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Research Affiliates, the US-based proponent of new-style passive strategies such as ‘fundamental’ indexing, has produced a paper outlining how investors can overcome potential principal-agent issues.

The paper, ‘How Not to Get Fired with Smart Beta Investing’, says that adopting longer evaluation periods for a manager’s assessment is one way to reduce these issues. Research Affiliates has suggested a five-point plan.

The paper says outcomes for investors can be improved by fostering a clear understanding between investors and delegated managers that the latter often have an incentive to protect their jobs by allocating the portfolios they manage across negatively, and even uncorrelated, strategies, even if the result does not produce robust returns for their investors. This principal-agent problem can limit the growth of, and even destroy, investor wealth. Both parties can better align their interests by combining several robust strategies in transparent solutions, by extending the evaluation period, and by more thoroughly educating the investment board and codifying investment beliefs.

Rob Arnott, the Research Affiliates founder, said more than 10 years ago that the chasm between the best interests of the investor and those of the asset manager is exacerbated by the fact that everyone has a client.

“The portfolio manager reports to the chief investment officer, who reports to the CEO of the asset management firm, who reports to the client’s investment officer, who reports to the treasurer or chief financial officer, who reports to the CEO of the client organization, who reports to the investment committee of the board of directors,” Arnott wrote in 2006. “Each step in the reporting process increases the pressure to focus on short-term results, in absolute returns and relative to one’s peers.”

Not much has changed in the past decade, the paper published last week says. “But by speaking straightforwardly now about how the investment industry can work to better align principals’ and agents’ interests, we may be able to affect positive change for both parties over the next 10 years.

“As an investment community, we have the opportunity (and the responsibility) to adopt practices that more closely align agent and investor incentives.” The five-point plan is:

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.