Reckoning with Risk (5)

For those of us in the investment business, career risk is generally either compliance related or client retention related.  By doing bad or stupid stuff we can get ourselves run out of the business entirely or make ourselves so toxic that we can’t get or keep a job. That’s the compliance related angle.  Client retention problems are no less deadly to a career whether they are related to general customer service (which covers a wide swath of potential errors) or whether they relate to portfolio performance.  If we do a lousy job, our clients can and often will fire us.

Most financial professionals focus on investment performance as the primary driver of success with clients.  However, and surprisingly to many of the pros, other aspects of the “client experience” are actually more important to clients and to their retention than return.  The biggest one is communication.  Clients want to hear from their advisors more, be reassured that their goals are being met and that the advisor is on the job, and have current events explained to them. But that happens far less than one would expect.

But my focus today, in this latest post in my series on risk, is how career risk and the financial professional’s approach to it puts his or her clients‘ investment performance at risk.  It is now well-known that it’s really hard to “beat the market” (however that’s defined) and that most funds and managers fail to do so most of the time.  Indeed, only 17% beat the S&P 500 for the year in 2011.

That raw fact seems as though it ought to be excellent incentive for managers to do whatever they can to win.  But they don’t.  The vast majority of mutual funds and managed portfolios are essentially closet indexes with no reasonable chance of persistent outperformance, especially when their (higher, and often substantially higher) fees are factored in.  The crucial reason for that sad reality is that managers — after carefully evaluating the career risks to them — see no value in it.

Beating a benchmark persistently requires being different in some significant way.  However, being substantially different in such a way that might allow persistent outperformance (perhaps via concentration) means that significant underperformance is possible too.  Indeed, even excellent investment approaches can underperform for significant periods of time (the markets are plagued by a lot of random noise).

For the vast majority of managers, especially those with substantial assets already (either due to some combination of earlier excellent performance — via luck or skill — or good marketing), performance in rough proximity to the applicable benchmark is enough to keep the assets “sticky” while significant underperformance will put all of those assets (and the manager’s career) at risk.  Moreover, managers are generally compensated far more for the size of the asset base they manage than for the portfolio performance they generate.  They are thus likely (and highly incentivized) to avoid managing money in such a way so as to make outperformance possible.  They simply want to keep their jobs.

A money manager’s career fear means that his or her clients bear a substantial likelihood of underperformance.  Ironic (not to mention unfortunate), isn’t it?

9 thoughts on “Reckoning with Risk (5)

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