What is Management Risk?
Management risk is any type of risk that arises from company management that is inefficient, incompetent, or unethical and that has the potential to damage a company’s performance, reputation, or ability to continue as a going concern. Management risk is a concern for shareholders, and board of directors oversight is one-way companies mitigate this risk. However, the board of directors can itself also be a source of management risk. This risk also applies to risks associated with the management of an investment fund.
Key Learning Points
- Management risk arises from the potential for inefficient, incompetent, or unethical practices by company management.
- Investors consider management risk in making investment decisions.
- Management risk also applies to the management of an investment fund.
Understanding Management Risk
Management risk refers to the probability that an investor’s holdings in a company can be negatively impacted by the actions of corporate officers and/or directors. Shareholders are considered principals while the management team that runs daily operations is considered an agent of the shareholders. The agency theory explores the important relationship between the principal and the agent.
Management risk arises from the fact that the management team, the agent, carries out actions and decisions on behalf of the principal. These actions and decisions may give rise to conflicts of interest, which pose a risk to the interests of the principal.
The management team of any public company has an obligation to the shareholders and is required to act in the best interest of shareholders when making financial decisions. The interests of the shareholders, who are the owners of the business, take precedence over those of management. However, the possibility that management will not act in the interests of shareholders is the essence of management risk.
Additionally, when applied to investment management risk, this risk can refer to a failure by portfolio managers to meet their obligations to investors. Portfolio managers have a fiduciary responsibility when managing client money. Any breach of fiduciary duty is a risk for investors and can lead to shareholder lawsuits.
Mitigating Management Risk
There are a number of regulations, rules, and market practices that have been implemented to protect the shareholders of publicly traded companies from management risk. For example, the Sarbanes-Oxley Act of 2002 stressed the importance of transparency and investor relations for public companies and was intended to protect investors from fraudulent financial reporting. As a result, publicly traded companies have established investor relations departments to take responsibility for managing investor events and maintaining communication with investors and compliance with regulatory obligations.
Investment fund managers have a fiduciary responsibility to their investors. Funds must comply with the Investment Act of 1940, which includes certain built-in provisions aimed at protecting investors against management risk. For instance, the Act requires that a board of directors be established. The board oversees the fund’s activities and decisions to ensure that they act in consistency with the fund’s investment objectives.
Even though fund managers are legally bound to uphold the best interests of investors, they have flexibility in making investment decisions. Depending on the investment strategy, portfolio managers can enter and exit various positions. However, investment decisions can give rise to style drift, which can pose a risk for investors.
Style drift may expose investors to new risks, which arise from investment styles they do not fully understand. Portfolio managers are at risk of style drift when they aggressively seek superior returns. While this can result in superior overall returns for investors, clients are still not getting exactly what they’re paying for. Style drift could also create the risk of lost capital from fund outflows.
Managers who do not comply with regulations mandating fiduciary responsibility may be subject to legal action. Financial scandals in the early 2000s involving publicly traded companies such as Enron, Tyco International, and WorldCom led to the passing of the Sarbanes-Oxley Act of 2002. These high-profile cases of fraud significantly reduced investor confidence in the validity and trustworthiness of corporate financial statements and resulted in a general demand to overhaul decades-old regulatory standards. The management of the companies mentioned above engaged in irresponsible and fraudulent activities, which eventually bankrupted these companies.
Management risk also applies to investment managers who may take actions and decisions contrary to their fiduciary responsibility to clients. However, for registered funds with an established board of directors and oversight processes in place, fraudulent activities are less of a threat. On the other hand, hedge funds, overseas funds, and privately managed funds may pose higher management risk since they are less heavily regulated.
Corporate shareholders and investors in funds all face management risk. They face this risk due to the possibility that a company’s management or a fund manager may deviate from business and investment objectives. Unethical, ineffective, or underperforming agents present a management risk to principals. Rules, regulations, and market practices have since been established to protect investors and shareholders from irresponsible actions and decisions by managers who are legally bound to act in their best interests.
MCQ – Management Risk
The multiple-choice question below is intended to test your knowledge. Download the excel exercise sheet attached to find a complete explanation of the correct answer.