Investment management: investment managers must be covered by the skin in the rules of the game

The Mirror recently reported that Boris Johnson, the UK Prime Minister, and his staff broke Covid rules by attending parties at 10 Downing Street (his official residence and executive office) in the run up to Christmas 2020 ( 1). When London was in the throes of a second lockdown and Tier 3 restrictions applied (which banned all indoor mixing except in domestic bubbles), the most prominent members of his team threw party nights at Number 10 – 40-50 people were crammed into a medium sized room. Yes, strict Covid rules applied to all of London but, apparently, not to the people who worked at 10 Downing Street.

Let’s look at another incident. On January 24, 2020, the US Senate Health and Foreign Relations Committee held a meeting with senators to brief them on the Covid-19 outbreak. Following the meeting, Senator Kelly Loeffler and her husband Jeffrey Sprecher sold shares worth $3.1 million. Senator David Perdue sold shares worth $825,000 and bought shares worth $1.8 million, including DuPont, a company that makes personal protective equipment, on the same day as the Senate briefing (2).

Senate Intelligence Committee Chairman Senator Burr and his wife sold stock worth more than $2.3 million on February 13, 2020, a week after he wrote an op-ed stating, “Fortunately, we have a framework in place that has put us in a better position than any other country to respond to a public health threat like the coronavirus.” An investigation ensued, and on January 19, 2021, the Department of Justice closed its investigation into Burr.

And this despite the existence of the STOCK law, the objective of which is to increase the transparency of the job of the legislator. An insider trading investigation found that 49 members of Congress and 182 of Capitol Hill’s highest-paid employees filed their stock trades late in 2020 and 2021.) exist.

Now compare that to the huge financial penalty (and sometimes incarceration) imposed on the general public for insider trading. The rules are strictly enforced, but not for those who are responsible for making the laws.

A similar nuance also exists in the investment management industry. It is currently structured so that the asset management company (AMC) receives either a flat fee for managing the assets (regardless of investor returns) or a “carry” (big upside if returns cross the obstacle, and no disadvantage if returns are negative). Investors are essentially writing a free option to their AMCs, which in turn encourages risk taking at the expense of investors.

This happened at the height of the small-cap cycle in 2017, when investment managers, fueled by exceptional two-year returns, continued to add illiquid small-cap stocks to investors’ portfolios. Many of these companies went bankrupt and suffered large-scale declines in 2018. As investors lost half of their investments, investment managers recorded “zero” fees for that year, to give birth to a new style of investing in 2019 and 2020 (buying only large-cap companies). stocks), and history will repeat itself in 2021.

In my opinion, there is a way to solve this problem. Investment managers should be mandated to park all of their equity investments only in the funds they manage, i.e. they have significant skin in the game (SITG). The idea behind SITG is mainly about symmetry – if you have to gain from the upside, you should also be forced to pay for the downside. If people with fiduciary responsibilities had SITGs, they would behave more rationally, rather than just “go with the flow”. SITG makes boring activities less boring, like checking the security door of an airplane that’s about to fly with you as a passenger or reading the fine print in annual reports while managing your money.

SITG also promotes results on perception. Investing is simple but not easy. But asset managers, to make it palatable to everyone, often reduce the investment process to miniature formulas that sound good. This makes them smart and helps their AMCs collect important assets to manage. However, when the market cycle changes and these formulas stop working, end investors pay the price, in the form of lower returns or loss of capital. If a large portion of the asset managers’ personal wealth is invested in the fund they manage, they will be incentivized to deliver sustainable results rather than coming up with theories that only build their personal brands. Check to see if your portfolio manager chooses to invest their personal wealth in the fund where they invested your money.

(The author, Jigar Mistry is co-founder of Buoyant Capital. Opinions are his own.)


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