This is the fifth article in an ongoing series on managed funds – Part 1: Using the Sharpe ratio to assess fund performance, Part 2: Identifying appropriate benchmarks for private equity funds, Part 3: Evaluating common measures of private equity performance and Part 4: The negative impacts of pension fund complexity.
“Too little attention is paid to the dark side of incentives. They are anything but a magic bullet. Psychologists have known this for years, but it seems largely hidden from the world of commerce.” – Barry Schwartz
In investing, as in any business, everything comes down to incentives. Good incentive schemes encourage superior employee performance and adherence to the firm’s mandate. Bad incentive systems, on the other hand, can lead to disaster. Sometimes it is very hard to tell whether a system is effective until it is tried – that can be a problem.
This problem has been addressed and rehashed by experts from across the fields of economics, business, sociology, psychology and more. One question that continues to persist and is of particular importance when we are discussing asset management was famously articulated by Steven Kerr in his classic essay, “On the Folly of Rewarding A, While Hoping for B.” In his essay, Kerr highlights some examples that continue to resonate today, such as the Heinz Corp., now Kraft Heinz KHC, paying division managers bonuses only in the event that they increased earnings over the previous year. Heinz thought it was paying for continuously improving performance and increasing sales; instead, managers were actually busily manipulating their records to reflect the stated performance metric. Heinz is just one of many companies that have created bad incentive systems and paid the price.
The pension fund problem
Simply put, it is difficult in any business to align the incentives of employee and employer to produce a desired quality or type of performance. Firms throughout history have found themselves getting exactly what they paid for, but not what they wanted.
How does this apply to your pension and the fund that manages it? I have written before in this series about the difficulties of measuring investment performance, especially for alternative investments such as hedge funds and private equity. It is clear that pension fund managers want to allocate funds in such a way as to maximize their expected risk-adjusted returns net of fees. The problem is that, as I discussed in Part 4, the complexity of pension fund organizations and the external funds to which they delegate makes it supremely challenging to accurately measure what is actually going on at the whole-portfolio level. Rather than trying to develop clearer understanding and implement strict decision-making protocols, it can prove more convenient to pension fund managers to simply delegate decision-making even further to external managers, like hedge funds.
Passing the buck
Delegating to external managers passes the buck from the pension fund manager to the external manager. While poor performance may reflect badly on the pension fund manager, they can simply switch external managers and proclaim that they were simply allocating to the very best in the business. The large and cumbersome pension funds that now dominate much of the fund allocation space are byzantine organizations that act more like government bureaucracies (which they often technically are) than as investment companies with the ultimate principal (i.e. the pension fund beneficiaries) firmly in mind.
One can think of it as a being a bit like the behavior of lawyers in court: The issue at hand is not what is actually true, but only what can be proven. For the pension fund middle-manager and allocator, what matters is not necessarily what is the best investment decision, but what can be justified to their superiors higher up the organizational chain of command. So asset allocation choices by one pension fund – a bit to hedge funds, a bit to commodities, a bit to private equity, etc. – tends to resemble the choices of all the other pension funds.
If an allocation strategy looks different, it will draw attention and prying questions. Justifying such decisions relies on a degree of independent insight, and no justification can be perfect. So it is often better, so thinks the pension fund manager, to move with the tide rather than against it – whether it is necessarily in the best possible interest of their principals or not.
The consultant conundrum
Another method frequently employed by pension funds at nearly every layer of organization is to further outsource decision-making by handing the allocation decisions themselves – or at least great influence over those decisions – to investment consultants.
Investment consultants have enjoyed a booming business thanks in large part to pension funds and other large-scale allocators. These consultants offer their “expertise” in choosing funds of various strategies and styles and are paid handsomely for their insights. Yet studies have consistently shown that investment consultants’ advice do not actually add value. In fact, there is substantial evidence that consultants exist as a way for pension fund managers to cover their backs and to retain their positions irrespective of ultimate performance. The same can be said for the whole business of delegation, since it reduces the appearance of responsibility and thus of culpability.
Peeling away the layers
Investors need to understand the internal psychologies and incentives driving the decisions of the people who are managing their money. For people with money ensconced in pension funds, they must be doubly sure that the people managing their retirement futures are doing so with the final principals’ interests in mind, not simply their own myopic desires for promotion or self-preservation.
Knowing how pension funds behave and how they make decisions is one thing, but changing their behavior is another. It would take a concerted effort by fund participants to actually move the needle, especially when considering the largest funds. So it may pay to know the pension fund you’re saddled with, and do your best to extricate as much of your investable savings to employ elsewhere.
Disclosure: I/We have no position in any stocks mentioned in this article.
