- Strategy A: A 250-stock portfolio that will beat the market by 1 percent per year over 25 years. This strategy will never underperform the index by more than 1 percent in a given year;
- Strategy B: A 50-stock portfolio strategy that will outperform the market by 5 percent per year over the next 25 years. This strategy also guarantees a five-year period of 5 percent per year underperformance.
Table 1: Summary Of Investment Options
|B||Extremely High||Extremely High|
Which strategy do you choose? If you are a professional money manager, the choice is obvious: choose A and avoid getting fired. But why choose A? It’s a bad long-term strategy for the firefighters relative to strategy B! Note that for the manager in this case, career risk is a more important consideration than alpha generation—the reverse of the priorities for the investor who owns the capital.
What is going on? Well, the incentives of an investment manager are complex. Fund managers are not the owners of the capital, but work on behalf of someone who owns the capital. Financial mercenaries, if you will.
These managers sometimes make decisions that ensure they maintain a job, but not necessarily maximize risk-adjusted returns for their investors. For these managers, relative performance is everything and tracking error is dangerous. In the example above, the tracking error on strategy B is just too painful to digest. Those firefighters are going to start screaming bloody murder during the five years of underperformance, and the manager won’t be around long enough to see the rebound when it occurs after year five.
But if the manager follows strategy A, he can avoid career risk and the fireman’s pension will not endure the stress of a prolonged downturn. While performance and returns for the firemen will suffer, the manager’s job will be safe.
Of course, the problem outlined above is not new. The dynamics of this problem are explored in an esoteric 1997 Journal of Finance paper by Andrei Shleifer and Robert Vishny, appropriately called, “The Limits of Arbitrage.” Moreover, recent research by Jason Hsu and Vivek Viswanathan highlights that active strategies are prone to investor fatigue, which leads to outflows when short-term relative performance is poor, and inflows when short-term relative performance is strong.