Skin in the Game

Feel Their Pain
Nassim Taleb has a new hobbyhorse. Best known for publishing a book (The Black Swan) on the randomness of financial markets one year before the 2008 market crash (good timing that), Taleb is now tackling the subject of manager compensation. Taleb argues that manager compensation must be truly two-way, so that in addition to rewards for success, managers should face "damage" for failure.

The argument is very broad, involving managers of all types--investment, corporate, and political. (For hedge fund chiefs, intellectual ambitions tend to expand along with net worth.) For this column, we need only concern ourselves with fund managers. Should they face damage for failure? If so, do they?

I can't help with the first question. Along with two pages of equations, Taleb's most recent paper cites Kant, Hegel, Ayn Rand, Isocrates, and the 18th century theologian Bishop Butler. Critiquing the argument is past my pay grade. I can, however, address the second question. Say that Taleb has it right, and that fund managers must have skin in the game, to use his phrase. Do they? My answer: Yes. Absolutely.

Official compensation schemes say otherwise. Mutual fund managers receive large bonuses if they succeed, and smaller bonuses if they flop. Nobody takes money from them if they fail. The hedge fund structure doesn't change matters. With hedge funds, the payoff for success rises from large to huge, and the payoff for flopping shrinks from small to nothing. Nothing is not fun, but it's not negative either. Once again, hedge fund managers don't give money back to shareholders.

Nor, seemingly, does it help for portfolio managers to eat their own cooking. Many argue that portfolio managers should invest heavily in their own funds, so as to align their interests with those of shareholders--to get their skin in the game, so to speak. However, manager ownership doesn't satisfy Taleb's conditions. Manager ownership only addresses opportunity cost, not absolute cost. Assume a manager who draws no salary, but only profits according to the results of the fund that he or she runs. If the fund gains 10% in a year when the index is up 20%, then the manager failed but is rewarded. Conversely, if the fund loses 10% when the index drops 20%, the manager succeeded but is penalized.

However, the fund manager is a special case. Unlike almost every other type of manager, the fund manager's performance is measured precisely, against a benchmark, and publicly. These three factors lead to severe penalties--damage, as it were--if the portfolio manager bungles. Precision means that a fund manager cannot dodge blame by arguing the result or by pointing to co-workers. The benchmark forces the severity of a relative comparison, which prevents the fund manager from dodging criticism by riding the tailwind of a winning market. Public means that everybody sees the results. There can be no hiding.  

The last part is perhaps the most significant. Losing portfolio managers have their psyches battered. The experience is draining. It's akin to being the NFL quarterback who is costing his team by throwing interceptions, and who hears the fans chanting for the backup. The managers' co-workers know that they are failing. Their bosses know. Their shareholders know. Their families know. Their neighbors know. Everybody knows. (When I see such managers at the Morningstar Investment Conference, I can usually read their numbers by their body language. They slump as they walk. And they walk slowly.)

Taleb's thesis addresses noncash damage. For example, he writes that in local governments, "[government officials] are typically kept in check by feelings of shame upon harming others with their mistakes." Fund managers would seem to run an even greater risk of reputational, noncash damage than do local government officials. Fund managers pass the Taleb test. 

Say What?
Yesterday, an academic study's press release stated that mutual funds don't sell more shares after they outperform during down markets. That is, the study claims that funds that lose less money than an index during the down times aren't rewarded for their relative excellence with new assets in the future. Their recommendation: Funds might as well mimic the indexes during bear markets.

The study hasn't yet been publicly released, but I do wonder. Mr. Taleb, for one, can point to the financial (and reputational) benefits of beating a down market. So too can American Funds, which in the mid-2000s was the king of the mutual fund industry, in large part because its funds' aversion to technology stocks and high positions in cash buoyed them when stocks fell from 2000-02. Hedge funds were also riding high at the same time, for the same reason. In addition, I'm old enough to remember the many fund companies and portfolio managers who attracted shareholders in the late-80s and early-90s because "they dodged the crash."

Hmmm. Must read.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.