The controversial and counterintuitive, yet simple and efficient way to solve the principal-agent problem in corporate governance and asset management. The byproduct of the restricted diversification is transparency of one-directional investment flows for financial crime enforcement agencies.

1. Next Generation
Financial Architecture
Part 3
Clustered Diversification
Eugene Kagansky
www.nordo.consulting
Inspired by lectures of
Professor Ingo Walter

2. Next Generation Financial Architecture Page 2 of 5
Introduction
The separation of ownership and control gave rise to the Principal-Agent Problem and the
corporate form of business organization. For centuries, the benefits outweighed the costs as
corporations were the engine of economic growth. Public corporations and investment portfolio
diversification introduced the Free-Rider Problem among corporate owners, that further
exacerbated the Principal-Agent Problem. Recently, the cost of economic crises outweighed the
benefits of economic lethargy and Conduct Risk has become a popular focus of political debate.
The corporate managers in the pursuit of happiness will not always act in the best interest of
corporate owners. The owners can only limit aberrant conduct of the managers by setting up
proper inceptives and monitoring mechanisms.1
In widely-held firms, individual owners with their tiny share of company stock have neither
motivation nor capability to effectively monitor the management. Apathetic to most elements of
corporate governance, they adopt a passive stance, implicitly leaving the burden of monitoring
the company management to institutional owners and private block holders.
Institutional owners managing other people’s money rather than their own in widely-diversified
investment portfolios, have neither incentive nor resources to invest in governance of individual
corporations.2
Private block holders with limited number of issues on which they can vote, do
not effectively balance the power or exercise monitoring of corporate managers and boards of
directors.
Thus the next generation financial architecture should aim at converging the interests of
corporate managers, boards of directors, fund managers, and ultimate owners.
Objectives
An important objective of the next generation financial architecture should be the creation of a
regulatory framework that would utilize market forces to ensure a proper business conduct of
public corporations.
The ideal framework should shift the balance from corporate control to corporate ownership
through increased ownership concentration, shared downside, and expanded owners’ voting
rights. This would allow regulators passing to newly empowered corporate owners the burden of
monitoring their own interests and establishing effective corporate governance.
1
Jensen and Meckling, 1969. “Theory of the Firm”
2
Roy C. Smith and Ingo Walter, 2006. “Governing the Modern Corporation”

3. Part 3 – Restricted Diversification Page 3 of 5
Clustered Diversification
Institutional investors such as pension funds, employee benefits funds, mutual funds, etc. hold
over half of the shares in publicly traded companies on behalf of individual investors.
Restricting diversification of public funds would be a powerful mechanism to focus fund
managers on long-term investments and corporate governance within their investment portfolio.
Restrictions on portfolio diversification could be done on a sector, group or industry level. This
would create three types of investment funds: sector funds, group funds, and industry funds.
1. Industry Funds
Investment vehicles that manage other people’s funds and are restricted to holding
securities or security-based derivatives of a specific industry. This fund type would carry
the burden of corporate governance as means to deliver long-term results.
2. Group Funds
Investment vehicles that manage other people’s funds and are restricted to holding
shares of Industry funds and Industry fund-based derivatives of a specific industry group.
This fund type would create a competition among Industry funds. It would concentrate
liquidity in a short list of transparent funds.
3. Sector Funds
Investment vehicles that manage other people’s funds and are restricted to holding
shares of Industry Group funds and Industry Group fund-based derivatives of a specific
sector. This fund type would create competition among Industry Group funds and offer
high liquidity and diversified sector exposure to unsophisticated investors.
Figure 1. Clustered Diversification

4. Next Generation Financial Architecture Page 4 of 5
Shared Downside
Interests of Principal and Agent are best aligned when Agent shares with Principal upside and
downside alike. Portfolio managers of public funds should maintain at any time an equity stake
in fund under their management equal to the volatility of the fund’s returns.
Equity stake in the fund under management is a powerful tool to focus fund managers on long-
term investment objectives, prudent risk taking, and effective corporate governance of assets
under management.
This market-based mechanism ensures that public funds with riskier investment strategies and
thus higher return volatility require fund management to maintain higher equity stake in the
fund. The regulatory oversight would be limited to monitoring of fund managers’ equity stake.
Owners’ Risk Appetite
Risk Appetite of the actual owners should be a guiding star of corporate boards and management.
Owners’ Risk Appetite should be expressed directly through annual voting process as shown in
Figure 2. This should be an efficient tool for investors to exercise their right to vote on major
issues.
Figure 2. Risk Appetite Vote
01. Risk Appetite
Directors recommend election of the following corporate risk profile:
20% Maximum Annual Loss and 10% Monthly P&L Volatility.
50% 35% 20% 10% 5%
Maximum Annual Loss 〇 〇 〇 〇 〇
20% 15% 10% 5% 1%
Monthly P&L Volatility 〇 〇 〇 〇 〇

5. Part 3 – Restricted Diversification Page 5 of 5
Conclusions
1. Clustered diversification of public funds would allow to pass the burden of monitoring of
corporate governance from regulators to industry fund managers.
2. Managers of industry funds would have market incentives to focus of long-term investment
horizon and proper corporate governance.
3. Direct shareholders voting on risk appetite would bind managerial power of risk taking.