Real incentives driving portfolio managers

(MONEY Magazine) -- The recent financial crisis is partly the result of something economists call the "agency" problem. Put simply, the people you hire to take care of your money -- your agents -- almost always have their own agendas.

For example, from your vantage point, the risks Wall Street banks took during the credit bubble may seem moon-bat crazy. But for a lot of top executives, the gamble was disturbingly rational. If their bet paid off, the result was a multimillion-dollar bonus. If it didn't, the result was a multimillion-dollar retirement package. Who wouldn't buy a lottery ticket with those stakes?

If you invest in mutual funds, you must always be mindful of agency problems -- though the consequences can be more subtle.

Think you're paying that steep management fee for your fund manager's bold insights into opportunities others can't see? Research out of Yale shows that a third of investors' assets are in funds whose holdings are statistically similar to index funds.

That may be because managers who stick out risk being fired. Economists Judith Chevalier and Glenn Ellison have found that younger managers, with less job security, tend to follow the herd. For pros, as John Maynard Keynes observed, "it is better to fail conventionally."

But sometimes managers can be pushed to gamble more than you'd like. Funds that show up at the top of performance rankings tend to draw in the most assets -- and thus the most fees. "But the losers don't lose assets in a disproportionate way," says University of Texas economist Keith Brown.

In other words, a fund isn't punished for ranking 21st rather than, say, 15th. So if you're headed for 15th, why not roll the dice and try to come in first? A study co-authored by Brown found that funds that did poorly early in the year tend to increase their risk (relative to the winners) in the following months.

Fund companies rely more and more these days on their 401(k) business, which raises new agency issues. A study in the Journal of Finance found that fund companies hired to be 401(k) trustees tend to overweight the client firm's stock. That suggests a conflict of interest, says co-author Lauren Cohen of Harvard University. Money managers shouldn't use retirees' assets as a tool to attract business.

Then there are target-date funds, the default choice in many 401(k)s. They offer a premixed collection of stock and bond mutual funds. Many who own these "set-it-and-forget-it" portfolios do just that.

"If there is little monitoring, then the incentive is there for manipulation," warns Vallapuzha Sandhya, a doctoral student at Georgia State University who's studying target-date funds. For instance, target funds might tilt toward owning the higher-cost funds in their own family.

So how do you avoid these risks? Index funds have few if any agency problems. And managers who trade less or have a long record of sticking to the same style may be more likely to put long-term performance first.

As for target funds, they can be a decent option, but you could easily build a similarly diversified portfolio with a few index funds yourself. And there's no one you can trust more than you.