SAFT ON WEALTH-Conflicts of interest make the markets go round

By James Saft

Jan 28 Money managers, because they do their job with an eye to their own bottom line, tend to drive over-valued assets higher and undervalued ones lower.

This momentum following and index hugging manages to drive the market as a whole higher while leaving clients concentrated in assets that may underperform.

A new study, looking at the theoretical impact of money managers having an inherent conflict of interest with their clients, shows how this distorts the way the financial markets function.

"We show that because of agency frictions, managers are compensated based on their performance relative to a benchmark. As a consequence, they become less willing to deviate from the benchmark, and the price distortions that they are hired to exploit become more severe," Andrea Buffa of Boston University and Dimitri Vayanos and Paul Woolley of the London School of Economics write in the study. here

When a manager is instructed to beat a benchmark, she faces a problem: how to balance risk and reward. While that is hard enough, complicating the issue further is that the manager is well aware that if she trails the benchmark by a big gap, she faces a rising risk of losing the client.

As a result there is a lot of index hugging going on, with managers making just small bets against the benchmark, not because they think it will achieve the best risk-adjusted result but because it controls for the much more profound issue of career risk to the manager.

This not only leaves many investors paying for an active management service they are not really getting, but they are also holding a somewhat perverse set of assets as a result. All else being equal, a managers are going to have a bias toward buying what has gone up, because they want to keep their tight relationship to the index. This makes markets a bit of a self-fulfilling phenomenon, sometimes called the momentum effect. Stocks that go up tend to keep on going up and stocks that go down will tend to keep traveling in the same direction.

As a result, over-valued stocks go higher and undervalued ones wallow. The biggest stocks become more important to overall index performance, trapping managers into buying or taking on extra career risk.

The authors discuss how good news for an over-valued stock will lead to further self-fulfilling price gains. While the news may be good, the relationship between how good the news is and how the stock goes is shaky.

Apple, which reported good earnings on Tuesday and saw its shares jump more than 6 percent, may be a good example of this phenomenon.

"I think you have an ad hoc short squeeze that has occurred and is occurring now in Apple," activist investor Carl Icahn said on Wednesday. "Index funds are in competition with regular mutual funds. Mutual funds have to do better than index funds because you are paying them three times as much. Indexes have Apple in them and therefore a lot of these funds have to catch up, to play catch up with Apple because Apple at 5 percent is a meaningful part of the index performance."

That short squeeze doesn't necessarily have to be fed by actual shorts, because any money managers who are underweight Apple will be feeling keenly their own vulnerability.

According to the study, the pressure to buy the expensive outweighs the pressure not to hold underperformers, thus giving the markets an upward bias. As well, the worse the conflicts of interests, the higher the volatility among over-valued stocks becomes.

As volatility equates with risk and as a high price now will lead to a lower performance in future, conflicts of interest help to fuel poor risk-return tradeoffs for investors, if not for the managers they hire.

All of this may help to explain the popularity of "smart beta," which tries to improve on index tracking returns by adjusting away from the typical cap-weighted style, in which a given fund will hold shares or securities in proportion to market capitalization.

"Smart beta has low tracking error versus the index. Although expected returns are modest, the manager will remain within hailing distance of the benchmark, and a principal can't complain too much about that, right? Unfortunately, this may not necessarily be in the principal's best interests." Jack Vogel, of asset managers Alpha Architect, wrote in a note to clients.

Just because you can measure it does not mean you can manage it.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by Dan Grebler)