Going Over the Falls: Part 2
The best and the brightest of the money management had their clients’ money deeply invested in financial stocks as the credit bubble inflated and burst. Over on the bond side, the portfolio managers were buying all sorts of toxic mortgage securities. This behavior should not really be a surprise, as the same people fully invested their clients’ capital in dot.com stocks at the start of the new millennium and savings and loan stocks in the early 1990s.
|Orange County Crisis (1995)|
In addition to making money on your behalf, portfolio managers are supposed to be “sophisticated” investors capable of keeping the market from reaching unsustainably low or high valuations. They certainly exude a great deal of confidence about their abilities and can endlessly mesmerize you with financial jargon. They consume gigabytes of computer capacity to run their investment models. We pay more than enough money to attract top-notch talent. Why did they help to inflate the credit bubble and then stood by helplessly as it popped?
The biggest problem is that most money managers aren’t trying to make money or prevent losses. Their goal is to beat an index such as the S&P 500. They believe they have done a great job if the return of their fund is better than the index, and they get paid a lot of money for achieving this goal. For example, if the market is down 20%, a money manager will declare victory if he only loses 15%. He’ll also collect a big bonus. You lost money, but he made money. And if he can’t beat the index, which is usually the case, he can at least try to beat his competitors. Thus, the vast majority of money managers are interested in relative performance, not absolute performance.
Money managers also look at risk very differently from most human beings. Most of us are worried about the risk of losing money. Money managers are worried about losing your account; after all it is the source of their salaries and bonuses. That’s how they define risk. They know that you’ll fire them if their performance is too far away from the S&P 500 or too far below their competitors’ performance (e.g. in the bottom quartile). As a result, most money managers don’t want to make bets that are too far removed from the index or competitors. For example, if 15% of the S&P 500 is made up of financial stocks, a money manager will be reluctant to have less than 7% or 8% of the portfolio in those kinds of companies. If being underweight financials is a sound strategy, then he is likely to achieve good relative performance (lose less money than the index or his competitors). But if he’s wrong and financial stocks continue to do well, he’s going to lose your business, as you’ll probably fire him for grossly underperforming the index. In short, managers take big business risks when they get too far away from the index or competition. Even if they have a strong conviction about an industry or sector, they are only going to express it in a muted fashion. The term for this type of investing is “shadow” indexing or index “hugging.”
The same principle applies to stock selection. When AIG was 1.5% or 2% of the index, a bullish manager might build a 3% position and a bearish manager might reduce his holding to 1%. The manager didn’t want to take the business risk of making too big a bet for or against a stock in the index. If he was really worried about the leverage at Lehman and decided to sell his entire position, he was going to pressure his analyst to find another investment bank to own. Hence, he might have purchased shares of Bear Stearns because he believed it was a relatively better holding than Lehman, even though he might have been worried about the investment banks as a whole.
Under normal circumstances, relative return investing is not a horrible way to manage money. The industry produces mediocre returns, but investors aren’t deeply harmed and the markets function reasonably well. However, when valuations become silly (e.g. dot.com stocks) or leverage becomes frighteningly high (e.g., credit bubble), relative return investing puts clients at huge risk, and helps to keep the bubble inflated until panic sets in.
As we’ll see tomorrow, money managers have very little incentive to change the system of relative return investing and no incentive to dig deeply into particular companies and ferret out looming problems.