Conflict of interest for fund managers

ANALYSTS are having a bad time. Their past recommendations look woeful, as the prices of their favoured shares have collapsed. This was not just bad luck. Many of their arguments were intellectually worthless and their motivation was distorted by conflicts of interest.

As the bear market continues, investors lose hope of recovering their losses. They seek to assuage their pain by blaming others. Fund managers are the next in line and they also have a major problem. Their interests and those of their clients can be in stark contrast.

In March 2000, the US stock market was priced at nearly three times the net value of the underlying assets. Nonetheless the probability of share prices falling over the next 12 months was about only 70%, though this rose to about 90% over five years.

Investors who understood this had an easy decision. If they were looking after their own money, the message was clear. Holding shares was silly. For fund managers, the situation was very different. If they looked after the interests of their clients and went liquid, they had a 30% chance of being wrong for the next year. This could easily have cost them their jobs and ruined their businesses.

There was, therefore, a huge conflict between the interests of the fund management businesses and the interests of the clients. Probably the only practical solution to this dilemma is for investors to have a better understanding of how the stock market works. In particular they need to learn two things. One is how to value the stock market and the other is not to judge fund managers on a one-year basis.

Many things, however, conspire to keep investors in ignorance. One reason is that conflicts of interest are very uncomfortable things. It requires moral and intellectual courage for investment managers to face the fact that their duty to look after their clients' interests can conflict with the practical need to look after their own.

Faced with uncomfortable facts, a common human response is denial. Fund managers have spent much of the past few years demonstrating that they are human. Denial has been rife, with many fund managers choosing to deny that the stock market was overvalued, even at its peak. This past behaviour is now a source of discomfort, so there is a strong inclination to deny the denial.

Because fund managers didn't want to believe that share prices had gone crazy, there was a ready audience for those who claimed that they hadn't. Since sensible reasons were not available, there was a bull market in silly ones.

Two pieces of nonsense were particularly in evidence. One was a claim that shares became more valuable if bond yields fell. The second was that this also occurred if productivity improved.

Neither of these claims has any justification, either in theory or in practice, but those who put them forward were popular with fund managers. Meanwhile, sound analysis was the short way to the dole queue.