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 Shares in the Japanese automaker have tumbled about 45 percent since
it admitted last week it falsified fuel economy data on several
models as employees tried to meet internal targets that the company
itself says may have been impossible.
The National Highway Traffic Safety Administration has asked
Mitsubishi for information on cars it sold in the U.S., opening the
possibility of wider repercussions.
While you cannot understand without measuring, you are kidding
yourself if you think measuring and target setting is the same as
control, a point investors have learned to their cost time after
time.
“Shareholders might consider again the uses of Goodhart’s law, which
predicts that measures become moribund as they become targets,”
Deutsche Bank analyst Sahil Mahtani wrote in a note to clients.
“Just ask the internet advertisers that covet digital ad clicks but
lost $7 billion last year paying excess fees for the two-fifths of
hits that were faked.”
Not to mention the very similar Volkswagen emissions debacle or, for
that matter, the way in which the gaming of credit ratings
contributed to loss, dislocation and disorder during the last
financial crisis. Volkswagen on Friday announced 16.2 billion euro
charge to its 2015 earnings to help fund the costs of the Dieselgate
affair, centering on the use of software to cheat emissions tests.
Named after the economist and Bank of England policymaker Charles
Goodhart, the law has as its central insight that the information
you get from data, be it miles-per-gallon figures or bond prices,
becomes muddied by manipulation when that data is used as the basis
for a target.
Sometimes, as with Mitsubishi, this becomes outright falsification
but the effects and pitfalls for investors are more wide-ranging and
subtle.
Agents, like fund managers working on behalf of investors, or
employees doing the same for shareholders, have an uncanny ability
to produce results in line with the targets they are set, a process
which often has little to do with the maximization of profits or a
firm’s future well being.
Attempts to manage these sorts of conflicts, between what is best
for a principal and what lines the pocket of her delegated agent,
have been less than fully successful.
CULTURE MORE POWERFUL THAN MEASUREMENT
The last 50 years or so have seen the replacement of a culture in
which managers of investments or companies were charged with meeting
broad mandates, such as “do what is best for the client”, with one
involving contractual bells and whistles which, while aiming to
align interests, often conflate measurement with management. Humans
being human, the results are very often very far from those
intended.
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Paul Woolley, a veteran IMF official and fund manager, and Dimitri
Vayanos, of the London School of Economics have explored the ways in
which the measurement of the “success” of fund managers creates
perverse incentives and bad outcomes.
Since most fund mangers are charged with beating a
market-capitalization index without taking too many huge bets, or
beating an index of other fund managers' performance, they end up
buying stocks which rise in price not out of conviction but as a
means of professional self-preservation. Stray from the herd and you
may get fired, so buy what ever is going up lest you be left behind.
The end result, Woolley and Vayanos assert, is lousy allocation of
capital, leading to the kind of bubbles and volatile investment
returns which have been the hallmark of the last two decades.
They argue for a system built more around mandates for “value
investment”, a style which requires patience and a leap of faith by
investors that their managers will do well over a much longer
period.
Mahtani of Deutsche Bank suggests that using a matrix of two or more
targets might produce better results.
Discussions about regulation, and by extension, about all agency
conflicts, often end with stressing the importance of culture in an
organization.
You can set banks and bankers with all of the risk-mitigating
targets, rules and regulations that you like, but ultimately in a
corrupt organization or industry with corrupt values you will get
corrupt results. New targets are just new games to play. So it is
with executives or with fund managers.
In the field of medicine, the patient's well-being, broadly defined,
is usually set as the highest goal. Perhaps investment and
management need a Hippocratic Oath.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(James Saft)
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