Confessions of a portfolio manager #4: The agency problem

In the latest installment our blog post series, we examine another type of behavioral bias: the agency problem, which looks specifically at the issues that arise when a party is expected to act on behalf of another. 

Spotlight on the agency problem

Looking back over my confessional series so far, I’ve put a lot of emphasis on behavioral bias in its various shapes and forms. My first confession in this series looked at what success really means for different people. My second confession addressed news and how it influences investing, while in my third, I explored the futility of predicting the unpredictable. Behavioral bias is not clear cut—as we’ve seen, it crops up in a number of different ways and disguises—and can have a detrimental impact on investor portfolios.

Today, I’m looking at another type of behavioral bias, putting the spotlight on the agency problem. The agency problem looks specifically at the issues which arise when a party is expected to act on behalf of another. It’s a little complex, but even more so for portfolio managers like me, so here goes …

What is the agency problem?

The agency problem is something shared across all sorts of businesses. To put it simply, the agency problem is a conflict of interest. It occurs specifically in a situation where an agent must perform a task on behalf of a principal.

In finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The management, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize long-term shareholder value, even though it is in the management’s best interest to maximize their own wealth.

This is where agency problems and risks arise. This can—and more often than not, does—affect behavior.

The agency problem in asset management = career risk

How then, does the agency problem apply to asset management?

1. The portfolio manager is the agent
2. The investor is the principal
3. The task is investing money and, quite often, also beating a benchmark or a peer group 

An asymmetric skewing of the risks and reward

For portfolio managers, there is an asymmetric skewing of the risks and reward whereby the agency problem can manifest itself into career risk, i.e., the risk of being fired. Consider these three scenarios:

Scenario one:

• The portfolio manager delivers good performance
• Their prestige is boosted
• They keep their job

Scenario two:

• The portfolio manager delivers average performance
• They (often) keep their job

Scenario three:

• The portfolio manager delivers poor performance 
• They (may) lose their reputation
• They (may) also lose their job

So, the dice is slightly loaded: only in one scenario does the portfolio manager lose their job. But clearly every portfolio manager intends to deliver good performance and avoid poor performance (and thus avoid losing their jobs), don’t they? So, what’s the problem?

Bucking the trend to achieve success = big career ?

The issue here is the pursuit of success. To quote Howard Marks of Oaktree Capital, he explains that we portfolio managers can’t take the same actions as everyone else and expect to outperform—bucking the trend is a “key element in all aspects of the pursuit of superior investment returns”.¹ In this case, then, portfolio managers need to dare to be different in order to do well and outperform ...

And that means that sometimes we are going to be wrong ...

Indeed, according to Peter Lynch, “If you’re great in this business, you’re right six times out of ten”. This also means we will be wrong four times—and most likely, if we have taken an anti-consensus view we are going to be wrong in isolation. And the isolation just increases the pain because with hindsight, everything is obvious. Trump as president? Well in 2015 his odds at bookmaker Ladbrokes were 66/1—interestingly, the same odds as Japan beating South Africa in the 2015 Rugby World Cup.² Both of which actually happened, despite the odds. 

Why do portfolio managers “get it wrong”?

It’s a simple question with a simple answer. We are always dealing with imperfect information. As a portfolio manager, I have to make decisions without knowing all the facts. Because, once the facts are clear and known, they are already priced in and the stock or asset class has adjusted to the new reality. That said, we should be expected to have a handle on the fundamentals of markets as they typically follow an observable pattern.

Of course, other things are more difficult to call ahead of time—such as tweets from political leaders or the next turn for geopolitics.

There are, however, certain periods where behavior and sentiment are more likely to drive markets (rather than fundamentals). This is typically toward the end of a bull market and the end of bear market. And it can be painful to step in the way of those powerful trends, as ordinarily you will be running against consensus.

Case study: Michael Burry (watch The Big Short)

The Global Financial Crash (GFC) was so obvious with the benefit of hindsight. But  at the time, market participants had no idea. Well, some knew—Michael Burry knew.

Michael Burry is a notable example of a now high-profile fund manager who was wrong in isolation before he was actually very, very right. He saw the housing market crash of the GFC before anyone else did and he bet on it. Many of his investors were outraged, thought his logic was wrong and withdrew their money. It probably would have been much easier for Burry to bow under the pressure and go along with the crowd.

Instead, Burry stayed true to his conviction, took on massive career risk and lost clients. But he made the right call. And for those investors who stuck by him, he was extremely successful and made them over $700 million. (I’m a huge fan of ‘The Big Short’ as you can tell. I’ve referenced it in my third confession and we recommended the book in our 2017 summer reading list.)

Why is the agency problem relevant today?

The agency problem is all around us every day, and it’s difficult to escape. For me, it all boils down to following the herd. If a portfolio manager is wrong at the same time as all the other portfolio managers are wrong, then it is excusable… isn’t it!? No! In asset management, there is perceived safety in crowds—but more often than not, it is because of a portfolio manager’s personal safety, rather than the safety of the client’s assets.

Portfolio managers must endeavor to put personal risk aside and do what is right for clients, even if in the short term they might not thank you. For us today, that might mean reducing our risk budget, and that feels as uncomfortable as it did in 2017—until volatility finally resurfaced in 2018!