Agents who attempt to minimize their risk of being fired by allocating funds to non-robust strategies are behaving perfectly rationally. Any fault for suboptimal investor outcomes lies with the incentives produced by the rules and conventions governing the investment management environment, in which we all chose to participate.
As an investment community, we have the opportunity (and the responsibility) to adopt practices that more closely align agent and investor incentives:
1) Increase the length of evaluation period. The probability of being fired declines as the evaluation horizon increases. Over longer horizons the statistical difference between robust and non-robust strategies becomes stronger, which can help mitigate the principal–agent problem. This often means extending the horizon beyond board members’ designated terms.
2) Combine multiple robust strategies. The combination of several robust strategies is beneficial for both the investor and the agent because this allocation significantly reduces the chances over a given period that the overall portfolio will underperform and/or that all styles in the portfolio will underperform.
3) Practice transparent line-item management. During the disarmament negotiations with the USSR, Ronald Reagan famously said: “Trust but verify.” Investment boards are well-advised to follow suit in communicating with their plan sponsors and CIOs. Transparency in the performance of individual styles, the investment process itself, and the resulting overall portfolio performance offers a great tool for communicating between investment boards and their agents.
4) Codify investment beliefs and educate the board. When the agent educates the investment board on empirical findings and the rationale for making (or often more important, not making) certain investing decisions, any period of negative performance is less likely to be viewed as a lack of skill and a reason to fire the agent.
5) Use non-robust strategies consciously. Some managers of non-robust strategies, such as growth, may be extremely skilled in delivering value-add. If an agent has high confidence in such a manager’s skill, foregoing the opportunity may be detrimental to the principal. Furthermore, non-robust strategies may at times be underpriced and ignored by many investors, presenting a tactical opportunity to employ non-robust strategies. Being deliberate about choosing to invest in non-robust strategies, and communicating that deliberation, will act to safeguard both the principal and the agent.