Investment Management: Mis-Incentivisation leading to suboptimal bets

Ever since money was created in human civilization, a significant challenge faced by each individual is management of his finance. Intuition would tell us that the investor would be acutely aware of the risk he is undertaking in the hunt of returns. However, the evidence is to the contrary.

Investment managers are specialised in making prudent investments on behalf of their investors. Asset management companies (AMC) employ investment managers and charge their clientele a fixed percentage as fees on their assets under management(AUM). What has to be noted is the revenue of an asset management company is directly proportionate to the size of its AUM. Hence, the internal objective of any AMC is to maximize its AUM. The portfolio managers (PM) are employees of the AMC who maintain portfolio of assets by investing the clients' money. Hence, as a corollary, the PM is also incentivised to maximise the AUM of his portfolios and not returns.

Now, the AUM is a function of multiple things. Our research suggests that investors are more likely to invest in AMCs/ portfolios, which have provided better than average returns in the short term. Other qualitative factors that affect the choice of AMC are the relationship with the wealth manager, perceived brands, and marketing efforts of the AMC.

However,our research suggests that there is no correlation between the risk based ranking of a portfolio and it's AUM. This ignorance of risk needs to be brought to the attention of investors as it could adversely impact their interest, when the tide turns.

How an Investment management company makes revenue: An investment management company earns revenue based on a percentage fees it charges on its assets under management (AUM). Hence, an investment management company stands to make revenues regardless of whether the company generates wealth or alpha for its customers (the unit holders) or not.

How Investment managers are compensated: An investment manager is a subset of the investment management company and hence is evaluated in line with the overall performance of his employer. Whilst an investment manager is compensated on the basis of the magnitude of returns or alpha that he generates over and above his benchmark, closer examination reveals that the underlying risk assumed to generate the returns is completely ignored.

Sharpe and Treynor ratios confined to textbooks: Academics have long endorsed the use of Sharpe and Treynor ratios, to compute the risk adjusted return index for evaluating investment schemes. However, our discussions suggest that most HNIs (High Net worth Individuals) make their investment decisions based on past performance (alpha). Our view is further endorsed by a scan at the many portals that compare investment schemes purely on AUM, entry and exit loads and total return generated over various timeframes.   
 
In the portals that we scanned, we found CRISIL ranking provided for all portfolios. This ranking is based on the various risks a portfolio manager has undertaken to generate the alpha. Such as liquidity, volatility, quality, etc.
What this article seeks to achieve: Common sense of the financially engineered brain would suggest that any investor while choosing the portfolio should look at the risk and the reward. This article seeks to decode whether todays investor is prudent in his investment decisions.

We primarily rely on secondary data to check if any co relation exists between the CRISILranking (representing risk) of a portfolio and its AUM (rs in crores). Our primary data collection is limited to discussion that we had with several wealth managers, portfolio managers, and High net worth individuals (HNIs).

As can be seen in the exhibit, on default settings, the portal gives details like past performance, CRISIL ranking and AUM of various mutual fund portfolios. We have deliberately chosen large cap equity portfolios as the risk matrix of each these portfolios can vary significantly, unlike the case in debt portfolios.

Primary data results:

The summary of our discussions with wealth managers is that they suggest investment schemes to their clientele based on the perceived brand of the AMC, the recent track record of the portfolio manager and of course their commission percentage.

Our discussion with portfolio manager suggest that their overall appraisal by the AMC is done based on quantitative targets like alpha generated over and above the benchmark as their portfolio and its AUM. For instance, a portfolio manager with a 2 per cent alpha on Rs100 crore AUM may be compensated at a similar level as a portfolio manager with a 10 per cent alpha on Rs 20 crore AUM. However, during appraisal these PMs are not questioned about the risk they undertook to generate the alpha, be it 2 per cent or 10 per cent.

Our discussion with HNI's suggests that their primary selection criterion is the amount of trust that the wealth manager commands. Other secondary criteria are transaction costs of the portfolio, recent return track record and brand of the AMC.

Hence in conclusion, the amount of AUM in any given portfolio would be a composite function of the repute of the wealth managers recommending it, recent performance, perceived brand of the AMC/PM and/or fee structure. Please note that the word "risk" did not escape the mouth of all the three parties involved.

Secondary Data:

We select top 10 large cap equity portfolios by AUM from the above mentioned portal. We run regression between the AUM (rscrores) and CRISIL ranking (absolute number, 1-5, rank 1 indicates lowest risk). Ideally, if risk was a significant variable in the decision making process of the average investor, then the co relation between risk and AUM would be negative, coefficient of determination would be on the higher side (closer to 1) and regression coefficient (beta) would be negative and statistically significant (p value of less than .05, t stat of greater than 2).  

As can be seen in the exhibit above, the correlation is 0.04 and coefficient of determination is less than 1 per cent implying that the CRISIL ranking explains less than 1 per cent of the variability in AUMs of the selected portfolios. Moreover, the regression statistics like beta is statistically insignificant.

The exhibit below maps the average returns of the top 10 portfolios by AUM and compares it to the top 10 portfolios by CRISIL ranking. The average CRISIL ranking of the former dataset is 2.8 compared to 1.6 of the latter; Implying that the former entails significantly higher risk than the latter.

The exhibit above clearly summarizes that returns in the near term on portfolios with higher AUM is superior to returns from the portfolios with lower risk. However, interestingly on a 1-5 year horizon, the lower risk portfolios have outperformed their riskier and larger counterparts.

In summary…

Hence, we conclude that the investor under appreciates risk while making investment decisions, and perhaps gives significant weightage to the near term performance of the fund/ portfolio.

Key issues with the financial services industry - the big picture

Naive investors are left with a disclaimer in fine print

We have all read the disclaimer that mutual funds are subject to market risk. However, this article clearly goes to show that investors do not understand the extent of the risk they undertake. Further, investors are more drawn by near term performance rather than understanding the risk adjusted return generated by a given fund.

Everyone for himself - the industry is serving its own interests

It is no secret that everyman is loyal to his purpose foremost. This theory has been the foundation of designing compensation packages across corporate and is even used by parents in daily life, when they bribe their child in order to incentivise him/her to do what is right for them.

Mis-incentivisation leading to riskier bets

We observe that today asset managers are increasingly assuming higher risk to generate higher returns. The incentives of the financial services community are aligned in a manner that encourages such behaviour.

The average financial services employee (an asset manager in the context of this article) is still appraised based on the revenue he generates for his employer regardless of the risk he undertakes to do the same.
Can we change this?

We recommend…

 

• AMCs start appraising PMs as per the risk adjusted returns (Sharpe and Treynor ratios) generated by the PM and not just merely AUMs and Alpha.
• Investors to be educated by SEBI and other agencies to understand the basis of risk based rankings like the one provided by CRISIL and the importance of taking such a variable in to account while making investment decisions.
• Wealth managers be regulated and trained by SEBI so that they don't mis-sell products where their incentives are higher. The lack of accountability for these wealth managers is a core reason for the mis-selling that occurs in financial instruments.

(The writer is a visiting faculty, Thakur College of Commerce and freelance consultant advising financial services companies on various aspects of marketing and incentives)