Fiduciary Hot Potato

The year-end rally appears unstoppable. As has been the case for much of the current market cycle, elevated valuations have been an ineffective deterrent for investors willing to pay higher and higher prices. After such a long and seemingly endless period of rising stock prices, wanting and expecting more comes easier than settling for less.

When overindulging in anything enjoyable, few people want to listen to the virtues of settling for less. No one likes to hear, “Hey buddy, you might want to put down that triple cheese burger, cigarette, beer, or grossly overvalued small cap stock.” I can relate. When I’m knocking down a large bowl of my favorite private label ice cream, the last thing I want to be lectured on is discipline and prudence!

After almost nine years of all gain and little pain in the financial markets, the topic and practice of risk aversion isn’t very popular. Nevertheless, considering the potential losses current valuations imply, I continue to believe risk is a very important message to communicate and consider. Fortunately, I’m not alone.

A fellow absolute return investor, Frank Martin, also continues to consider and write about risk. Last week he focused on tail risk. In his article, “The Tail Risks Optimizer’s Dilemma: Taleb Vs Spitznagel”, Frank writes about the leading experts on tail risk and their attempt to position for black swan events.

While I found his comparison of Taleb and Spitznagel very interesting, Frank’s discussion regarding the difficulty of applying their strategies caught my attention. His comments reminded me of the challenges encountered by many absolute return investors.

Frank writes, “In reality, most people are simply not hardwired to endure pain before gain, especially when the duration of the suffering and the magnitude of reward are uncertain. Moreover, most investors find it difficult to remain patient and circumspect as the gravy train to apparent riches pulls out from the station. The loneliness of watching the caboose get smaller as it fades into the distance is more than most can handle. Benjamin Graham quantified those who can stand such isolation at 1 out of 100.”

Frank goes on to discuss a very important topic that I believe is underreported and underappreciated by many investors. Specifically, business risk and its influence on investing and decision making. As many of you know, Jeremy Grantham is well known for his comments on career risk, or how portfolio managers’ fear of “being wrong on their own” influences decision making. But what about business risk?

Business risk differs from career risk as it’s sourced from the asset management firm, not the portfolio manager. Just as a portfolio manager can invest too differently and risk his or her career, if an asset management firm thinks and positions itself too independently, it can risk losing assets and revenues.

Frank explains, “The human aversion to pain and desire to join others aboard the train affects clients and investment firms alike. Managers, however, are assumed to be more aware of systemic risks than their clients, or else there would be no reason to employ them. Investment institutions are often risking their own economic survival if they try to optimize their clients’ portfolios for adversity and get off the train before their peers. The optimal scenario would constitute institutions that are unconditionally client-centric and clients who understand and appreciate that value proposition. In a battle between human nature and nirvana, the state of the world would suggest that the former will invariably dominate. Consequently, many firms fail to properly prepare clients and their portfolios are left to suffer the vicissitudes of the market.” [my emphasis]

I love that paragraph. It touches on a very important and relevant topic for the asset management industry. Specifically, the possible conflict between business risk and “properly preparing clients and their portfolios”.

Imagine for a moment you’re a board member of an asset management firm. You have a duty to the owners to maximize the value of their business. Asset managers are not charities – they have some of the same desires and objectives as most businesses, such as growing assets, revenues, and profits.

Now imagine you’re in a board meeting. As you sit in the meeting, a discussion of current market conditions, asset valuations, and risk begins. A board member throws up a chart of historical equity valuations, clearly illustrating current prices suggest significant losses to client capital are possible, and if history is an accurate guide, probable.

What do you do? Recommend reducing risk, increasing cash, or returning client capital? This option would most likely cause assets to leave the firm and revenues to fall. Or do you stay invested and point to investment mandates requiring the firm to stay fully committed to risk assets? This option would most likely increase the odds of retaining assets and allow the firm to benefit from further increases in asset prices.

The conflict between business risk and doing what is right for the client (also known as fiduciary duty) is complicated further by investment mandates. Investment mandates often require asset managers to invest in a certain manner, regardless of price, valuation, and risk. I’ve often wondered if strict investment mandates and fiduciary duty can coexist.

For example, during periods of broadly inflated asset prices and elevated risk, can an asset manager with a fully invested mandate act as a fiduciary? In other words, can certain investment mandates nullify an asset manager’s fiduciary duty? If so, do advisers and consultants that request mandates also assume a greater fiduciary responsibility? In summary, where does fiduciary duty reside, where should it reside, and how do investment mandates interfere with its implementation and allocation?

These are very important questions for most relative return managers and their clients. Absolute return managers, on the other hand, typically have more flexible investment mandates that are less likely to conflict with their fiduciary obligations. However, higher flexibility and fiduciary responsibility do not come without a price. To comply with their fiduciary duty, absolute return managers may be required to assume above average levels of career and business risk, especially during periods of excessive asset inflation and overvaluation. As an unemployed absolute return manager, I can certainly relate! 🙂

To conclude, business risk, fiduciary duty, and investment mandates are interconnected and have complex relationships. I believe it’s important to recognize these relationships and understand how they influence investment decisions and the allocation of fiduciary responsibility. Fortunately, given where we are in the market cycle, it is not too late to add flexibility to investment mandates and increase the level of business risk asset management firms are willing to assume. Such modifications, in my opinion, would better enable asset managers to perform their fiduciary roles and as Frank Martin wrote, “properly prepare clients and their portfolios”.

Have a great weekend!