Management Risk

Management risk is the risk — financial, ethical or otherwise — associated with ineffective, destructive or underperforming management. Management risk can be a factor for investors holding stock in a company. Management risk can also refer to the risks associated with the management of an investment fund.

Management risk refers to the chance that an investor’s holdings will be negatively affected by the management activities of its directors. Directors of publicly traded stocks have an obligation to their shareholders and must act in the best interest of the shareholders when making financial decisions. Portfolio managers have a fiduciary responsibility when managing capital for investors. Any breach of these obligations can create risks for shareholders and could result in shareholder lawsuits.

Numerous rules, regulations and market practices are implemented to protect shareholders of publicly traded companies against management risks. The Sarbanes-Oxley Act of 2002 increased the importance of transparency and investor relations for public companies. Publicly traded companies have extensive investor relations departments that are responsible for managing investor events and communicating compliance with investor obligations.

Fiduciary responsibilities are a common practice associated with the management of investment funds. Funds must comply with the Investment Company Act of 1940. This Act includes some built-in provisions that help to protect investors against management risk. One such provision is the requirement for a board of directors. The board oversees all activities of the fund and ensures that it is investing according to its objective.

While fund managers must comply with legal obligations that mandate fiduciary responsibilities, they do generally have some latitude for investment decisions. Within a broad market investment strategy, portfolio managers may shift investments into and out of various investments. Generally this type of investing may cause style drift, which can become a risk for investors. When style drift occurs, investors may find their investments at risk to new investing styles for which they are not fully aware. Style drift most often is caused by return chasing, which increases the overall return for investors. However, style drift can also lead to lost capital, which typically results in fund outflows.

Managers who act outside of their obligations may be subject to legal actions. Noteworthy corporate scandals that subsequently led to Sarbanes-Oxley include Enron, Worldcom, Tyco and Xerox, whose managers acted in a manner that eventually bankrupted the companies and destroyed shareholder wealth.

Management risk also applies to investment managers, whose decisions and actions may divert from the legal authority they have in the management of investor funds. Fraudulent activity is less of a threat in registered funds with an established board of directors and oversight processes. However, hedge funds, privately managed funds and offshore funds may have higher management risks for investors due to less regulation.