When Warren Buffett invested in Goldman Sachs Group at the height of the financial crisis, he took a calculated risk that the company would survive the subprime mortgage crisis and avoid the fate of one of its rivals, Lehman Brothers Holdings. Whereas there was substantial risk to the Goldman trade, Buffett saw the opportunity to buy a chunk of the storied investment bank for a bargain price, because at the time few others would touch it. Five years on, Goldman is still here, Buffett’s trade proved to be a winning one, and the Berkshire Hathaway chairman continues to hold one of the longest track records of beating the market.
Most investors, however, fail to beat the market — not because they aren’t as brilliant in assessing investments as Buffett is (which may also be true), but because they fear putting their careers at risk if things don’t work out as they expect. In fact, playing it safe — driven by investors’ fear of putting their careers on the line — may be one of the biggest enemies of alpha, or risk-adjusted returns above a market benchmark.
That’s what State Street Corp.’s Boston-based Center for Applied Research found as part of a larger study about the factors that drive institutional investment decisions. The majority of the 200 investors interviewed — including endowments, foundations, pensions and sovereign wealth funds — say that the largest determinant in their decision-making process is career risk.
Suzanne Duncan, the center’s global head of research, defines career risk as “investment professionals’ fear of losing their jobs, fear of not getting promotions or not being compensated fairly,” but she says it can also include a portfolio manager’s, chief investment officer’s or trustee’s desire to ultimately find a job with a hedge fund or a private equity firm or build relationships with these investors. The professionals might want to hire a certain fund to open new career doors, or they may be late in firing a manager for similar reasons. Duncan emphasizes that investors’ desire to protect their careers is not always a conscious decision. “It’s often an unconscious drive we all have, to protect our situations or improve our situations,” she says.
The findings are just part of the center’s larger study, called “The Influential Investor,” which also found that investors are adopting alternative investments at a rate that exceeds their ability to understand these investments’ complex risks. They are also part of Duncan’s thinking about why it has become more difficult to find alpha. A joint paper from the Center for Applied Research and the Fletcher School of Law and Diplomacy at Tufts University found that fewer than 1 percent of 2,076 U.S. mutual funds tracked between 1976 and 2006 achieved superior returns after costs. A working paper from the University of Maryland reports that before 1990, 14.4 percent of equity mutual funds delivered alpha, whereas in 2006 only 0.6 percent did so.
There are many reasons behind the decline in alpha, including increased competition, advanced technology and a changing regulatory environment. But the old-fashioned phenomenon of career risk fear — a behavioral quirk — also appears to play a big role in shrinking outperformance, just when large institutional investors are facing expanding liabilities and the prospect of shrinking market returns.
Duncan cautions that the concept of career risk is nuanced and surfaces only during broader questions about how investors determine policies on everything from asset allocation to selecting managers. Certainly, few investors readily admit to being cautious or opportunistic at the expense of alpha. But Duncan emphasizes that career risk points to just how hard it is to make truly independent decisions when it comes to investing. “It takes a lot of courage to go against the herd,” she says. “There’s so much written by academics about the behavior of retail investors. But we found that there are very similar behavioral biases that exist on the institutional side.”
As an example of the career risk syndrome, Duncan says, investment professionals don’t get fired for adding the hottest asset class, because “everyone ends up in the same quagmire” when a category like high-yield bonds takes a turn for the worse. Duncan has seen instances of institutional investors in developing economies that stated their lack of faith in active management, even when their own asset allocations included a majority of active managers. When questioned further, she found that in part those managers wanted to support local employment in their country. Active managers employ more people than passive managers do. In essence, they were protecting their jobs.
Benchmark hugging is one result of professional investors worrying about career risk. Benchmark hugging occurs when managers populate their mutual funds and other active portfolios with securities at similar proportions to the benchmark against which they are being measured. Managers may then overweight or underweight a specific sector or stock, but they aren’t bringing many new ideas to the portfolio.
“We’re human beings,” says David Daglio, lead portfolio manager of U.S. opportunistic value strategies at the Boston Company Asset Management. “As human beings, we don’t like risk. Given the choice between the potential of winning $1,000 and the sure thing of $400, most people will take the $400.”
Institutional investors can use a measure called active share to identify benchmark huggers. Created by finance professors Martijn Cremers of the University of Notre Dame and Antti Petajisto of the Yale School of Management (now a researcher and portfolio manager at BlackRock), active share represents the percentage of a portfolio’s holdings that differs from the benchmark index’s holdings. “Investors who take higher active share and do that with a modicum of risk management tend to outperform according to academic analysis,” Daglio says. “In my mind, it’s all about understanding where your skill set or edge is and taking risk in that area and reducing all other risk.” The Opportunistic Value funds that Daglio manages at The Boston Company have active share above 90 percent.
Daglio says that to take the right risks, investment firms have to recruit people who have demonstrated that they can persevere through periods when things don’t play out as expected. Investors, for their part, can help protect against career risk by focusing on a manager’s investment process, which lays out a road map to the manager’s decision making. “Money management is tricky,” says Michael Mauboussin, head of global financial strategies at Credit Suisse. “In the short term, there is a big dose of luck in determining outcomes. But the answer is to emphasize process.”
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