Moral Hazard and Professional Asset Management

Moral hazard is a very important concept in information economics and game theory. It refers to a situation in which the agent makes decisions about a project involving risk on behalf of the principal. Generally, the principal bears the costs while the agent does not. Agents act differently from how they would if they were fully responsible and exposed to the project’s risk. Agents may choose risky projects because this way they maximize their expected payoffs.

Moral hazard can be present in professional asset management for various reasons. The truth is that investment decisions are very complex and there are lot of information asymmetries as well. Investment managers (agents) use methods, models and data to make investment decisions that individual investors (principals) are not aware of. Very often, investment managers focus on short term results taking extreme risks, a situation that individual investors cannot identify. Investment managers focus on short term performance to maximize their bonuses and attract new clients.

Extreme risk taking can take the form of insufficient portfolio diversification, concentration to a limited number of asset classes or securities and extreme leverage. Investment managers form portfolios concentrated to those asset classes or securities that are likely to outperform the benchmark during a specified time period. In this case, investment managers expose client’s money to specific, idiosyncratic risks that otherwise could be diversified away easily. For example an asset manager may overweight high yield (junk) bonds or invest in companies with high bankruptcy risks. Moreover the asset manager could use margin or leveraged structured products. These strategies have high expected returns if the good scenario is realized but catastrophic consequences if the bad scenario is realized.

Extreme risk taking comes from the fact that bonuses and management fees depend on whether performance is better than a specified benchmark. Moreover, typical contracts do not assume any responsibilities for asset managers if anything goes bad. Thus, investment managers who manage billions of dollars have the incentive to outperform the benchmark as soon as possible to maximize their payoffs. A margin of 5% percent over the benchmark in a given year, is sufficient to secure investment managers’ financial independence for the rest of their lives.

Moral hazard risks are evident in the asset management industry. However do not think that the asset management industry is a scam or that moral hazard risk is everywhere. Most asset management firms have a long history in the business and employ mechanisms to limit risk taking. Risk management departments and individual whose bonuses do not depend on performance monitor portfolio management in a daily basis.