Career risk trumps investment risk

As someone who has worked most of his career on the buy side, I know that career risk is real and overrides many investment considerations. But measuring how fund managers deal with career risk can be tricky, since public investment funds are subject to a lot of confounding factors. This is why I find the results of an analysis of separately managed accounts (SMA) in Italy fascinating.

I am always a bit sceptical when I read a sentence like this in the abstract of a paper: “Using a hand-collected dataset of Italian occupational pension funds over the period 2003–2023…” but let’s be honest. There is no other way to gain access to the data on SMAs since they are, by their very nature, private information.

What makes SMAs such a great testing ground for career risk, though, is that it is a very simple relationship. One fund manager has one client (the pension fund) and a clear objective to run the portfolio in a specific manner. This allowed Lucia Spotorno and Giacomo Nocero to isolate the driver behind decisions of a pension fund to replace a fund manager with another one or terminate the SMA altogether.

As you may have guessed, the key driver for the termination decision was the performance of the fund manager vs the benchmark. Underperformance vs the benchmark significantly and quickly increased the probability of being terminated by the pension fund. Unfortunately, though, outperformance vs the benchmark did not reduce the probability of being fired. The deal the pension fund offers with an SMA literally is ‘heads, I win, tails, you lose.’

Probability of being terminated and relative performance

So, how are fund managers dealing with career risk? Unfortunately, just as you might expect:

• Fund managers focus much more on preventing downside risks, which means their portfolio beta drops below 1.0 so that in a bear market they lose less than the benchmark.
• Fund managers also reduce their active risk in order not to deviate too much from the benchmark performance. Of course, this means that pension funds then pay active fees for semi-active portfolios.
• This behaviour is even more pronounced if the same mandate is split between different fund managers because fund managers know they are much easier to replace if another fund manager can just take on their portfolio without much friction.
• Performance fees do nothing to change fund manager behaviour because performance fees are uncertain, and career risk dominates. As a result, performance fees tend to be only a small fraction of the total fees paid to managers because they tend to run SMAs with a lower degree of activity and more defensively than the market.