Going Over the Falls: Part 3
Most of the professional money management business is engaged in relative performance investing: building portfolios and trading based on the composition of index. While investing is supposed to be a long-term exercise, the vast majority of portfolio managers are focused on quarterly results. They’re interested in the quarterly results of their own portfolios and the quarterly results of the companies they invest in. As a result, most managers are traders rather investors and move in and out of stocks constantly. Companies mirror this short-term obsession and focus on delivering quarterly results that meet, or hopefully exceed, the earnings expectations of portfolio managers. If the CEO and CFO can wrack up a series of positive quarterly earnings reports, they stand to earn big bonuses and create additional wealth through their stock options. Portfolio managers operate with similar financial incentives.
|We Know Best (1995)|
This fixation on the short-term undermines much of the incentive to conduct detailed and in-depth research. What’s the point of delving into the complexities of Citigroup or Bank of America if the focus is on near-term results? So long as management can make the numbers, most money managers aren’t going to ask too many questions. Unfortunately, the banks, investment banks, mortgage brokers, and government sponsored enterprises (e.g., Fannie Mae) used all kinds of accounting tricks, increased levels of borrowing, and unsound business practices to make the numbers work. These unsavory tactics allowed the credit bubble to continue, because most money managers accepted the results at face value.
Not all money managers engage in this short-term game. They dig deeply and are willing to make large investments in their portfolios. They’re also willing to short stocks (sell stocks they don’t own, which is the ultimate vote of no confidence in a company). These types of managers are a small part of the market and are most often shunned by management. Their efforts to expose the shortcomings in a company can be overwhelmed for many years by the sheer amount of capital playing the relative investing game. So bubbles can persist and grow bigger before they are pierced.
What we have is an unholy alliance between money managers and corporate managers. Money managers don’t have a lot of their own money in their funds, and corporate executives don’t have a lot of their net worth in the companies they manage. Money managers and corporate executives can earn inordinate amounts of compensation based upon short-term results. Thus we have a situation where the folks overseeing your portfolio and the people managing public companies are more aligned with one another than with you.
In finance, this misalignment is particularly dangerous because these companies are highly leveraged, and many operate with the explicit or implicit guarantee of the Federal government. If something goes wrong, as it did in the credit crisis, financial institutions don’t just lose money. They go bust. And if one institution gets into trouble, it can threaten the entire industry, since they lend money to one another.
As a result of relative return investing, our financial institutions are in the hands of renters, not owners. Portfolio managers are, in fact, very bad tenants. How do they get away with it? We’ll pick up the story in the next post.