manager with another or terminate the SMA altogether. The primary driver for the termination decision is the fund manager's performance relative to the benchmark.
Underperformance against the benchmark significantly increases the likelihood of termination by the pension fund. Interestingly, outperformance does not necessarily reduce the termination probability, highlighting the stark contrast between 'heads, I win, tails, you lose' and 'heads, I lose, tails, you win' scenarios when dealing with pension funds.
The SMA agreement essentially favors the pension fund, offering a generous deal when the SMA performs well and penalizing the fund manager for underperformance. Unfortunately, this arrangement has prompted fund managers to focus on minimizing downside risks, leading to portfolios with a beta below 1.0. In bear markets, these portfolios underperform the benchmark, resulting in lower losses.
Additionally, fund managers reduce their active risk to avoid deviating significantly from the benchmark performance. The downside of this strategy is clear: pension funds pay active fees for semi-active portfolios, which translates to higher costs for investors. This behavior becomes even more pronounced when the same mandate is shared among multiple fund managers, as fund managers know they are more easily replaceable if another manager takes over their portfolio with minimal friction.
Performance fees, designed to incentivize fund managers, prove ineffective in altering their behavior. The uncertainty surrounding performance fees and the dominance of career risk in the decision-making process result in performance fees accounting for only a small fraction of the total fees paid to managers. Consequently, fund managers tend to run SMAs with a lower degree of activity and take a more defensive approach than the market average.
Written by urgent.news from Klement on Investing's reporting — not their text. Machine-written — may contain errors; check the original before relying on it.
