It was roughly 27 years ago when I became convinced that the brokerage industry business model was irrevocably broken.  It was too conflicted.  Customers were taken advantage of by hidden commissions.  However, it continued right up to the moment two Bear Sterns managers couldn’t sell bonds they held in a hedge fund.   It started the debt crisis.  But from 1982 – when the Fed started to cut interest rates – bond salesmen had had a legal license to “steal” money … with hidden commissions.   I wanted to be on “the same side of the table” as clients.  If I made money for them, I would also make more money.  If I lost them money, I would also lose.   So I started to look into the investment management business.

 I first learned of the actual business reality of managing money in 1990. A young stock analyst at Goldman Sachs rolled out his new coverage of the then nascent public investment industry by saying, “The business of managing money is not about managing money … it is about gathering assets.”  Whoa!  The investment world did not like that kind of candor.  In fact, he was excoriated for it.  But it was the truth.  After all, how much a portfolio manager makes depends on how much he has under management.   And the driver for that reality is performance.   Peter Lynch made Fidelity famous and very rich just as Bill Miller would start to do for Legg Mason Wood Walker beginning in 1991. 

But how does one achieve performance?  First, you have to have the right environment; an environment in which individual stocks are traded … individually.  This can only occur in a low correlated market.  For the past seven years we have had a stock market moving with a correlation of 75% to 95%.  Normal stock correlation is historically 26%.  We can easily understand 75% to 95% in a declining market because everyone wants to sell.  But in an up market there is no reason other than ETFs and index funds trade with a 100% correlation.  Pair that with high-frequency trading and it can amount to 80% of trading volume without price discovery.  And price discovery is the very reason markets exist!

It may seem strange to refer to money management as a game.  But keep in mind “the business of managing money is not about managing money, it is about gathering assets.” Nothing gathers assets faster than a mutual fund with “hot” performance.  It is the difference between running a pooled account and a separate account.   A mutual fund is a pooled account.  A separate account is one with your name on the portfolio; it and the tax consequencs are unique to you.  And so is the performance risk taken by a portfolio manager.   If one is after performance, then you own as few stocks as possible. Ten to fifteen is ideal but no more than twenty.   It’s called a concentrated portfolio. 

Bill Miller’s management style was an example of the strategy.   With it, he established a record 15 consecutive years of beating the S&P 500.  At one point, four stocks were 50% of his portfolio.  But when the debt crisis hit, he went from having the best record in the business to one of the worst.   That is the inherent danger of a concentrated portfolio.   It is a game.  For the separate account manager, a concentrated portfolio is not an option.  We have a fiduciary responsibility to the individual client.  And that is the key difference between a pooled mutual fund customer and a separate account client. 

-Francis Patrick Boland