Sunday, September 30, 2012

September 2012 Drawings

Untitled (2012), Ink and Watercolor

Danger, Birds Nesting (2012)

Financial Crisis (2012)

American's Dependence on Animal Infrastructure (2012) 
From a Hike  on the Eno (2012)

Along the Saranac River (2012)

Santa Fe, NM (2012)

The Bay of Kotor, Montenegro (2012)

Saturday, September 29, 2012

Incentive Compensation

Incentive Compensation

Wall Street is the home of “incentive compensation,” bonuses paid for achieving certain goals: beating a certain investment benchmark, making a sales quota, or achieving a profit target.  This is a highly leveraged game because the most senior people have the biggest base salaries and are also entitled to the biggest multiples of their base salaries.  For example, a lowly junior analyst might be paid $150,000 salary and be eligible for bonus that is 50% to 100% of her base salary.  At the upper end, a portfolio manager might enjoy a seven figure base salary along with the opportunity to earn 5 or 10 times the base.

At the moment I’m not concerned about those base salaries.  It’s the incentive compensation that has me upset, because it is largely a fraud.  The theory is that bonus plans create powerful incentives to employees to achieve certain goals or targets.  In other words, if a portfolio manager is eligible to receive a big bonus, he will try harder to achieve top quartile performance (top 25% among all managers investing in a similar manner).

Corporate Ideals (1999)

There are two huge holes in this theory.  First, I have never seen any evidence that portfolio managers with bigger incentive plans work harder or do better than those with smaller incentives.  Everyone is striving (and most are failing) to beat a benchmark like the S&P 500.  Second, when the incentives are paid, a huge piece of the compensation is based on dumb luck, not skill.  The market happened to move in the manager’s direction in a particular year, or a marketer had a product that sold itself (such as an enticing track record).  Nonetheless, companies create complicated incentive plans in lengthy documents with all manner of grids, targets, and benchmarks, and hold endless meetings to explain the systems and dole out the cash.  Why?

These systems seem objective and scientific, so it appears that the big dollars are being doled out on a fair and meritorious basis.  However, if you dig into these plans, the goals are seldom objective.  In money management anyway, the benchmarks and targets are often rigged or are the by-product of political negotiations between the top portfolio managers or marketing executives and senior management.  No such luck for the rank-and-file; their bonuses are probably the result of a McKinsey consulting study.  Moreover, the measuring periods are often too short, so big dollars are paid for short-term performance even though the client’s interest is long-term.

The real reason these systems exist and proliferate is that they are a handy way of paying people huge sums of money without it appearing that the recipients earned a windfall.  The biggest beneficiaries can claim that they “earned” their bonuses, when it was good fortune that produced the bumper crop of dollars.

I’d have less concern about the Wall Street incentive compensation system, if it were confined to Wall Street.  However, these schemes are everywhere, including the classroom.  I really don’t think that a 10% or 25% bonus offered to school teachers whose students achieve certain test scores or outcomes is going to change anything in education.  Teachers are simply not in control of enough that is going on in the lives and minds of their students.  If a teacher hits the target, we’ll pay him the bonus and congratulate him on his achievement, even though the woman in the next classroom over did a better job with a much more challenged group of students.  

I find it rather ironic that people who insist that they need to make 5 and 10 times their base salaries in order to produce their financial alchemy think that a small bonus to a school teacher is going to change educational outcomes.  I suppose the teachers should be grateful because these schemes are about the only way they’ll make any more money.  We on Wall Street and in money management have our nerve criticizing a profession where a large portion of the practitioners spend their own money to meet the needs of their classrooms, while we charge every expense possible to our company or investors despite our seven figure pay packages.  We should examine our own pay practices before recommending them to others.

Friday, September 28, 2012

One more reason why I’m critical of the finance business

One more reason why I’m critical of the finance business

Bank of America settled a class action lawsuit for $2.43 billion for having misled investors about the Merrill Lynch merger.  Hard to fathom how the SEC agreed to settle the similar charges for $150 million.  That’s not my central point.

I went to the New York Times web-site and searched on the terms “Bank of America” and “settlement” and stopped after ten pages (I was getting tired).   I came up with 20 separate settlements worth a total of $22 billion in payments.  Now the bank neither admitted or denied the charges in most, if not all, these settlements, but the list of allegations includes all kinds of bad conduct: improper collection of fees on overdrafts, big-rigging on bond auctions, a variety of mortgage claims, several securities frauds, money laundering violations, improper trading, etc. etc. 

This list is probably far from complete and doesn’t include any claims that are pending.  Moreover, it only covers the last 8 years.  I’m sure I could come up with the same laundry list for every other major banking institution.

These institutions may be “too big to fail”, but they clearly are failing their shareholders, customers, and the taxpayers.

The particular problem of money management

The particular problem of money management

A former colleague of mine pointed out that every business has a significant problem living up to its stated values, especially when times grow difficult.  I think money management is a special case and is particularly challenged when it comes to adhering to values and maintaining appropriate standards of business conduct.

As a business, money management has three peculiar characteristics that are particularly toxic to the preservation of values.  First, it doesn’t produce anything other than money (from an investors perspective, hopefully more of it).  There’s no tangible product or service, just a statement with a bunch of balances and percentages.  Your money manager probably sends along a market commentary, but most commentaries are mere entertainment (if you’re into investment letters) and largely irrelevant to the task of managing money. 

Self Interest (2000)

Second, there’s no endpoint until you fire us or ask for your money back.  Everyone once in awhile a money manager admits that he can’t find appropriate investments and sends the capital back to his clients.  Think about the products and services created in any other industry.  There’s a beginning and an end. Parts are shipped into a plant, and a car rolls off an assembly line.   You provide your accountant with a shoebox full of statements and receipts, and she sends you a completed tax return.   In money management, the product is never finished.  Each day the interaction of the financial markets and the money manager’s trading reshapes the portfolio and changes the investment returns.  At the end of a quarter or a year, there’s a momentary pause as the results are tabulated for clients, and then the chase begins all over again the next day.

Third, the core function of money management, investing in financial markets, is an amoral pursuit.  It is not about right or wrong.  Rather it is a game of building collections of securities based on one’s predictions of corporate profits (stocks) or whether those profits will be sufficient to service interest and pay down debt (fixed income).  It’s about deciding when to buy and sell those securities.  Democrats, Republicans, liberals, conservatives, believers, and atheists can be equally good or bad at the game as their personal views are irrelevant when it comes time to invest. 

Isn’t social investing a moral pursuit?  We’ll leave that question for another time, but the short answer is that it makes the investor feel far better than they should feel.

A business that is about nothing except money, in which there is no end, and the playing field is decidedly amoral, is an industry where values have a great deal of difficulty governing behavior.  True, there are armies of compliance professionals hovering around the money managers, but their job is to monitor processes, not make value judgments.   If compliance tries to inject value judgments into the investment process, they’ll soon be looking for another job.

Undoubtedly, there are exceptional individuals and institutions who are able to maintain their hold on values.   However, the industry as a whole shows few signs of maintaining its values, except when it’s easy to do so or it’s time to issue the annual report.  The industry’s behavior in the run up to the financial crisis, its conduct during the crisis, and its quick return to “business as usual” is strong evidence that nothing has changed.

Thursday, September 27, 2012

Back to Values

Back to Values

A couple of days ago I lamented that all too often values take a back seat to goals and processes in all too many aspects of our business lives.  However, I didn’t describe any values other than “integrity”.  So I sat on my couch and started to make a list of business values in my notebook.  After about five minutes I grabbed my computer, and after checking my email, yet again (bad habit), and my Facebook page (new bad habit), I decided to look at the values statements of financial companies: my former industry.  I delved into the annual reports of some of my former employers (Legg Mason and Bank of America), some of the casualties of the financial collapse (Lehman Brothers and Bear Stearns) and a few of the biggest names in the business (Goldman Sachs and JP Morgan).  Here’s how one firm begins its annual report to shareholders.  All the other statements are variations on the same themes, whether they were written before the credit crisis or this year:

A FIRM COMMITMENT to provide superior service to our clients, best-in-class returns to our stockholders and a superior workplace for our people.  Our commitment is backed by our guiding principles. More than words on paper, they are the CORNERSTONES of our culture.  Although [the company] has grown and changed dramatically in the 83 years we have been in existence, these FUNDAMENTAL beliefs still serve as the foundation of our success: Respect, Integrity, Meritocracy, Innovation and Philanthropy. [company name removed and italics added]

It turns out that this statement comes from Bear Stearns in the year that it failed.  It follows a similar pattern.  The statement espouses three laudable goals that mention the three key constituencies (clients, investors and employees).  It tries to foster credibility by saying that these are long-held views and aren’t mere words.   Then we get to the values.  Other firms add cooperation, dedication, confidentiality, fair dealing, or professional excellence.  It all sounds great.

Napkin #1 (1999)

I sat in countless meetings (and, drew a lot of pictures) where we debated and adopted value statements; selecting one value, and rejecting others.  It seemed hugely important at the time.  However, in my former world the words we selected now ring particularly hollow and laughable given the industry’s behavior in the run up to and aftermath of the credit crisis. 

As I look back, any combination of these values would have produced ethical, measured and acceptable corporate behavior, if we were only willing to live by these principles.  At least in my world, I guess we really didn’t mean it, despite our statements, glossy brochures and high-minded speeches (In thinking about this topic, I read Lehman Brothers ex-Chairman Richard Fuld speak about his firm’s values in a Harvard Business School publication: it reeks of sincerity).

In my experience, there are two problems with value statements.  First they are crafted when business is going well, and it’s easy to agree to be ethical and moral.  As competition heats up and it gets harder to make sales targets or earnings goals, the values start to fray.  The values aren’t abandoned, they are merely loosened as employees struggle to bring in business or keep down costs.  Inevitably things go wrong, and the values are largely abandoned, and anything goes to save the day, or hide the problem.

My second observation is that most financial services companies expect their employees to live by the values published in the annual report and posted in the break room, but the bosses get to live by a different set of rules.  As result, there’s a failure of leadership, which makes it quite easy for the rank and file to abandon values in favor of reaching a goal or violating a policy without regard to values.

The key to making values work in business is living them, not just writing them down.  Over three decades I have seen how hard it is difficult to operate by those lofty values, whatever they are, when the decisions become difficult.

Wednesday, September 26, 2012

How we get away with it: investment management fees

How we get away with it: investment management fees

Quickly flip through a stack of bills on your desk.  I am not asking you to get upset at how much you owe the electric utility, your cell phone provider, or the cable company.  I just want you to recognize that all your other service providers tell you exactly how much you owe in dollars and cents.   Now dig out your latest brokerage or mutual fund statement, and try to figure out how much you paid to have your money managed.  I’ll keep writing while you look around.

Money management is one of the most ingenious businesses on the planet.  It’s not our brilliance at managing money that stands out.  Nope, as a whole we’re mediocre at our central task, but we are superstars when it comes to billing.  You see we don’t bill in dollars and cents, we much prefer “basis points.”  So your mutual fund might charge you 150 basis points per year, which is 1.5% of your average account balance (this charge covers management of the money, accounting, marketing [yup, most of you pay so the mutual fund can market their product with your money]).  So if your average balance during a year was $10,000, your bill will be about $150.  You might be a bit more reticent about the fee if you were writing a check for $150 every year and hopefully more as you’re expecting your money to grow.

In Exile (2000)

Mutual fund managers are even cleverer.  They don’t need to send you a bill.  They quietly debit your account during the year for the $150 in small amounts, so you don’t even notice.  It’s all perfectly legal and spelled out in detail in the prospectus.  As long as we’re talking basis points, you’re not quite as focused on how much you’re paying for money management services.  The industry works the same way with so-called “sophisticated” institutional investors.  No hedge fund manager in his right mind would tell a client that a $200 million mandate is going to cost them $4 million in management fees, plus another $4 or $5 million in performance fees.  It sounds much better as: “we charge the standard 2% fee, plus 20% of the profits.”  More importantly, it works.

I’m sure you’ve stopped searching for the amount you paid to your money manager as you’ve either read the previous two paragraphs or realized on your own that the amount is not to be found.  Well, you say, whether its 150 basis points or $150 that doesn’t sound so expensive.  Ah, but it is a steep price because the industry wants you to look at the fee as a percentage of your average account balance, not as a percentage of the amount of money they make for you.

Think about it this way.  Why would you pay anyone a fee for managing the money you already have?  You could put the money in a bank or Treasury bill (granted at a very low rate of interest), but you wouldn’t owe a management fee at all.  So the real question is how much of the increase in the value of your investment is going to paid out in fees.  Let’s assume our $10,000 account increased in value by 8%, or $800, the annual fee would be about $156 (in this case the average balance was more than $10,000 during the year because of appreciation so the fee is more than a flat $150). 

So you paid $156 in fees to generate a gain for your account of $644 (before taxes).  Nearly 20% of your profits went to pay fees, and we’re not even looking at trading costs. 

Here’s the point.  It doesn’t much matter if you invest in a bond or equity fund, a hedge fund, or private equity.  It’s going to cost you somewhere between 20% and 40% of the gains in your account to pay for the care and feeding of the manager and associated expenses.  And, if the investment doesn’t work out, you’ll still have to pay a fee.  Now that is a great business model . . . for the industry.

How can you drive these expenses down to a reasonable level?   Index funds, exchange traded funds, and other products that give you exposure to stocks and bonds, but take away the chance to earn a higher return than the stock or bond market averages.  What you lose is the patter of your money manager, who is confident he can beat the market and determined that you don’t ask too many questions about how much it really costs.