The Principal-Agent Problem is an issue in a number of industries. It is an enormous issue for the fund management industry.
The Wikipedia description linked above is well worth reading for anyone unfamiliar with the concept. It can be summarised as arising when someone is appointed to act on another’s behalf, but instead acts in their own interest.
Because the sums of money in the fund management industry can be very substantial, there are a number of ways the Principal-Agent problem can manifest.
One thing that caused me to think on this issue was this Twitter thread and others related to the same matter, read it and draw your own conclusions.
The issue where returns misrepresented is obvious; people invest with a false sense of the managers abilities. There is the prospect the returns will be much worse than those represented, or possibly that there is a straight fraud in place. Neither situation is one you want to find yourself in.
Another issue of relatively modest size that is peculiar to Australia as I pointed out to a fellow fund manager via email this week is the preponderance of managers counting franking credits as part of their results, but using an unfranked index. Given the high level of dividend payment in Australia, this gives such fund managers a roughly 1.5% head start each year. This was acceptable to some degree before there were suitable indices that included franking, but they’ve been around for a couple of years now and there hasn’t exactly been a wholesale shift towards using them (as EGP does).
But more than this problem, in terms of the total scale of the amount of money lost by investors, there are two far greater issues in the fund management industry.
The first arises when a new fund raises a large amount of money, say $1 billion. They charge a 1% management fee, meaning they will generate $10 million per annum in fees. Now there is certain infrastructure required to operate such a fund, some office space and a few staff etc. The Principal-Agent Problem in this situation often manifests via a quasi-index fund behaviour by the manager, they will tightly hug the index and make no meaningful effort to beat the benchmark, trying often only to generate enough alpha to cover most of the management fees and costs, if any. This problem we have attempted to solve by having no underlying management fee. If we don’t deliver on what we say we can deliver, we earn nothing. I suspect the fund management industry will drift in this direction over time as ETF’s force it and investors demand it.
The second very big problem created by the Principal-Agent Problem is where a fund manager has next to no investment in their own fund. This can lead to a fund manager being tempted to ‘Shoot the Moon’. This customarily involves taking an undue amount of risk in a situation where the potential payoff is high. Because the Agent has very little of their own wealth at risk in the fund, the potential payoff from the ‘moon-shot’ makes them behave in a way they wouldn’t with their own money. If the risk pays off, they earn a very large performance fee. If it doesn’t, well, not their money, not their problem. At EGP we have solved this issue as best we can by the largest Agent also being the Principal, my Wife and I have our entire net worth outside of the family home in the fund, as do our children.
As a bonus consideration, unrelated to the Principal-Agent Problem, you should consider this – at larger fund managers, the person who built the record you think you are investing in may not be the fund manager running the fund today (if you’re not sure, be sure to ask!). If I sold EGP and retired tomorrow (don’t worry, as I’ve said before – from my cold, dead hand…), any new investor may think they were buying into a fund that on average had beaten their benchmark by over 10% annualised for years. But whoever won the role of managing the fund would not have earned that record. They may be very good, but that’s not what you were investing in.
When you’re deciding where to invest your money under professional management the aforementioned things should be at the forefront of your thinking.
The September Report is linked here, enjoy your long weekend – Tony Hansen 30/09/2016
|
|
Apr 1st 2011 |
Jun 30th 2016 |
Current Price |
Since July 1st 2016 |
Since Inception |
Annualised |
|
EGP Fund No. 1 |
1.00000 |
1.70130 |
2.01743*1 |
18.58%*1 |
149.23%*2 |
18.06%*2 |
|
37333.23 |
52006.69 |
55545.34 |
6.80% |
48.78% |
7.49% |
*1 after a 31 May 2013 dividend of 2.333 cents per share (cps) plus 1.000 cps Franking Credit, a 31 May 2014 Dividend of 7.000 cps plus 3.000 cps Franking Credit and a 31 May 2015 Dividend of 8.6667 cps plus 3.7143 cps Franking Credit and a 31 May 2016 Dividend of 6.0000 cps plus a 2.5714 cps Franking Credit
*2 calculated based on dividends reinvested
