Agency risk at the fund level … and happy holidays!

If this is a time of year for reflection on a personal level, perhaps with some plans for self-improvement over the next year, whether it be more time with the family, get fit, etc, then it may also be a good time to consider the human element in the management of a fiduciary fund.

Despite the best intentions, the trustee role and inhouse management of other people’s money involves agency risk which is as significant as the risks involved in outsourcing various parts of a fund’s investments and administration. It’s counter-party risk as much as is dealing with an investment bank on a swap.

Like it or not, investment professionals who work for pension funds are as susceptible as everyone else to the human foibles we carry through our lives, even though they can put their hand on heart and say they are working solely in the members’ (investors’) best interests.

The two big foibles, to the extent that they are overdone, are these: confidence and security. With the advent of behavioural finance many studies have looked at the impact of common psychological biases on investment patterns. If you throw agency risk into the mix, the end investor not only has his or her own demons to contend with, but also someone else’s and that other person doesn’t even have exactly the same issues in common.

Over confidence is well documented. Everyone knows of the research that says 80-90 per cent of people think that they are better-than-average car drivers. In portfolio managers, this leads to bigger bets and hanging on to stocks for too long. For fiduciaries, this leads to excessive insourcing of decisions even when the required skill-set is not available inhouse. How hard can it be?

Risk aversion, on the other hand, is all about missed opportunities. When faced with the same odds of gain or loss people will most often choose to avoid the loss. There are lots of nuances involved in people’s attitudes to probabilities, though. For instance, you are more likely to take a chance with money you have won or been gifted than money you have worked for.

Risk aversion is probably the bigger problem for fiduciaries because they are merely agents of the end investor. Even if they have a more cavalier approach to the money than the actual beneficiary has, they have the additional concern of losing their jobs if they underperform consistently.

A lot of attention has been focused on the agency risk of counter-parties, fund managers and other service providers during and following the financial crisis. Not much attention, however, seems to be paid of the agency risks associated with trustee boards and fund staff.

What can a board do to avoid problems of group think, peer group shadowing and the sense of entitlement to the position that some board members may exhibit? Are they truly governing in the interests of plan sponsor or, in the increasingly DC world, the member?

Are staff incentivised such that their interests are aligned with the members? Are they too focused on the more-measurable costs side of the ledger than on returns? Are they doing too much with too-few resources?

If you’re in the habit of making New Year’s resolutions, this year forget the ‘get fit’ campaign. You need a whole lifestyle change for that to work indefinitely. Instead, take a look at your role in the fiduciary process and how you can combat some of the built-in biases which may be inhibiting someone else’s retirement incomes.

*Greg Bright is publisher of conexust1f.flywheelstaging.com

This column will return on January 12, 2011.