The Cost of Reputation

Or, more accurately, the cost of caring about your reputation.

My recent article on Risk Management for Beginners closed with some unrigorous speculation about the peculiar incentives of fund managers, who are consistently well compensated in decent and good years and, in bad years, lose their clients’ money and move on to start a new fund. Steven Malliaris and Hongjun Yan have a paper on this topic entitled “Nickels Versus Black Swans:” “nickels” being the typical hedge fund strategy of making a small but consistent return with a small risk of a huge loss, and “black swans” being Taleb’s preferred strategy that makes a small but consistent loss with a small risk of a huge gain.

Simplifying the model, the problem with a black swan strategy is that by the time the huge gain rolls around, you the manager have already been fired (your clients have withdrawn their money) because of your consistent losses. The result is overinvestment in nickel strategies and underinvestment in black swan strategies – even when the latter have a higher expected return. This result holds even when you assume that the investors are sophisticated, because the key factor is the reputational concerns of the fund managers themselves.

Malliaris and Yan also show that the system can reach multiple equilibrium points: the system can be in one equilibrium where most hedge funds are pursuing suboptimal strategies, and then suddenly shift to another quickly, meaning that the hedge fund industry does not allocate capital as efficiently as one might imagine. This might help explain why (a) everyone is saying that AAA-rated mortgage-backed securities are underpriced yet (b) no one is buying them.

This paper might be seen as simply translating common sense into mathematics. Seen another way, though, it helps explain why individually rational behavior (by fund managers) does not produce the efficient outcomes you learn in first-year economics.

One response to “The Cost of Reputation

  1. Interestingly in the commodities trading market it looks like Red Sox Owner John Henry (who owns and operates a commodities/futures trading firm) was basically using a black swan strategy for the last couple years because he didn’t think the price rises in commodities were real. Turns out he was right but by the time he made up the difference (and more) over the second half of this year his firm was only managing a quarter the amount of money it was five years ago. http://www.cnbc.com/id/28507143