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In Practice: A Hedge Against Career Risk

Stewardship offers insights into whether fund managers are committed to their investment discipline or likely to waver from it.

Jeffrey Ptak, 06/22/2012

In managing mutual fund portfolios for our clients at Morningstar Investment Services, we meet with scores of fund managers. In introducing themselves, it’s not uncommon for managers to, well, tell us what they think we want to hear. For example, they’ll express their fervent desire to be relevant to what we do. They’ll say that we share values and organizational priorities. They’ll state their commitment to delivering good outcomes for clients. And then they’ll get into the key pillars of the investment process itself.

Here’s a common scenario: A fund manager says he prizes the stocks of firms run by management teams that allocate capital not for instant gratification but to derive long-term economic benefits; that are willing to abide short-term adversity in the name of constructing a more durable franchise; that treat their shareholders as true partners in the business and invest alongside them; that share economic profits equitably as the firm grows; and that refrain from wasteful practices such as lavish compensation schemes that promote short-termism and empire-building.

So, how would you expect that manager to conduct the fund’s affairs? Well, you’d probably expect him to subsidize the fund’s operating costs to keep expenses low, thereby enhancing the competitiveness of the fund’s returns. You’d expect him to build breakpoints into the fee, so that investors share in scale efficiencies as the fund grows. You’d expect him to invest significantly in fund shares and use a compensation scheme that aligns with the strategy’s long-term success. And you’d hope he’d do his utmost to prevent the fund from growing so large that it’s unmanageable.

The fact is, we don’t often see this.

This disconnect is one of the reasons we consider fund stewardship vital. Not as a “goody-two-shoes” award bestowed on managers who give their investors a warm and fuzzy feeling, but as a gut-check into how managers do business and whether it comports with the investing philosophy they espouse. You say you’re patient? You’re willing to cast your lot with those who share your long-term orientation? You like incentives that are well-aligned with investors’ interests? OK, then explain why you’re levying high fees, don’t eat your own cooking, and tie compensation to asset growth.

Good stewardship is good business, but it takes discipline. Thus, when it’s lacking, it’s only natural to question how committed that manager is to carrying out the investment strategy itself. Put another way, we think stewardship can be a good “tell” when assessing how a particular fund’s results are likely to stack up in the future.

Role of Career Risk
But we think stewardship’s appeal goes beyond enhancing manager selection. Indeed, it can play a more fundamental role in enhancing an investor’s odds of succeeding. But to understand that, we need to consider “career risk.”
Career risk, a concept championed by famed GMO strategist Jeremy Grantham, refers to the risk professional investors court in going their own way. For example, a growth manager could have refused to invest in technology stocks in the late-1990s for valuation reasons. But he held them anyway, despite knowing they were grievously overpriced. Why? Grantham argues persuasively that running against the herd is far likelier to get a manager fired than simply conforming. So, managers fall into line, explaining why so many funds resemble their benchmarks.

Grantham extends that thread to argue that career risk also explains the role that price momentum and mean reversion play in moving markets. When professional investors herd to hedge career risk, they tend to push securities meaningfully above and below intrinsic value. In extreme cases, this behavior can cause asset bubbles to form and then, when reason overtakes euphoria, burst.

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