One big source of tension for today's portfolio managers is the conflict between the business of investing (revenue and profit) and the craft of investing (performance). Over the long term, these goals are not mutually exclusive: the best marketing tool is a superior long-term record. Over the short term, however, the conflict can encourage decisions that hurt long-term investment performance and, with it, portfolio managers and clients alike.
Specifically, with the investment business getting ever more competitive and investors ever more impatient, portfolio managers feel pressure to concentrate on ever shorter timeframes. Gone are the days when managers were judged on five-year and 10-year records: They now live and die on performance posted over years, quarters, and months.
Unfortunately, if portfolio managers adapt their styles to address these realities – as most can be forgiven for doing – they will often also sacrifice the discipline that provides the best chance to post superior returns.
Rationality in retrospect
The source of this conflict is "investment risk" versus "career risk." In this regard, professional investors generally display far more rationality than they get credit for. Now that the technology boom has turned to bust, for example, those who participated are ridiculed as dizzy idiots. What is forgotten is that the major risk to the livelihood of fund managers in the late 1990s was not the potential for a crash – which would offer the safety of the crowd – but the risk of missing gains.
Technology stocks outperformed the broader market almost every quarter from 1996 through 1999. Fund managers who didn't own them during this stretch not only underperformed but also lost clients, reputations, and, often, jobs. The "rational" career move, therefore, was to buy technology stocks. And so most portfolio managers did just that.
With the media and fund-ranking firms providing frequent surveys of "winners" and "losers" – and, therefore, encouraging investors to maim themselves by frequently switching funds – it is not hard to find examples of portfolio managers emphasizing business concerns over investment principles. A portfolio manager at a major fund complex a few years ago, for instance, was sent an email every week showing his performance versus comparable funds. A star manager at another firm, meanwhile, dumped technology stocks in mid-1999 on the theory that the sector was primed for a crash – only to soon be told by the boss to buy technology, or be fired. (The boss was sick of seeing outflows caused by the fund's underperformance.) So the (rational) fellow followed orders, and so set his shareholders up for a mauling.
From an investment perspective, this is lunacy. The shorter the timeframe, the more fundamental factors like valuation, industry trends, return on invested capital, and management quality are irrelevant, and the more performance depends on the market, fund flows, sentiment, rumours, upside and downside "surprises", and other catalysts. Although a handful of investors can parlay such data into consistent market-beating performance, the vast majority can't (remember that nearly half of funds will beat the market each quarter from luck alone). For most funds, hyperactivity just generates higher research, trading, administrative, and tax costs, and, in so doing, reduces the chance that the funds will outperform over the long haul.
Jeremy Grantham of GMO – one of the few firms whose funds do tend to beat the market – recently summarized the situation this way: "In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone's ultimate job description becomes 'keep your job'."
So, what should portfolio managers and investment firms do?
First, acknowledge the problem. Humans will do what they are encouraged to do, and if portfolio managers and client relationship personnel are evaluated quarterly, that's the timeframe they will focus on. Incentives should therefore be structured to encourage superior long-term performance. If this leads to poorer quarterly rankings (not a given), it will trigger redemptions and Bronx cheers from morons in the press. It will also chase away the hot money and result in a temporary loss of revenue. But by clearly stating that the goal is five-year to 10-year returns, not quarterly returns – and delivering on this – the strategy should eventually win people over.
Quitting the rat race
Second, firms must work hard to explain to clients and the press why most funds under-perform market indices over the long haul. To wit: the vast majority of fund managers cannot generate enough incremental performance to offset the costs of administration, trading, research, and management fees, especially on an after-tax basis and especially with cash on hand for redemptions. The few funds that do generate superior returns tend to be those with ultra-long holding periods (Buffett), low costs (Vanguard), or exceptional trading skill (Soros), or a combination of these.
Third, given that two of these factors can easily be controlled, firms should cut management fees and reduce turnover. This, too, will lead to a near-term revenue loss, but it will be somewhat offset by lower costs. Over the long term, meanwhile, it will almost certainly lead to better performance (witness Vanguard), which happens to be the best and cheapest advertising there is.
In short, the secret to getting out of the quarterly rat race – a waste of investment talent and effort if ever there was one – is to play the long game. Leave the Pyrrhic pursuit of quarterly performance to hamsters and their customers.