The governance problem with mutual funds
All of us are now familiar with the ``corporate governance problem''. Economists call these ``agency problems'' or ``principal--agent problems''. Here we have a principal (the shareholder) who hires an agent (the manager of the firm), and the principal needs to worry about whether the actions of the agent are in his best interest. Whenever principal--agent problems surface, the principal can choose between two strategies for controlling the agent: monitoring inputs or monitoring outputs.
- Monitoring inputs
- This is micro--management : it involves closely watching the agent and ensuring that every action of the agent is indeed consistent with the goals of the principal.
- Monitoring results
- We can treat the firm as a black box, not taking interest in the details of how it is run, and focusing on clearly defined goals for the outcomes. The shareholders could set targets for profit growth, relative to other firms in the industry. The implicit assumption in monitoring results is that (a) the "best" agent will be selected based on the likelihood of obtaining results, and (b) if an agent fails to obtain results, he will be sacked.
We can gain great insights by applying this mindset to the fund management industry. Here, the investor is the principal and the fund manager is the agent. How is the investor to choose among competing fund managers? How is the principal to monitor the fund manager, and ensure that the actions of the fund manager are in his best interest?
Fund management is a complex process, in which agency problems could surface at many levels. There are many decisions where the fund manager could choose to act in ways which are not in the best interest of the investor. Some examples are offered here:
- The fund manager could be sloppy and not work hard in thinking about which stocks to buy.
- The fund manager could choose to buy stocks for reasons other than the future expected returns.
- The fund manager could ``front-run'' against the fund; buying stocks on his personal account immediately before doing so on behalf of the fund.
- The fund manager could choose trading mechanisms which yield "rents" instead of choosing the trading mechanism which yields the lowest transactions costs. It is widely believed that brokerage firms often reward individuals in fund management companies with "commissions", or induce the individuals to use the resources of the fund in ways that help a manipulative cartel. The history of ethics lapses in the South Bombay community over the last two decades, and the paucity of law enforcement actions in response to these, suggests that there is a serious problem here.
- The fund manager faces choices about custodial and administrative services, which might not be made in a cost--minimising fashion.
It is impossible for an investor, or for a trustee, to closely monitor the fund manager and ensure that these decisions are being made in his best interest. Since monitoring inputs is infeasible, the only device through which control can be exercised is by monitoring performance. The investor could try to select fund managers who have exhibited the highest returns in the past, and fire fund managers who fail to perform.
A naive comparison of returns across alternative funds, which is often done in India, is incorrect when there are differences in the levels of risk adopted by different funds. Scientific performance evaluation efforts could be the answer.
Fund performance evaluation, as yet, suffers from many conceptual difficulties. Given the large extent of market fluctuations, it is difficult to discern ability by looking at the NAV time-series. A classic illustration of this is in the book Investments by Bodie, Kane and Marcus. They show an example of a fund manager who has substantial skill -- he adds returns of 0.2 percentage points per month (i.e., in excess of 2.4 percentage points per year). If the standard procedure of measuring the `alpha' of the fund manager was applied, using monthly returns, we need 32 years of data before we can be sure that he has non-zero ability with a 95% level of significance.
This low "signal to noise ratio" in fund management makes performance measurement difficult. It is difficult for investors to identify performance in fund management, and hence reward it. When a manager obtains good returns, it could often be because he was just lucky; when a manager obtains bad returns, it could often be because he was unlucky. Discerning "results" in hiring a fund manager is extremely hard.
Consider a situation where a pension fund committee selects an active fund manager:
- This poor signal-to-noise ratio reduces the ability of the committee to identify the manager with the best ability. When ability is hard to measure in a transparent fashion, there is a greater role for a variety of unrelated criteria, such as political lobbying, corruption, pedigree, size, etc. in the selection process.
- Once a manager is chosen, suppose the returns prove to be below the index at a future date. The pension fund committee would then be vulnerable to accusations of having chosen the wrong fund manager. This factor also generates a bias towards hiring fund managers who fare well on signals such as pedigree, size, etc.; this helps the committee in producing a plausible defence in the future.
What all this means is that hiring and appropriately motivating an active manager is extremely hard. You can't hire a fund manager who has produced good returns in the last two or three years; he might just be lucky, and vice versa. A simple "results orientation" is misplaced when dealing with the degree of volatility of financial markets. This volatility serves as a cover for managers to hide many activities which are inimical to the interests of investors.
Is there a way out? Index funds are an investment strategy with clear accountability and minimal governance problems. The index fund manager is under severe pressure: he has to replicate the returns of a publicly observed benchmark. If Nifty moves by +7.13%, the index fund manager has to obtain exactly +7.13%. The resources and trading activities of the fund are not available to the fund manager for other purposes. The "tracking error", which is the extent to which the fund NAV moves differently from Nifty, is a simple check through which the investor can ensure that the fund manager is working in his interests.
A standard argument that is given for index funds is that it is hard to obtain better returns than the market index. The long-run average rate of return on Nifty has been around 18.5%, and Nifty Junior has doubled since 1995. It is hard to compete with these numbers. However, an equally important argument which drives the "flight to indexing" is the difficulty of inducing fund managers to work in the interests of investors. These difficulties are present everywhere in the world, and are particularly important given the poor law enforcement in India. There is a way out, which we should exploit as investors and for India's pension reforms: it is index funds.
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