Portfolio manager’s Letter September 2009
Career Risk has a huge impact on financial markets worldwide. With many trillions of dollars in the hands of professional investment managers (a phrase that I might be tempted to classify as an oxymoron if I were not one of them) anything that impacts the psychology of this class is likely to move markets, and usually in ways that defy rational explanation.
If an investor is attempting to evaluate a potential investment manager or to manage his own money it is important to understand the psychology of the individual that is trying to make a living by managing money. The most important thing to keep in mind is that a investment manager’s performance is almost universally evaluated using short-term results. Most investors focus on short term results. They do not have patience that is required to outperform the market in the long term.
In the media managers are compared using quarterly, monthly, or even daily returns, this creates pressure on managers to focus on short term performance. As Seth Klarman said in a recent interview: “Managers who do well in the short term are rewarded with more assets,” he said. “Those who do not do well in the short term often don’t survive to see the long term.”
Career risk means that investment managers are pressured by what their clients think or by what they think their clients think. When a investment manger’s current performance is not up to his benchmark money will start to exit. This makes it difficult for a investment manger to focus on the long term, even if he would like to. The irony is that while the market place is selecting for the best short term results, what the customer is really selecting is high risk and a poor long term outcome.
For the investor managing his own money the investment managers’ problems can be a blessing because the irrational behavior caused by the pressure for short term performance will create buying opportunities as money is sucked into hot stocks. This short term investing bias is investor driven and is not likely to change. It increases market volatility, helps prolong bull markets and bear markets, and generally helps to create pricing inefficiencies.
Unless the investment manager has been very careful to control expenses and cultivate clients with a long term prospective, and it will hard to really practice value investing. Value investing sounds easy, but done right requires a lot of patience. The marketplace seldom leaves a investment manager with that option. If his customers lack patience the manager can not afford to have it. The problems get bigger as the assets under management grow.
Size compounds the problems of money management for two reasons, first of all size is an anchor to performance, and as a mutual fund gets bigger it’s overhead expenses increase, and it becomes more dependent on clients with short term objectives. This means that most very large mutual funds no longer try to out-perform the market and instead become closet indexers.
Not all investment managers all equal in when to trying to judge to the disadvantage of size. Mutual funds are more susceptible because their regulatory structure means they have high administrative costs. RIA’s may be less subject to this pressure if they have been able to keep their overhead low. As for hedge funds it is impossible to tell because are no reliable industry wide performance statistics. They have access to arcane stratagem and leverage that may give them some advantage, but until there is regulation that requires reporting of performance and administrative cost on the same basis as other investment managers we do not know if they will be able to achieve better results than other investment managers.
A case could be made that investor pressure had something to do with Buffett closing his Partnerships in 1969 (he may have been getting pressure from partners to do things he did not want to do). This might seem unlikely, but anyone who attended Berkshire Hathaway annual meetings during the tech bubble knows that there was no shortage of mucks who would start up at the meeting, and explain to Buffett all the reasons he should be investing in wonderful bubble stocks.
Then when Buffett got back into investing in the seventies it was through a vehicle where he did not have to pay a lot of attention to investors. The advantage of the corporate structure being that since he owned the controlling interest in the corporation there would never be any career risk.
For the investor considering hiring a investment manager, large size is not just an anchor, but is likely eliminate any chance that the investment manager can outperform the market. Buffett seems to do quite well with a $70 plus billion, but a doubt there are other managers that can handle this size portfolio and still beat the market.
I do not think that any Big Cap (Over $20 billion) mutual fund will out-perform the market over the long term. Or at least the odds are small enough that I would recommend that all money that is currently in this type of vehicle would be better off in an index fund or in Berkshire Hathaway. I have a huge preference for Berkshire Hathaway because I feel it has less risk and much more potential any large mutual fund, managed or index.
Finally, an investor picking a investment manager based on short term performance can expect poor results. Using the best six month, one year; or three year record is sending money into the current market fad and will increase the investor’s exposure to risk. Yet Individuals are encouraged to make this kind of choice by the media’s obsession with short term results. It is important to accept that short term behavior is market driven, and that learning to avoid it is an important step in improving your investment performance.