An Alternative Reason Good Investment Managers Struggle To Persist

Posted by Michael Kitces on Wednesday, August 21st, 11:06 am, 2013 in Investments

Earning an income is a fundamental incentive to work. It starts with just earning enough for the essentials of food, clothing, and shelter. From there, it grows to a desire for a greater lifestyle, the “nicer things” of life, and perhaps even the opportunity to accumulate enough to not need to work in the future (i.e., to retire), which in turn incentivizes trying to further grow income and advance a career.

Yet the reality is that the incentives of this “game” change over time; taking a high-stakes risky “stock-like” approach to career is great in the early years, when the upside is great and the downside is limited, but becomes less appealing as the years go by. Wealth is accumulated, goals are achieved, lifestyle is increased, and at some point the game of life changes to be less about getting more and instead is more about enjoying (or at least, not losing) what you’ve got. Accordingly, good career management shifts from treating the career less like a risky stock to something more like a conservative bond.

These dynamics of how the career management game is played, though, impacts career incentives as well, and in the context of investment management can result in a material change in career/performance incentives. This may be particularly true in the world of investment management, as the desire to build a great fund or firm gives way to a new desire to ensure it's not (quickly) lost. And as the incentives to excel potentially decline for many as success comes, the risk rises that even the best managers will lose the willpower and desire to continue to be the best… which ironically means that perhaps the best investment managers most likely to persist are the ones we often lambast - those who are the most money-obsessed, who keep driving for more and more and more despite the fact they probably could have checked out of the game long ago, and who never wane in their desire (or lose their incentive) to keep playing the game to be persistently great.

Making Career Capital Decisions

Imagine a world where you’ve reached a point of success in your career, you’re earning “good” money, and you reach a fork in the road, where you must decide what career path to pursue from here. The fork to the left is the high-risk high-reward path, where you take some big career gambles that will result in significantly more income if it works out well, but if it doesn’t you’re fired. The fork to the right is the more conservative route; it’s where you keep your head down, try not to rock the boat, and just try to keep your current job, your current income, and your current lifestyle.

You might say that the path to the left of this hypothetical fork treats your career and human capital like a stock, while the right treats it more like a bond. Smart, ambitious people who are more inclined to take risks will typically choose the path to the left in the early stages of their careers; it is the more ambitious path, after all, and is how you "get noticed" and climb the ladder for higher career returns.

But as income and success grows, the dynamics of this risky decision begin to shift. Your human capital portfolio isn’t just a basket of speculative risky stocks which not much at stake; there are now a number of clear winning decisions that have significantly increased your income and net worth. The natural response, of course, is to take some of the risk off the table, since it’s no longer just about the potential of what can be in the future, but also preserving what’s been created. After all, it’s not a big deal to risk getting fired early on; you don’t have far to fall when you’re only on the bottom rung of the career ladder in the first place. When you’ve climbed much higher on the ladder, though, the potential fall back to the bottom looks a lot scarier.

In other words, the bottom line is that one can manage their human capital, just as they manage their financial capital, which often involves taking risks early on, and then taking some chips off the table once wealth has been created.

Career Decisions In Investment Management

Notably, in the investment management context, this dynamic presents a significant challenge and a potential conflict of interest.

In the early years of an investment manager’s career, the opportunity is almost all upside. The incentive is to score big victories, to “make your mark” and get noticed. There may be some dollars under management to make it an official track record that’s being built, but there aren’t many dollars at risk, yet. With a job that may not pay much yet, the downside risk of being wrong is limited, and it’s worth the effort to try for some big investment career hits.

As fund managers find success, though, this dynamic shifts. Good performance brings in investor dollars, and as assets under management begins to rise there may be a promotion or a partnership offer, and income starts to climb. A rising income brings a rising lifestyle for the individual, as he/she begins to enjoy the fruits of the labor. And that’s when the real problems begin.

Because once lifestyle begins to ramp up, there’s usually no going back. The thought of losing a current lifestyle is horrific to most people; we have a remarkable ability to attenuate to our current circumstances and then view anything less than what we enjoy today as a catastrophic loss, even if the reality is that we were living at just that level a few years ago.

In the context of an investment manager, this begins to distort the incentives for good management. Sure, hitting some home runs was great to get your fund or firm noticed, to get some investment dollars in the door, to get that promotion or partnership or grow the business. But after the lifestyle moves up, the fear sets in. Now it’s less about the glory of the home run and more about the fear of a strikeout. The increased expectations – a result of prior successes – becomes a heavy burden to bear, and investors are fickle; a “genius” for a decade can become a “has been” with just one big swinging miss and an onslaught of outflows.

The end result of this shift: the incentives go from playing offense to defense, which can have a significantly adverse impact to the results for investors. It’s not that the brilliant investment manager suddenly forgets how to be successful; it’s that the risks and rewards to play the game have changed. It’s no longer about getting big hits; now it’s about not being seen taking a big swing that misses.

An Alternative Explanation For Poor Persistence?

The fact that investment managers might find the incentives and the rules of the game changing over time because of their personal circumstances shouldn’t be entirely surprising. Think of it from the perspective of managing your own career. If you’re managing your career like a stock, get some big wins early on, and adjust your lifestyle to your newfound wealth, would you want: A) to keep swinging for the fences; or B) start playing it safe?

Many – perhaps even most? – rational human beings choose option B. The end result in the investment management context? There aren’t many (or any?) more big bets and bold calls. It’s less about beating the benchmark and more about not drastically underperforming it. The portfolio investments begin to hug the benchmark, and active share declines. The drag of fees becomes more pernicious in the case of such closet indexers, but it takes a long time for small misses to eat away at a good historical track record. Especially since the reality is that statistically, the small misses will be lost in the magnitude of overall market volatility anyway.

While ultimately, such a path is almost certain to eventually end with a slow and steady decline in success, that’s actually the point; a slow and steady decline has a lot more years of big income before the game ends. Big strikeouts can end the game more quickly. In other words, the optimal way to play the personal career, income, and lifestyle game has changed, and benign mediocrity has become the best way to keep winning. Of course, almost anyone going through the experience likely rationalizes their reasons for changing their behavior in other ways, but the problem is there nonetheless.

On the other hand, the reality is that not every investment manager operates this way. Some really do keep swinging big. Given the choice of risking it all to make more money, or taking the safe route to enjoy the current lifestyle, they keep choosing to swing for the fences, over and over again.

We would probably call most of these people greedy and obsessed with money; we’d chastise them for caring about the money more than the people, the game itself more than the outcomes and how it impacts the real world. These are the people who keep driving for “more” and never reach the point of “enough” – and yet the ultimately irony is that perhaps it’s actually those people obsessed with money, who could have checked out of the game long ago but never do, who actually do the best job on behalf of their investors. Because ironically, it’s the ones for whom money is not a means to an end, but an end itself and the way of keeping score itself, who actually have the persistent self-motivation to keep playing the game in the first place, and keep treating their career like a stock when they could have long ago shifted to treating it more like a bond. Especially if they're able to separate their feelings from the process and view investing in an entirely dispassionate and unemotional manner and operate successfully as a form of 'functional psychopath'. Go figure.

The point of this discussion isn’t to necessarily to weigh in on the passive versus active debate itself, but simply to acknowledge that in the end, the best investment performance lies at the intersection of skill and incentives, and that a person’s drive for incentives can change over time as their own circumstances change. So the next time we look at another study about the difficulty of finding persistence in fund performance, consider for a moment whether the real problem is whether markets can be beaten or not, or simply whether good managers are consistently incentivized to do so.


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