The circle initially starts with a decent premise — “a good business, run by competent management, is a good investment, if it is offered at a decent price”. In years where there is a flight to safety, it’s indeed a great investment strategy. Many active fund managers start buying into the theme. More people believing in this theory results in higher market capitalisation, which in turn leads to inclusion in several indices tracked by large passive funds.
Now passive funds
command a larger share of incremental investments and their investment catapults the stock even higher. So far so good. The problem starts when active fund managers daftly tweak their investment strategy ever so slightly to “a good business, run by a competitive management, is a good investment at any price .”
This modified investment strategy seems to be in vogue these days. The problem is, historical evidence is completely to the contrary. If one compares the rolling 10-years’ returns (for the past seven years) of BSE Sensex, BSE Midcap
and BSE Smallcap, the difference in annualised returns is under two percentage points, which essentially implies that the returns mean revert. A large underperformance of one index is made good over the long term; the only debate is, when.
And yet, many asset management companies choose to launch new funds based on an investment strategy that is “in vogue” and many asset managers choose to keep investing based on the strategy that has been profitable over the recent past. To some extent, the “recency bias” (one where a person easily remembers something that has happened recently compared to something that may have occurred a while ago) can be blamed for such behaviour.
To a great extent, however, I would pin the blame on the lack of investment mangers’ skin in the game. The way the investment industry is currently structured, the management company either gets a fixed fee for managing assets (regardless of investors generating a positive or negative return) or they get a carry (large upside if positive returns are generated, no downside in case of negative returns). This, to me, is tantamount to investors writing a free option to their investment managers, which in turn, promotes large scale risk-taking.
It brings back memories of the peak of the mid-cap mania as recently as in 2017. Investment managers kept adding small- and mid-cap companies to investors’ portfolios until those indices tanked in 2018, by which time, investors had lost half their investments and investment managers recorded “zero” fees for that particular year. Then comes a new investment style, and we begin all over again.
I believe, the solution to this problem is mandating investment managers to park a large part of their liquid equity investments in the funds they run. The idea behind skin in the game is primarily about symmetry — if you stand to gain from the upside, you should be compelled to pay for the downside as well. If people with fiduciary responsibilities (like a portfolio manager) had skin in the game, they would behave more rationally, rather than just going with the flow. Skin in the game makes boring activities less boring, like checking the safety door of the aircraft which is about to fly with you as a passenger.
Let me end it by quoting Taleb again: “If your private life conflicts with your intellectual opinion, it cancels your intellectual ideas, not your private life.” The next time you invest with a fund house do inquire if the portfolio manager’s skin is in the game.
The author is a co-founder of Buoyant Capital; tweets @BuoyantCap