This is part one in a series about how active management could be better. This is my perspective alone. Of course, the dynamics I describe do not apply to all managers. In a prior piece, I explained how active managers could theoretically outperform their benchmarks; now we arrive at the question: why don’t they?
Part One: Bad Incentives and Portfolio Managers as Salesmen
Incentives are powerful. They unconsciously motivate everything we do. Even with the best intentions, the wrong incentives will keep pushing us to do the wrong thing. “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it,” says Charlie Munger.
Across vast swaths of the money management business, the incentives are broken, causing a vicious cycle that erodes returns. I will describe how this dynamic plays out.
There is a giant pool of portfolio managers (PMs) trying to build a track record. In such a large field of PMs, some will have periods of strong performance. Some perform well due to talent, others due to luck.
For a PM who shows good short-term performance, the incentive is to sell based on that performance. It’s hard to resist because the PM gets most of his income from a percentage fee on assets. The more the PM wants that new vacation house, the less he cares about his strategy’s fit for prospective clients. The prime directive is to grow AUM and ask questions later. He might employ a sales team whose bonus is tied to short-term inflows. Because the sales team has no long-term incentive, they will be eager to please. With these incentives, every prospective client seems like a perfect fit for the strategy.
Due to the laws of probability, the strategy does not outperform forever. Now that the PM has built a sizable AUM, his incentives shift to retaining assets. When performance lags, there is enormous pressure from clients to defend every quarterly return. The PM may say “some periods of underperformance should be expected in this strategy,” but that’s not how he pitched it when times were good. Clients are upset. The PM becomes myopic, short-term focused. There is pressure to hug the benchmark. It becomes harder and harder to stick to the strategy that gave him success in the first place.
It doesn’t help that many large clients want active managers to hug the benchmark. Many prefer closet indexers. Many consultants rank PMs using “optimization formulas” that heavily penalize managers for deviating from their benchmark. In my opinion, this is an area where the industry has lost its mind. If you don’t want deviation from the benchmark, don’t hire active managers—buy an index fund. If you just want less deviation from the benchmark, allocate less to active management!
Most equity managers don’t believe they can outperform every single year, much less every month. Not everyone is Renaissance Technologies. Most PMs have long-term investment strategies; they expect to have good years and bad years.
But misaligned incentives create a bad dynamic: when performance is good, the incentive is to sell fast, grow AUM, and ask questions later. This creates a poorly-fitted client base of impatient investors with unrealistic expectations. When performance lags, PMs feel pressure to become defensive or hug the benchmark, forgetting what brought them success in the first place.
What can be done about the problem of incentives?
Underlying almost every problem with active management is an uncomfortable fact: there is still more of it than we need. Too many PMs try to grow AUM without making sure clients are a good fit. Too many clients hire active managers without understanding the strategy. They develop unrealistic expectations and don’t stick with the strategy long-term. For many investors, indexing is a better approach. Encouraging more investors to use index funds will improve active management.
The other problem affecting PMs and their clients is a culture of impatience and desire to get rich. For most of us, active management shouldn’t be about getting rich quickly; it should be about getting rich eventually. Active managers should charge lower base fees (fees based on a percentage of AUM). When possible, they should use long-term performance fees and invest more of their own personal savings in their strategies. Aligning these incentives places the PM’s primary focus on long-term returns, not month-to-month AUM.
Finally, active managers need to focus on setting the right expectations and building trust. Some PMs have been model citizens in this regard. Seth Klarman’s Baupost Group has gone so far as returning money to investors when it doesn’t see enough good investment opportunities. If clients understand an investment strategy and trust it for the long term, the manager won’t need to do backflips every time quarterly performance lags a bit.
Changing these incentives would certainly benefit clients, whose fortunes are on the line. For many PMs, this could mean less money. But the system would be fair—the best active managers could thrive just by implementing their strategy. If they skillfully invest a sizable chunk of their own money, they will earn great returns for themselves. With great returns, they can attract a well-fitted client base and build a solid foundation of trust. It may take a bit longer, but everyone will be better off in the end.