The Investment Risk You’ve Never Calculated
Investment management professionals are trained to measure many kinds of risk. Indeed, in the quest for performance, it is all about risk-adjusted returns. Any student of the markets can list off key risks, such as interest-rate risk, credit risk, liquidity risk, counterparty risk, and even tougher-to-quantify risks like geopolitical risk. The one we rarely speak about that has a significant impact on returns, however, is career risk, namely the potential to be fired from your organization for subpar investment performance.
In the investment profession, we are united by our love of numbers, so it’s no surprise that we tend to see our success in terms of a single figure. Whether we measure performance versus a benchmark, versus peers, or on an absolute basis has little bearing — it is the almighty track record that defines status, compensation, and longevity in this field.
The challenge is that investing is difficult, markets are uncertain, and no one gets it right all the time. Even those who have done well over long periods will underperform during shorter intervals — disappointing clients and colleagues.
How many months of underperformance would it typically take before members of the investment team are dismissed/fired from your organization?
We asked CFA Institute Financial NewsBrief readers how long investment teams could underperform at their firms before they should start to worry about their jobs, and their responses confirmed that the pressure is real. Of the 774 respondents, 78% said that career risk due to underperformance is a factor at their firms, and the largest number (28%) said that between one to two years was the time period when job security would start to be an issue. Another 13% said that in even less than one year the investment team should be concerned. In other words, 41% said investment teams have less than two years to turn around underperformance or it may be time to dust off the resume.
This is an even more dramatic finding than that reported in “The Folklore of Finance,” in which 54% of institutional investors and 45% of asset managers said career risk was a factor for them. This group gave an average time frame of 18 months of underperformance before there would be job consequences.
The issue here is not about avoiding accountability, but rather that the pressure leads to sub-optimal results for clients. The most common distortion in incentives is that professional investors who are worried about correcting a poor track record will tend to become overly risk averse, seeking to minimize the tracking error from the benchmark or variation from a peer group. This sacrifices better long-term returns and creates a mismatch in investment horizons: Very few end investors have a time horizon of just 18–24 months, yet this is the narrowing of perspective that the investment team has.
An even greater potential misalignment is style drift. This was quite prevalent in the late 1990s before the bursting of the tech bubble. It was a trying time for value investors, so many became growth-like despite their mandates. GMO was one example of a value firm that stuck to its philosophy — despite losing many clients along the way — and the investors who stayed did very well in the end. In his comments to GMO clients earlier this year, Ben Inker, CFA, reminded them to “keep the faith” as this has also been a difficult period for long-term value investors.
Incidentally, CFA Institute has featured investment pros from GMO as speakers for educational events over the years, and those who have usually been audience favorites were criticized in the conference evaluations of the late 1990s. There is an undeniable reputational risk of going it alone, even if you are eventually vindicated.
In his paper “Career Risk,” Joachim Klement, CFA, looks at the impact of performance evaluation frequency and shows how even high-performing investment managers suffer from career risk. Assuming a 5% tracking error and 0.5 information ratio (a “true” annual alpha of 2.5%), the probability of an underperforming observation is 31% if evaluated annually, 40% quarterly, 44% monthly, and 47% weekly. Therefore, the more frequently a client evaluates their portfolio, the more likely they are to prematurely discontinue a relationship with a good investment firm, and very often the client does worse after switching.
Combating career risk comes at two levels: There are the twin risks of clients leaving and the investment firm forcing out the underperformers. For the 41% of poll respondents who said their firm would give the underperforming team three or more years, or would not dismiss them at all for performance, they have either a supportive firm structure (i.e., the firm is owned by the lead portfolio manager) or the clients have a deep and abiding respect for the investor at the helm. Star managers have become increasingly rare since the financial crisis, though, as very few managed to emerge unscathed.
Track records don’t necessarily reveal as much as we think about the quality of an organization or investor. Keep in mind that even Warren Buffett has had periods of underperformance; From 2009–2013, he outpaced the S&P 500 in only one calendar year.
Both clients and those leading investment firms would be wise to recognize the evaluation frequency effect and consider more criteria about a team’s potential going forward than one number from its past.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.