Removing Long-Only Constraints: 120/20 Investing

Bernd Scherer


Cynics have long seen constraints as a lawyer’s approach to risk management. On the positive side they promote a dialogue between manager and client on risk management and alpha generation, possibly align manager actions with manager skill and protect against a worst-case breakdown in risk controls. Constraints are often the direct consequence of the difficult principal–agency relationship between manager and client. While the client can directly observe neither skill nor effort, the manager has a strong incentive to pose as skilful (even if they are not) and dial up risks if performance turns against them. While the impossibility of writing the perfect contract (in which the agent acts solely in the principal’s interest) in a principal–agency relationship is well known, investment constraints are partly used to supplement incentive contracts. From the author’s perspective, however, many of the constraints used in practice are not in the principal’s (plan sponsor’s) best interest: rather than reducing the possibility of excess risk taking, they increase it. Effectively, most investment constraints (position, turnover, number of stocks, etc) impose the

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