A troublesome result of the financial crisis has been a serious breakdown in trust between society at large and capital market agents. In the latest of a monthly series, Rodney Sullivan discusses opportunities for serious investment professionals to position themselves and their companies as true governance leaders.


What role has governance
played in the financial crisis?

The current crisis can be best understood as a crisis of governance rather than an inherent failure of markets or capitalism itself. A sound governance culture addresses a myriad of issues, including conflicts of interest, risk management, and fiduciary duty.

For example, investors typically seek to satisfy predetermined and contingent obligations with their funds. Although most serious investment professionals put their clients’ interests first, some may have incentives that misalign their interests from those of clients.


Haven’t these conflicts
existed for some time?

Yes. However, the costs associated with these misaligned interests are exacerbated by exceedingly high or opaque fee structures and product proliferation in our increasingly complex world. Moreover, a culture of “short-termism” often ignores conflicts in pursuit of short-term gain.


How can companies better position themselves as true leaders in governance?

Compensation structures that align the goals of investors and their managers in a straightforward manner can help align incentives thereby reducing agency conflicts. For example, management fees might be tied to long-term performance rather than assets under management. A portion of incentive compensation could be held in an escrow account until the manager demonstrates true skill.

This compensation mechanism conveys to clients that the manager will focus attention on value added on behalf of their investors rather than asset gathering to the point of distraction. In a sense, this structure manages the risk associated with agency.


Has the crisis affected our understanding of risk?

Yes, I believe so. We now understand that risk management is not about measurement at all but rather about the quality of the decisions we make in the face of uncertainty. Investment managers can further distinguish themselves by meaningful discussions of risks that they and their clients are taking to include their risk management decision processes.

How should fund managers
adapt their thinking about risk?

The globalisation of finance means that markets will remain volatile and will likely not transition smoothly from one environment to another in the near future. As a consequence, portfolio construction should evolve to accommodate a wider array of possible outcomes. Despite claims to the contrary, diversification – not concentration – should be our portfolio foundation.

Diversification might be complemented by contingent claim strategies that reflect the harsh reality of rapid market adjustments. Thus, diversification and risk hedging might be partnered to form a more holistic approach to global portfolio construction. This means parsing and hedging of investment results across time, conditions, and preferences – a process that will go far towards helping to secure positive outcomes in our “anything can happen” capital markets.


How does increased risk-awareness affect the use of financial models?
A true risk-aware culture appreciates that models have limits and merely represent a view of the world. They contain errors. They interpolate and extrapolate the world; but by no means do they offer the correct interpretation of reality. Useful risk models reflect global economic outcomes relevant to the risks of the portfolio, not merely goldilocks conditions.

Therefore, a reliable risk process identifies specific exposures to risk (including model limitations) and provides for continuous measurement, including concentrations and correlations,
of these exposures.


What is the importance of fiduciary duty in preventing financial crises?

The high standards of trust imposed by fiduciary duty have a long history, with roots in English common law. Investment professionals have not only an ethical responsibility but also a fiduciary duty to those whose assets have been entrusted to their care.

An investor must be able to trust that his or her fiduciary is making beneficial, not harmful, decisions. A fiduciary is thus required to act at all times for the sole benefit and interests of the beneficiary and must have primary loyalty to those interests. Investors’ interests always come first.


Is this a viable business model?

Firms that lead with sound governance structures not only restore trust and integrity in financial markets but also distinguish themselves professionally, which, in the end, is good for business.


Rodney Sullivan, CFA, is head of publications at CFA Institute

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