Key Points

  • The cumulative pressures of overseeing someone else’s money creates what economists call the “principal–agent problem”: the principal relies on the agent to make decisions on their behalf when the agent’s best interests may run counter to those of the principal.
  • Agents often have an incentive to choose portfolio allocations designed to minimize their risk of being fired at an all-too-common three-year evaluation horizon, over which both robust strategies and “the best” managers can experience prolonged bouts of underperformance.
  • A remedy for the principal–agent problem is to better align incentives by adopting longer evaluation periods, combining multiple robust strategies, using non-robust strategies consciously, and practicing transparent management by individual style performance.


It may not be my money, but it is my job.
Charles Ellis in Investment Policy: How to Win the Loser’s Game

Such is how Charley Ellis describes the delicate balancing act facing agents—CIOs, pension sponsors, and consultants—tasked with managing large pools of long-term fiduciary assets. Charley should know. He started the investment management consultancy Greenwich Associates in 1972, chaired the Yale Endowment Investment Committee for nine years, and served on the boards of Vanguard and CFA Institute. In describing the paradox of long-term pools of capital being managed with a very short-term focus, he elaborated on the struggle faced by investment decision makers due to this misalignment:

We should recognize those who are ‘at the controls’ are usually only representatives of an organization and subject to after-the-fact criticism by powerful Monday-morning quarterbacks. These representatives have clear economic incentives to protect their careers.…[T]hey will seek the most acceptable near-term balance between desires for superior returns and avoidance of unusual or unorthodox positions.  And above all, they will avoid any unnecessary risk to their own careers  (Ellis, 1985, p. 27).

These incentives create what economists call the “principal–agent problem”: the principal is relying on the agent to make decisions on their behalf when the agent often has an incentive to act in alignment with his or her own best interests, which may run counter to the best interests of the principal.

Such a misalignment appears to be evident in the substantial amount of assets allocated to an investment style—the growth style of equity investing—found by a large body of the financial literature not to produce robust returns. Why is this nonperforming style so popular? With a stylized example, we show how agency problems could lead an agent to rationally invest in non-robust strategies—those that do not deliver robust long-term excess returns—hence, not in the best interests of their principals.

Investment Options: Factors and Felines
We highlight the principal–agent problem in delegated asset management with a highly stylized example and demonstrate how agency problems might lead a plan sponsor or CIO (henceforth, “the agent”) to rationally invest in strategies1—including non-robust strategies—that are not in the best interest of principals.

Suppose an agent has the mandate to equally weight investments across eight individual equity funds and is restricted to long-only positions. What should the agent invest in?

We define a set of investments to include eight long-only value strategies, four momentum strategies, four quality strategies, and eight growth strategies. The variations of each strategy are formed on different signals to mimic variations across managers within the given investment style. We select four of the myriad quality definitions, all having an average return close to zero; these signals of quality have recently become popular even though they have not been convincingly demonstrated to be robust sources of long-run return. The growth strategies are the opposite of value and are supposed to underperform the benchmark over the long run.

Over the period 1967–2016, the value-add of the value strategies compared to a capitalization-weighted benchmark ranges from 2.25% (earnings to price) to 0.85% (dividends to price); momentum strategies from 1.77% (2-12 month) to 0.08% (2-6 month); quality strategies from 0.20% (book leverage) to ?0.35% (gross margins); and growth strategies from ?0.85% (assets to price) to ?1.62% (earnings to price).

We also add to the roster of investment strategies an intentionally absurd option. In 2012 a ginger Tabby cat from England named Orlando outperformed a panel of stock-picking experts by throwing a toy mouse on a grid representing the companies in the FTSE All-Share Index (King, 2013). We simulate Orlando’s performance by generating four random portfolios with zero expected return and with tracking error identical to the four quality strategies. By design, Orlando’s value-add is very close to zero.The Investment Options
A naïve investing approach would equally allocate across the eight strategies in our set of investment options that have the largest average value-add (assuming past is prologue). Most sophisticated agents realize, however, the important benefits (for themselves and for investors) of diversifying across funds with low or even negative correlations. The average correlations of the value-add between the style portfolios formed by equally weighting across each style’s strategy variations are:

Value has a well-known negative correlation to both momentum and quality, in this case ?0.38 and ?0.40, respectively. Growth—the opposite of value by construction—is almost perfectly negatively correlated with value, while quality and momentum have little correlation with each other, and unsurprisingly, the four Orlandos are basically uncorrelated with the other four strategies.To illustrate the investment allocation an agent might choose, given these correlations, we create five different allocations constructed by equally weighting across the strategies within a style as indicated by X and summarized in the following table:

The five allocations form three groups. The first group, composed of Value and Value/Momentum, invests in known robust factors. The second group, composed of Value/Momentum/Quality and Value/Momentum/Four Orlandos, invests in a mix of robust and non-robust factors. The third group, the Traditional Style Box, allocates equally between the robust value strategies and their opposite, non-robust growth strategies.You’re Fired!
Both robust strategies and “the best” managers can experience prolonged bouts of underperformance, well beyond the standard “long-term” performance measurement horizons of three-to-five years.2  The agent therefore has an incentive to choose an investment allocation designed to minimize their risk of being fired over these three- to five-year stretches.We select two highly stylized rules for a hypothetical investment board to use in evaluating the agent’s performance:

1) Fire the agent if more than 50% of funds selected by the agent underperform the benchmark in a given period.

2) Fire the agent if the

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