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Will Success Spoil Performance Investing?

Written over 50 years ago, this piece celebrated the remarkable long-term “bell curve” business cycle that would take active “performance” investing from a surging young growth business up and over its apex in the 1980s and on to the steady decline—for consumers, if not for producers—by the turn of the century. Ironically, the factors that would lead to its inevitable self-destruction were buried within what most of us—over 50 years ago—saw back then as clear indicators of progress.

Big Money is on the move. It has been a long time since the Great Depression, which was the Ice Age of the U.S. economy, during which the investment principles and practices of Big Money got solidly frozen. But now, with competitive pressures for good performance heating up, the glacial Establishment is rapidly melting around the edges. And it is beginning to slide.

Traditionally conservative institutions—banks, trust companies, university endowments, pension funds, insurance companies and the more staid mutual funds—are moving at an accelerating pace towards the performance method and philosophy. Technicians, traders, young portfolio managers, incentive pay and talk of highflyers are surprisingly common within the marble halls of these once staid bastions of fiscal tradition. Performance investing has come from suspected intruder to accepted darling among the nation's major institutions and their customers.

The ascendancy of performance investing is due to achieved results. And results in recent years have been very good. Perhaps too good. Possibly, even probably, its great success will soon spoil performance investing.

Before discussing the developing problems for performance “investing,” it is worth defining what it is. Performance investing is an aggressive, eclectic, intensively managed effort to continuously maximize portfolio profits. Performance investing goes far beyond such quotable quotes and slogans as: “Don't marry stocks; love ’em and leave ’em.” “It's a fashion business, so don't buck the trend, ride it.” “Go where the action is.” It's a tough, highly competitive, brain-draining, fast-moving and wide-ranging struggle to beat the pack. And to beat most of the other young lions.

The Successful Performance Investor

The performance fund manager operates somewhere between the extremes of tape reading traders and very long-term holders. Traders try to combine high turnover with very small profit increments per decision: long-term holders with low turnover depend on much larger price changes per decision. The successful performance investor combines the best of both, capturing the larger mark-ups than traders and turning over his inventory faster than long pull investors.

The performance investor specializes in identifying and acting quickly upon the factors that he feels will probably change stock prices, seeking to buy or sell before the general market reacts to these developments. To operate effectively, the performance fund manager must have access to current information on a very great many companies and stocks in order to find openings in the market to ply his trades. Charts and other technical studies of prices and volume can be analyzed to catch changes in supply and demand. Quarterly earnings become critical. Bits and pieces of information of all kinds must be acquired and processed, and this requires a very wide network of helpers who call in with data, rumors, ideas, etc. He must be mentally and emotionally capable of making a great many more decisions with less complete knowledge than his longer-term competitors. Performance investing is not nearly as easy as it looks to some of the noncombatants.

Not only is performance investing hard to do, the most effective practitioners face serious problems. These are the problems that raise the question: will success spoil performance? The performance investor is trying to capture the profits available for early recognition of changing value that will cause rapid change in stock prices. But the total potential profit available is limited because the performance funds do not, in the long run, make the market; they can only operate in and upon the market made by other longer-term investors. Since the performance pie is not indefinitely large, when too much money chases pieces of that pie, the rate of return per dollar invested must fall. Performance techniques would simply get less and less “performance.”

Second, as the number of funds operating in the performance manner increases, portfolio managers, who want to “get in early,” are obliged to act sooner and sooner. This means that they act with less and less certainty that the expected positive or negative development will actually happen. And this lowers the probabilities of being right, which reduces the profits.

Third, the most successful funds may get swamped with money. As they rack up profits, more and more investors jump on the razz-matazz bandwagon and new money flows in, these funds can get too big for their own kind of game. For example, if market liquidity limits holdings to $1 million in a small “hot” stock, a $50 million fund can go after it. But a $500 million fund would need positions of $10 million in such a stock—a dangerous amount to liquidate. So the large fund manager is limited to stocks with bigger and bigger capitalizations.

Giant Fund Manager Disadvantaged

But even in the most liquid stocks, a $1 billion fund has trouble cutting in and out of positions that may average $15 million (300,000 shares of $50 stock). That much stock is hard to buy and hard to sell. So the giant fund manager just can't act on the frequent, but small profit opportunities that come along because the costs of moving big blocks may be more than the profit opportunity identified.

These are some of the major problems facing the best performance funds. If performance investing is doomed to follow the typical phases of development, maturation, and decline, the first two phases are easily described.

During the first phase, the creative impact of the pioneers results in the development of a new, iconoclastic approach to equity management that is disparaged and/or rejected by the Establishment. But the approach works well and earns high portfolio profits. It can't be ignored. Public acceptance leads to grudging, then intrigued acceptance by other institutions. Good investment results cause accelerating endorsement by the Establishment which, paradoxically, may doom the darling to dreary disappointment.

The third phase is decline. The problem with success is simple: You get too big, almost “money bound.”

Individual funds have grown enormously in the past decade, and the number of new and old portfolios committed to performance is expanding rapidly too. The result is a geometric increase in the amount of money trying to exploit the performance opportunity. The problems of success are most acute for the individual fund whose success has caused a financial form of elephantiasis. Limit to “big capitalization” stocks and paying high tolls to get in or out of each position, their performance gets hurt. In the good old days, there was plenty of room for everybody who wanted to try fleecing the public and the slower institutions, but now former comrades in arms are by necessity trying to fleece each other. There is not enough profit to go around. Success is beginning to spoil performance.

Two solutions or offsets are worth considering because there are two different problems. What can help the individual performance fund? And what can help the performance funds as a group?

Three answers have been offered to the problem of an individual fund's size: limit the size of the fund by closing down new sales when a size such as $100 million is reached; start new funds as the old get too big; and try to convince shareholders to accept lower rates of return. Each of these methods is being tried and they seem to work for a few individual funds.

In addition, there is a good chance that the problems facing performance funds as a group can be at least deferred This prospect is inherent in the increasing acceptance of the performance goal by the very large institutions such as banks, pension funds, endowments, and insurers. Their movement into the field brings relief in several ways:

First, the market is made more liquid by having more active participants. This allows larger and larger holdings to be bought and sold quickly and without undue disruption of price.

Second, with more money looking for high profits, stock prices react faster to changing expectations. The payoffs for good selections come faster, which can dramatically increase the annual rate of return of each investment.

Third, the traditional institutions are buying into the kinds of stocks the performance funds already own. This raises the general P/Es of “performance” stocks while selling down the prices of traditional “Dow Jones” Issues. This shifting process is lifting prices in that area of the market where performance investors operate, giving them an extra advantage in their efforts to surpass the market averages.

Liquidity Loses Usefulness

While each of these elements of change is helpful to the performance investors, they can't and won't help for very long. Greater liquidity loses its usefulness when too many funds try to do the same thing at the same time. Getting the bigger profit from faster price moves depends on buying early, and the younger generation at the traditionally slow institutions are anxious to be early too. Competition for leadership could get tough. Finally, switching from “slow” to “go” stocks is not going to take forever and its relative impact on multiples may be diminishing already.

Unless the traditional institutions both insist on trying performance investing and consistently fail to be very good at it, winning them over may eventually compound the problems of success which “performance investing” already faces. The decline phase of performance may be delayed a bit and then be made all the more inevitable. The general concept of performance investing may also come in for strong abuse if the big institutions, in trying to learn the game, are hurt badly. Many of these traditional capital pools are already too large, have administrative problems that prevent quick reactions, and are not staffed by aggressive “swingers” who will thrive on the competitions, challenge, and excitement of the high-performance game. It now appears that many conservative funds are being seduced by the siren song and are starting to play a game that they are ill prepared for.

Whatever the facts of individual funds or the general view of performance investing, it does seem clear that the business of managing institutional money has been permanently changed away from capital preservation. Performance investing is surely not the only way to get good portfolio profits, but it must be given credit for forcing money managers to try harder. The risk is that money managers may try too hard, relative to their own abilities and market opportunities and begin to stumble.