Efficient Frontier
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William J. Bernstein

The Executioner of Excellence

For many years, I’ve been troubled by a conundrum: If mutual fund investors are not earning the market return, even adjusting for expenses, who is taking the winning side of their transactions? The yawning gap between dollar-weighted and time-weighted mutual fund data demonstrates just how far short John Q. Public falls. Amazingly, professionals, as represented by the managers of hedge funds, mutual funds, and pension funds, don’t do that much better.

So, after Bogle’s Croupier collects his take, who is getting rich off the losers? Recent articles from the finance literature, popular press and, strangely enough, cognitive psychologists shine some light on this thorny question.

The first piece, by Marcin Kacperczyk and Amit Seru in the latest Journal of Finance, is entitled "Fund Manager Use of Public Information: New Evidence of Managerial Skills." In order to probe the relationship between public information and equity returns, the authors devised a measure of how aggressively and often mutual fund managers responded to analyst recommendations. They found that the more a manager did so, the worse his results. The authors concluded that "the value of a sophisticated investor derives from the private information he brings to the process." (Italics added.)

Kacperczyk and Seru cannot possibly mean that successful fund managers are able to uncover material nonpublic raw data on a large number of companies. Rather than "private information," I suspect what they meant was "private evaluation." That is to say, successful managers demonstrate an ability to think for themselves. Whatever their precise meaning, the message is clear: those who live by the buzz die by the buzz.

The second piece of the puzzle appeared in the April 5, 2007 Wall Street Journal in an unobtrusive article by Ilan Brat on Illinois Tool Works, an industrial conglomerate that has done rather well buying up small private firms. As every small business owner ruefully knows, tiny concerns do not sell at anywhere near the multiples that public companies do. In fact, until very recently, ITW has been able to purchase compatible small businesses for an inexpensive annual-revenue multiple of 1.1. Of late, it has had trouble meeting this hurdle in the U.S., but is having better luck in China.

The message of both pieces is: If you want to earn high investment returns, you’re going to have to look far from the overgrazed investment commons. At a bare minimum, you have to tune out the noise from the media and analysts of all stripes, and actually think for yourself. This is not something everyone can do; abstracting investment ideas from Forbes does not count.

Beyond that, you’ll probably need to avoid the public securities markets altogether and invest privately. Needless to say, purchasing and running a diversified stable of small concerns is not for the faint hearted, the quantitatively weak, or those without razor-sharp interpersonal skills, exquisite business training, and huge gobs of spare time.

The authors of a third piece, from the same issue of Journal of Finance, agreed. Josh Lerner, Antoinette Schoar, and Wan Wongsunwai examined the investment returns of various organizational structures, reasoning that if investment skill was to be found anywhere, it would indeed be in the wild and wooly world of private equity. Their results were stunning. As expected, banks, insurance companies, investment companies, private advisors, and corporate pension funds did not do terribly well. Public pension funds did a little better, and one group—endowments—did spectacularly well, with returns 21% better than average.

What’s going on here? One would have expected better performance emanating from managers motivated by the stratospheric pay available at investment companies, banks, and venture-capital advisory firms. Why did the relatively monastic public pensions and endowments do so well?

The natural place to start is with David Swensen, Yale’s wildly successful endowment manager, who was paid $1.3 million in 2005—chump change for someone with his track record. What drives him? Why does he hang around Yale when he could be doing so much better elsewhere? In a recent interview with the New York Times, Swensen described his pleasure at knowing that he made it possible for many more poor students to attend Yale: "In the finance world it is very easy to measure winning and losing in dollars and cents. That has always seemed to be an inadequate measure. The quality of life is a better way to measure winning and losing. Money is only one element of that."

And speaking of successful money managers, while Warren Buffett has not exactly taken the same vow of "poverty," he does share Swensen’s otherworldliness, living in the same modest house for several decades, fitting out his living room at the Omaha Furniture Mart, and subsisting on Coke and cheeseburgers. Is there a connection between Buffet and Swensen’s relative disdain of the material world and their brilliance as money managers and, more generally, of the superior performance of endowments and public pension plans?

You bet there is. Cognitive psychologists have long known that we are very poor judges of what makes us happy: the pleasure from money, fame, possessions, and power turns out to be quite transient (and so is the pain from things which we think would permanently sadden us: the depression caused by sudden, permanent blindness or paraplegia, for example, is surprisingly short-lived).

Three things provide long-lasting satisfaction, as quantitatively measured by academic psychologists: autonomy, meaningful contact with others, and the development and exercise of competence. Cognitive researchers loosely refer to fame, fortune, and power as "external rewards," and autonomy, connectedness, and competence as "internal rewards." The American workplace environment pushes far too many people to sacrifice the latter for the former. That humans often exchange independence and the love of friends and family for mammon is a trite homily; that they frequently sacrifice the pleasure of craft for lucre is less obvious, but equally true.

How else to explain the goings on at Enron, WorldCom or, for that matter, Dell Computer, once highly successful companies whose managements sought all the wrong incentives? Likewise, money managers at large investment companies, banks, and insurance companies, too focused on next quarter’s bottom line and next year’s bonus, gradually disengage from the slow, methodical development of their skills. Add a soupçon of fear of failing unconventionally, stir in a large dollop of groupthink, cook slowly for several years, and competence eventually simmers off.

That the pursuit of high compensation actually destroys ability should not surprise; the fact that the CEOs of large European corporations are paid a small fraction of what their American counterparts receive does not mean that our firms are better managed. Far from it; were pay related to performance, then Disney, Time Warner, and Blockbuster should be the best-run firms in the United States. Were high salaries a necessary ingredient for performance, the Diplomatic Corps, Jesuits, and Navy Seals would not be able to attract highly qualified personnel.

The conflict between compensation and competence resonates far beyond finance and the corporate world. As someone who spent a third of a century in medicine, the recent enthusiasm for physician pay-for-performance ("P4P") frightens the bejabbers out of me. I’d rather not have my physician more concerned with making her cholesterol screening quota than evaluating my new cough in expert fashion. Medicine is a field which requires exquisite judgment in ambiguous situations—exactly the circumstances in which cognitive psychologists have found "external incentives" to be the most corrosive.

Ambiguity and complexity, of course, are also finance’s middle names. This goes a long way towards explaining why many of the best money managers are paid a relative pittance, and why many of the worst CEOs have the fattest compensation packages. For investment’s top tier, the craft is far more than a job, a paycheck, or even a profession; it’s a lonely quest for excellence, a calling which maximizes the metaphorical distance from Wall Street.

The message for small investors is clear. Begin with the assumption that you value your independence, family, friends, and intellectual and physical development, and do not want to spend the rest of your life buying and managing small machine tool shops and insurance offices, or financing chip, software, and Internet startups. Even with their relatively lower returns, the public securities markets will allow most people to finance their children’s education and their own retirement goals.

If you want to pick your own stocks and bonds, be my guest. Just don’t imagine that making your decisions on the basis of publicly available information and analysis will lead you anywhere but to the poor house. You’re going to have to look at the primary data and analyze it entirely by yourself. And you’d better be good at it.

Most people will choose the mutual fund or ETF route, where it pays mightily to ask exactly what values underlie your investment company’s culture: raw financial incentive or pride of craft? In a poker game, the person who doesn’t know who the patsy is, is the patsy. In the same way, if you’re not absolutely clear about whether your fund family is a marketing company or an investment company, then you are the patsy.

Copyright © 2007, William J. Bernstein. All rights reserved.

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