Too Great an Emphasis on Career Risk Management Leads Portfolio Managers to Underperform Their Benchmark
Young finance students often ask what topic should be taught during undergrad that presently is not. My response is always the same: “Career Risk Management”. The students are most often left speechless, unsure as to whether I am serious or providing a clever quip. The fact is I could not be more honest if I tried. With each passing year that I add to my 20 -plus in the finance industry the greater my conviction becomes that career risk management runs far too pervasively throughout finance and that it negatively impacts investment returns. Investors must be cognisant of this dynamic and should make certain to investigate accordingly during the due diligence process.
Career Risk Management Negatively Impacts Returns
Portfolio managers driven primarily by the career risk management make suboptimal decisions that negatively impact portfolio performance. Focusing foremost on career management sways managers to become aversion to risk. This is in contrast to what a portfolio manager should be doing which is to generate the highest returns given their mandated risk through the execution of high-conviction investment ideas. The former is about the preservation of a high-paying compensation package. The latter requires a strong work ethic, intelligence and the freedom to execute sound decisions in a timely manner.
The detection of career risk management of a portfolio manager during the due diligence process may in fact give indications about the manager’s firm culture. Investors should take heed to this as investment management is a zero-sum game. Portfolio managers that are focused too heavily on career risk management are typically the losers in this game. They tend to own too many positions in order to minimize their tracking error. Moreover, their investment decisions are based on chasing the benchmark which structurally ensures underperformance – they buy and sell after the fact, not before. On the opposite end of the spectrum, the winners care little about benchmarks and have concentrated positions that reflect their strong opinions.
What Type of Character Oversees The Portfolio Manager?
In certain situations the career risk management to be worried about is not that of the portfolio manager but rather that of his superior. The investor must also be aware of this. A good CIO provides the portfolio manager with the necessary support and the leeway to execute on his investment views. At the same time the CIO must himself be confident that investment decisions have a sound basis. We have come across CIOs that expect powerpoint presentations that provide week-over-week portfolio assessments including minutiae surrounding each investment decision. We deem this kind of high-frequency to be counter-productive and exaggerated. During due diligence investors should ensure that the CIO strikes the right balance.
When investors allocate wealth, it is critical they ensure that their portfolio managers are motivated foremost by their fiduciary duties to their stakeholders. The largest tell-tale sign that a portfolio manager’s interests are not aligned is that he owns too many positions, which makes it difficult to deliver investment returns makedly different from those of the passive benchmark. Also, understanding the culture of the firm for which the portfolio manager works for is very important. For instance, a portfolio manager spending too much time justifying his actions to the CIO may create undue emotional pressure on himself which in turn can lure him to chase performance by buying or selling specific securities following – rather than before – the market makes a move. It is imperative that investors seek a situation in which the CIO in place has a justifiable amount of oversight but not too much as it could in fact be damaging. Too many portfolio managers have underperformed their benchmarks because they put their careers ahead of investor needs. Investors owe it to themselves, their sponsors and beneficiaries to add career risk management to their investment due diligence.PDF version