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Sunday, January 23, 2022

Investment managers should be covered by skin in the game rules

The Mirror recently reported that Boris Johnson, the UK Prime Minister, and his staff breached Covid rules by attending parties at 10 Downing Street (his official residence and executive office) in the run-up to Christmas in 2020 (1). When London was in the grip of a second lockdown, and tier-3 restrictions applied (which banned all indoor mixing except in household bubbles), top-ranking members of his team held festive bashes at Number 10 — 40 to 50 people were crammed into a medium-sized room. Yes, strict Covid rules applied to all of London but, reportedly, not to people who worked at 10 Downing Street.

Let us look at another incident. On January 24, 2020, the US Senate Committee on Health and Foreign Relations held a meeting with senators to brief them about the Covid-19 outbreak. Following the meeting, Senator Kelly Loeffler and her husband Jeffrey Sprecher sold stock worth $3.1 million. Senator David Perdue sold stocks worth $825,000 and bought stocks worth $1.8 million, including DuPont, a company that makes personal protective equipment, on the same day as the Senate briefing (2).

The Chairman of the Senate Intelligence Committee, Senator Burr, and his wife sold stock worth over $2.3 million on February 13, 2020, a week after having written an op-ed stating: “Luckily, we have a framework in place that has put us in a better position than any other country to respond to a public health threat like the coronavirus.” An investigation ensued, and on January 19, 2021, the Justice Department closed its investigation into Burr.

This is despite the existence of the STOCK Act, whose purpose is to increase transparency of the lawmaker’s trade. Insider trading investigation revealed that 49 members of Congress and 182 of the highest-paid Capitol Hill staffers were late in filing their stock trades during 2020 and 2021. Yet, no public records of who has violated the STOCK Act or has paid a fine (3) exist.

Now, compare this to the huge financial penalty (and at times, incarceration) imposed on the public at large for insider trading. Rules are strictly enforced, but not for those in charge of making the laws.

A similar undertone exists in the investment management industry as well. It is currently structured in a way where the asset management company (AMC) either gets a fixed fee for managing assets (regardless of investors’ returns), or a “carry” (large upside if returns cross the hurdle, and no downside if returns are negative). Investors essentially write a free option to their AMCs, which in turn, promote risk-taking at investors’ expense.

It happened at the peak of the small-cap cycle in 2017 when investment managers, fuelled by stellar two-year returns, kept adding illiquid small companies’ stocks to investors’ portfolios. Many of those businesses failed and suffered a large-scale drawdown in 2018. While investors lost half their investments, investment managers recorded “zero” fees for that year, only to give birth to a new investment style in 2019 and 2020 (buying only largecap stocks), and the story repeats in 2021.

In my opinion, there is a way to resolve this problem. Investment managers should be mandated to park their entire equity investments only in the funds that they manage — i.e., have a sizeable skin in the game (SITG). The idea behind SITG is primarily about symmetry — if you stand to gain from the upside, you should be forced to pay for the downside as well. If people with fiduciary responsibilities had SITG, they would behave more rationally, rather than just “going with the flow”. SITG makes boring activities less boring, like checking the safety door of an aircraft that is about to fly with you as a passenger or reading the fine print in annual reports while managing your money.

SITG also promotes results over perception. Investing is simple but not easy. But asset managers, to make it palatable to everyone, often reduce the investment process to bite-sized formulas that sound cool. This makes them sound intelligent and helps their AMCs garner large assets to manage. However, when the market cycle changes and these formulas stop working, the end investors pay the price, in the form of inferior returns, or loss of capital. If a large part of asset managers’ personal wealth is invested in the fund they run, they will have an incentive to produce durable results rather than coming up with theories that just build their personal brands. Do check if your portfolio manager chooses to invest his personal wealth in the fund where he has invested your money.

(The author, Jigar Mistry is co-founder of Buoyant Capital. Views are his own.)

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

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James Mackreides
'Mac' is a short tempered former helicopter pilot , now a writer based in Sofia, Bulgaria. Loves dogs, the outdoors and staying far away from the ocean.

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