Agency risk is a key challenge facing investors. This risk arises as there are several intermediaries or ‘agents’ between the investor and their investments, each of whom faces some degree of conflict when recommending or managing investments.
While there have been many attempts by regulators to eradicate, or at least manage, these risks (most notably the RDR reforms), they have tended to focus on the business practices of the agent.
While these are the most obvious, they are not the only agency risks that exist. Less well-understood are the risks that emerge from the investment process. However, these risks are increasingly being recognised as behavioural science enters the mainstream of the investment management industry.
The clearest example of agency risk is fund managers’ reluctance to stray far from the benchmark, despite the fact that Martijn Cremers, from the University of Notre Dame, has shown that having a high active share is a key component of superior relative returns.
The reasoning behind both Mr Cremers’ conclusions and the reluctance of managers to act on them are equally intuitive. Investors can only overcome the fee drag of an active portfolio by being sufficiently different from the benchmark for their holdings to lift the overall performance of the portfolio above the index. The greater the active share, the less each differentiated holding has to contribute towards lifting performance.
However, managers are reluctant to adopt this approach as they perceive they are at risk of losing their job if they underperform by a large margin rather than a small one. Consequently, 27 per cent of the assets in UK funds are invested in ‘closet index trackers’ (as defined by Mr Cremers).
Even where funds maintain a high active share, it is possible to perceive agency risk in the way portfolios are being invested. The most obvious example of this can be seen in just how few fund managers adopt a valuation-driven investment process.
Academics, investors and analysts have demonstrated that the valuation at which an asset is bought is a key determiner of the absolute return over the subsequent seven to 10 years, yet many fund managers ignore this, preferring to adopt other approaches despite a lack of evidence that these work.
The solution to this conundrum lies in the fact that adopting a valuation-driven approach typically involves buying assets that are hated by the broader market. This, in turn, requires the fund manager to have the fortitude to withstand the ridicule of other investors and the short-term losses that frequently beset these holdings before their value is eventually recognised.
Consequently, a fund manager adopting this approach must be sufficiently secure in their employment to be able to continue holding underperforming assets for a long period of time.
The more clients clamour for consistent outperformance, the lower the incentive for managers to adopt a valuation-driven approach and the greater the agency problem becomes. To overcome this cycle, we must instil in clients the patience needed to adopt this approach, and choose managers with the behavioural characteristics to successfully pursue this strategy.
