Dad gave good lessons on how to understand costs and pricing and how to make more informed decisions as a customer. Fees in investment management are far, far higher, when correctly seen, than most investors recognize. “Only 1%” is an extraordinary self-deception. Taken as a percentage of superior results, fees for active investing (before taxes) average over 100%.
Dad taught lessons in a memorable way. We children came home at the end of a winter's Saturday afternoon of movies at the Warwick Theater on Pleasant Street in Marblehead, Massachusetts, and Dad asked, “Enjoy the movies?”
“Yes,” we replied. “John Wayne.”
Then Dad asked one of those questions that starts a lifetime of pondering: “Why? Why do they charge so little for tickets?” The easy answer was easy: “Because we're kids, Dad. And they charge only 12¢ so lots of kids will come.” But easy answers would not do, and Dad persisted, “Why does the Warwick charge only 12¢ when the truth is they don't make any money showing movies?”
“Dad, is this a trick question?”
“No, it's not a trick question, but getting the right answer will take some careful thinking.”
And that is how Dad got us to work it out with him that the folks at the Warwick were willing to show John Wayne movies at a loss because they were making a real profit selling cokes and popcorn at very high prices. Dad wanted us to learn to separate appearances from realities.
Several years later, Mom and Dad invited us to join them in New York City for dinner at a very special French restaurant named Château Chambord. As we examined the enormous menu, we could not help commenting on how wonderful the dinner would be and how very expensive it was.
Then Dad asked another of his probing questions, “How would you explain the fact that this fine restaurant continues in business if I told you something I happen to know: They don't make any profit selling this wonderful food?”
“Dad, is this a trick question?”
“No, it's not a trick question, but getting the right answer will take some careful thinking.” And that is when we learned that the profits at a great restaurant are not from gourmet food, but from drinks, cocktails, and wine. Dad was again teaching us to think about the salient differences between appearance and reality. (J.P. Morgan had the same idea in mind when he said that for every important business decision, there are almost always two reasons: One is readily recognizable as a very good reason; the other is the real reason!) Dad's philosophy was simple and profound: Whatever you are doing, be sure you recognize what is really going on. Do not get confused.
In investing, we are learning that the best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy. Sure, these approaches all have their current heroes and “war stories,” but few hero investors last for long and not all war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy: setting the right asset mix and holding on to it.
Most of the most important developments in the macro-environment of investment management within which we practice our profession and build our businesses can, with only moderate outrage to the data, be described by using one all-purpose chart, which summarizes our apparent “reality”—ever upward over many years. This one chart can be used to support each of these 10 key propositions:
The realities are different. Professional investment managers are not “beating the market.” Annual data are increasingly confirming the grim reality: The professionals are lagging.1
The data are even more disappointing when the length of time for which results are reported is extended to cumulative 10- or 15-year evaluation periods. In these rather more important time periods, even fewer professionals can keep up with the market averages.
Equally disconcerting, the overarching reality of performance data is that it is not predictive. The past is not prologue. So, even the manager with a “good” record is often not a good bet to outperform in the future. Results are closer to random than we would like to believe. The long-term experience of investors with the active portion of their portfolios—after deducting the index-fund equivalent so we can examine just the incremental consequences of active management, is grim.
Do you recall Fred Shwed's wonderful story about the innocent out-of-towner being driven past the yacht basin on the East Side of Manhattan? With pride and enthusiasm, his host and guide pointed out the largest boats: “Look, those are the bankers' and brokers' yachts.” His guest asked, “But, wh-wh-where are the customers' yachts?”2
So far, clients have not focused on the inability of professionals to add value through active management because they have been looking at the overall experience. “A rising tide lifts all the boats,” and the tide in our market has been rising very favorably. Our clients' views might be very different if we did not have the rising tide. So, now is the time for our profession to be asking Dad's kind of questions: Why is our profession so generously rewarded when unable to add value? Why are the results of the efforts of so many hard-working and talented professionals with so much data and such advanced tools so disappointing?
The answer is simple: One great environmental change appears to have up-ended—in just one generation—the central assumption on which active investment management is based. The cheerful ratio of 10:90 has been converted to a glum 90:10. Let me explain.
To achieve superior or better-than-average results through active management, you depend directly on the mistakes and blunders of others. Others must be acting as though they are “willing to lose” so you can “win.” In the 1960s, when institutions did only 10% of the public trading on the NYSE and 90% was done by individual investors, the amateurs were set up to lose to the professionals.
Here are some of the characteristics of individual investors that are worth keeping in mind: Individual investors typically do not do extensive “comparison shopping.” Most individual investors are not expert on even a few companies. They rely on retail brokers who are seldom experts either. They buy because they inherit money, get a special bonus, sell a house, or something else equally outside the stock market. They sell because their child is going off to college or they have decided to buy a home—again, for reasons outside the stock market. The activity of most individual investors is not driven by investment information based on market analysis or company research or rigorous valuations. The activity of most individual investors is what academics correctly call “informationless trading.”
So, it is little wonder that professional investors—who are always in the market, making rigorous comparisons of price to value across hundreds of different stocks on which they can command extensive, up-to-the-minute information—would have thought they were able to “outperform” the individual investors who did 90% of all the trading done on the NYSE. They could and did—a generation ago.3 But not today.
Today, after 50 years, the old 90:10 ratio has been completely reversed. The tables have been turned all the way around—and the consequences are profound. Now, 90% of all NYSE trades are done by the “professional” crowd.4 And what a crowd of professionals they are. Top of the class at graduate school, they are “the best and the brightest,” and they are highly motivated. They do not “play to play”—they play to win.
But hard as they try, the grim reality is that the professionals are not beating the market. The simple reason is that these skilled and unrelenting professionals are the market. Sure, the professionals will not always get it right, but they will just as certainly be trying very hard—all the time and with every resource they can muster. Yes, they do and will make errors, but they will make fewer and fewer errors less and less often and the errors they do make will be corrected more and more quickly. Their “only” problem is that there are not enough amateur patsies around. So, active investing produces too little reward or costs too much or both.5
The cumulative genius of the past generation has transformed the challenge—for both investment managers and clients—from finding ways to beat the market to learning to accept the semi-efficient market reality as a given and to make the best of this reality by making explicit the important choices about long-term objectives and policies. This challenge means shifting from investment craft to the true investment profession of informed, skillful investment counseling.
To advise on asset mix, investment counselors will do well to have skills in managing portfolios in each asset class—so they can help implement what they recommend—and to have open channels of communication with clients. Communication is important because both parties have important work to do in the process of determining appropriate long-term investment objectives and defining the investment policies most able to achieve those long-term objectives.
The trusted investment counselor's main professional work is to help each client identify, understand, and commit consistently to long-term investment objectives that are both realistic in the capital markets and appropriate to the particular client. The hardest work is not figuring out the optimal investment policy; the hardest work is helping clients stay committed to sound investment policy and maintain what Disraeli called “constancy to purpose.” Sustaining a long-term focus at either market highs or market lows is notoriously hard. In either case, emotions are strongest and current market realities are most demanding of change because the facts seem most compelling which is why there is enduring truth to what Pogo so wisely explained: “We have met the enemy and he is us.”
Holding onto sound policy through thick and thin is extraordinarily difficult and extraordinarily important work. The cost of infidelity can be very high. For example, during the past 15 years' very favorable stock market, the average mutual fund gained 15% annually, but the average mutual fund investor gained only 10%. Fully one-third of the available return was lost by mutual fund investors switching from one fund to another fund—all too often selling low and buying high.
Dad would have challenged the perceptions of investors—and of most investment professionals—with what we kids found a familiar series of inquiries, but with an interesting difference. Instead of asking why the sellers are selling their services, Dad's questions would drill down into why buyers are buying. Here's the way the inquiry might go:
“Why do investors pay such handsome fees for investment management?”
“Because, Dad, folks want to make money and they expect to make more money when they pay up for the best managers.”
“Did you know that it actually works the other way around?”
“Dad, is this a trick question?”
“No, it's not a trick question, but getting the right answer will take some careful thinking.”
And before long, Dad would have us understanding that there are three levels of decision for the investor to make and that, whereas most investors take investment services as a blended package, services can be unbundled into three separable components or levels:
Dad would then explain that investment counseling on asset mix (a Level One decision) and on equity mix (a Level Two decision) is inexpensive and needed only once every few years. (An individual investor with $1 million can buy this service from an expert for less than $5,000 once every 5 or 10 years. An institution with $10 billion might pay $50,000.) Active management (a Level Three decision) can cost—for the management and the transactions—about 1% of the $1 million individual investor's assets, or $10,000 each year and $50,000 over five years.
The irony, Dad would point out, is that the most value-adding service available to investors—investment counseling—although demonstrably inexpensive, is in very little demand. Active management, although usually not successful at adding value, comes at a high cost.
Dad would want us, as investors and as investment professionals, to at least consider thinking independently enough to realize that the three levels of service can be obtained separately and that we can limit what we pay to the added value of the results we can reasonably expect. Dad would want us to think carefully about the real challenges we face. As Warren Buffett has said about poker: “If after 20 minutes you don't know who the patsy is, you are the patsy!” Let us not fool ourselves.
Source: Copyright 1998 CFA Institute. Reproduced with permission from CFA institute. All rights reserved.