Recently, a lady friend told us about an acquaintance of hers who had lost everything in the Bernard Madoff scandal. I replied that it was astounding to me that anyone would invest all of his financial assets with only one manager, particularly one who refused to discuss his methodology, and who acted also as stockbroker, fund administrator, and custodian. The lady replied, "What's a custodian?" Therein lies the root of the problem. Many people who have accumulated wealth in fields other than finance and who now require management of their financial assets rarely have sufficient understanding of either the vocabulary of Wall Street or the workings of the investment management business. About a decade ago, we were given a summary explanation of Madoff's strategy by one of his investors, and we quickly concluded it would be impossible for this method to produce consistently positive returns regardless of prevailing financial market conditions. For so many investors to have accepted it on faith seemed incomprehensible.
Most prospective clients have little capability to evaluate an investment management firm and almost no framework of inquiry to properly monitor and evaluate a manager's ongoing performance. There is an old saw that says, The money always follows the performance. Investment managers whose recent performance records are particularly impressive inevitably attract large sums from new clients, often just as their particular style is nearing the end of a good run. Managers have many different investment styles, e.g. focusing on small companies, mid-sized, or large capitalization companies in both growth and value categories. None of these styles works equally well in all economic and financial market environments. An investor needs to understand what style he is committing to and to understand the likely characteristics of that style, particularly its volatility relative to some broadly accepted benchmark, such as the Standard & Poors 500 Stock Index. Moreover, an investor needs to understand how the manager proposes to control risk, both in individual holdings and in the portfolio as a whole.
Numerous techniques are employed by professionals to measure and evaluate a manager, including among others, such indicators as Tracking Error, Sharpe Ratio, Information Ratio, Up Month/Down Month Performance, etc. In addition, Portfolio Attribution Analysis will reveal which investments are earning the returns, both absolutely and relative to the manager's benchmark, and conversely, those where negative results are impacting performance. A manager needs to be able to explain his selection and retention criteria for both his winners and his losers. For a layman to evaluate each individual portfolio holding is likely to prove impossible, but if one understands the proper framework of questions to be put to a manager in periodic performance reviews, some success is achievable.
An industry of Investment Consultants has emerged over the past twenty-five-thirty years to aid the uninitiated in the selection and monitoring of investment managers, but even here there are pitfalls to be avoided. Consultants spend a great deal of effort allocating client assets over a broad range of investment categories including various types of bonds, as well as small, medium and large capitalization equities, both domestic and international, and a whole range of so-called alternative investments, e.g. real estate, oil and gas, commodities, structured products, hedge funds, etc. In the years before this practice became widespread, there was often a distinct lack of correlation between the results achieved by many of these. However, the evidence of recent years suggests the vast majority of these asset classes have become highly correlated. Ergo, diversification does not always dampen a portfolio's volatility. Another misconception to which the consultants adhere is the notion that "Cash is always trash."Nothing could be further from the truth, as the experience of 2008 amply demonstrates. If one cannot have true conviction regarding the risk/reward prospects of an investment, cash is always a wise alternative. Finally, consultants typically ask their clients to choose from a "short list" of managers, all of whom have impressive three to five year records. By itself, this should be a signal for caution. Moreover, consultants often recommend firing a manager just as his investment style is about to come back into favor. Like the economy itself, investment styles are cyclical.
In addition, it has become fashionable lately to debunk the notion of long-term investing. In fact, such a strategy has rarely proved successful except in some cases of family controlled and managed companies. Instead, successful investing in publicly traded assets has always depended on seeking out the most undervalued asset classes and being willing to buy them when they are out of favor and sell them once their potential for profit margin expansion or, in the case of bonds, spread narrowing, is over and peak market valuations have been achieved. Said differently: Buy Low, Sell High has always been the proper investment strategy.
If one does not know the right questions to ask when choosing a manager or monitoring his performance, one should either learn them or refrain from investing. This time, as always, the global economy will eventually recover. A rise in business activity and corporate profitability will pave the way for an increase in the capital value of many businesses. Savvy investment managers who know how to evaluate companies and their profit potential will have the conviction to invest early and benefit accordingly. Regrettably, it will only be after the economy has enjoyed a few years of recovery and equities already reflect that improvement that the uninitiated will return to the marketplace paying prices that already reflect the new reality. The irony is that the Bear Market of 2007-8 culminating with the Madoff scandal has now reached the "Revulsion" stage, which has probably removed most investment risk. Few will accept that notion, however, until much later.
December 29, 2008
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