The first piece in this series the research puzzle | It was called “failed incentives.” explored the misalignment of interests at the point of sale of many investment products:  The seller aims to generate a fee that is based in whole or in part on the assets captured, while the buyer is looking for a pattern of returns that fits his needs.  Those interests are frequently at cross purposes.

The management companies charge asset-based fees too, so they seek to drive assets ever higher and develop infrastructures that support and feed the sales culture.  There is relatively little incentive to focus prospectively on downside risk in any one product area or asset class.  Sure, the firms can get hurt when assets decline during market swoons, but the playbook is reactive (thus the cost cutting now in process) and the name of the game remains the same — sell what you can.

Upon that foundation sits another simple but ill-fitting incentive structure driven by this philosophy:

This is the promise of actively-managed products, including mutual funds, separately managed accounts, and institutional portfolios:  “We will outperform (fill in the blank) Index in all kinds of markets.”  It is a laudable goal on its face versus the alternative referenced most commonly, a passive strategy that would underperform the index line by the amount of the fees.  We will leave for another day the debate of passive versus active management.  (In fact, they share a linearity that presents a mismatch with the goals of most buyers.)  Instead, our gaze is fixed on incentives.

The incentive compensation of most portfolio managers is based on the chart above:  Beat your index (and/or your close competitors) and you get a big bonus.  Beat it (or them) by more and you get more.  This leads to the circumstances of the day:  A manager whose index was down 41% and who managed to deliver a return of minus 35% can get a great bonus and declare victory in the yearly battle as defined.

Such a construct does not fit with the goals of investors.  It removes from the portfolio managers (who ought to have some great insight into the attractiveness of an asset category) the need to be objective about the reasonableness of the category’s valuation and prospects versus other investment possibilities, including cash.  Everything becomes a relative game in a defined space and decisions are made in keeping with that.  The fine points of an incentive plan can make this dynamic even less desirable; often managers are presented with situations in which they might press their bets to meet benchmarks that have real monetary meaning to them and little marginal benefit for the investor.  It is no surprise that sometimes reckless risk-taking results.

Speaking of incentives, prolonged underperformance (within this relative ballgame) can lead to a portfolio manager losing her job.  Here’s how a new CIO explained his philosophy to a group of clients assembled at a dinner:  “I am going to provide lots of incentives for those who do well and those who perform poorly will be gone after a few years.”  In attendance, this is what I thought that meant for me:  “Those portfolio managers who have my assets will probably either hug their indexes or take a lot of risk to win the big prize.  In the meantime, they are free to make their choices based upon their own risk/return parameters, not mine.”  That hands-off approach to the risks being taken in the portfolio relative to the pattern of rewards that a client might get is standard practice at most firms and wrongheaded.

As with the previous posting, this is an area that shouldn’t require government action as to disclosure, but the market sure has done a rotten job of generating answers to the key questions (“What is the economic interest of the person managing my assets, and does the pattern of returns generated by his incentives look anything like what I need?”) or driving better and more transparent structures for incentive compensation.  Again, the media really has no interest in this sort of inquiry — it’s much easier to promote the celebrity of managers and their past performance than to examine what might happen because of the nature of the incentives in place.  The key players in forcing change should be the most powerful and sophisticated buyers of investment management services:  mutual fund directors, fiduciaries at big institutions, and consultants.  By and large, they accept things as is when it comes to compensation.

These structures are embedded within the industry and are not easy to change.  Crafting alternative incentive structures is complicated even within a small organization,Disclosure and confession:  I recently was registered as an investment advisor.  While I want to come up with a more innovative fee structure, to get registered and get started it turned out that simpler was better, so fees are based on straight assets under management for now. to say nothing of the challenges that would be in store at the mammoth firms that run most of the money.  However, disclosure is easy, and the process of becoming more transparent yields the side benefit of the opportunity to rethink how things are currently done.

Our journey into the world of incentives continues in the next posting with some thoughts about hedge funds.