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One of my favourite films is The Shawshank Redemption, based on a short story by Stephen King. It stars Tim Robbins and Morgan Freeman, and the whole thing takes place inside a prison. There is a scene where Freeman’s inmate character is talking to another inmate about a guy named Brooks who has been locked up for 40 or 50 years and has basically lived his whole life in prison. Brooks is now an old man and up for parole, and he is terrified of getting out because he does not remember how to live in the real world. My favourite line is in this scene, when Freeman says: “These prison walls are funny. First you hate ’em, then you get used to ’em. Enough time passes, you get so you depend on ‘em. That’s institutionalised.”
This notion applies to many areas of life. It is easy to resign yourself to a bad situation and accept your lot in life. After a while you do not know how to live any other way. You make up all sorts of reasons to justify why it is alright to remain in a bad situation. This can be true of jobs and relationships and other things. Like the money management business.
I think a lot of money managers are like Brooks. They have become institutionalised.
The average actively managed mutual fund in the US holds about 100 stocks. This means the managers can’t possibly be doing in-depth research on each company they hold. So how is the average fund managed, if not by researching each stock in the portfolio?
The most common way is for a manager to figure out what sectors they want to overweight or underweight and then have their analyst staff figure out which stocks to buy based on targeted sector weightings. They come up with these weightings based on whatever benchmark they’re judged against, tweaking them a bit to beat the index by a small amount. The optimal sector weightings change daily based on valuations and momentum and other factors, and so managers have to continually re-balance their portfolios.
Is this rational? Well, the answer depends on what these managers are trying to achieve. If their goal is to make as much money as possible over a given time-frame, say 10 years, then this is highly irrational. They do not stand much of a chance of beating the market by a significant amount if they are just mimicking the market and adding a few small tweaks. If, instead, the goal of a money manager is to keep his or her job, then this behaviour is rational.
I am amazed that someone who gets paid $1m or $2m a year is holding 50 or 100 stocks in the portfolio. The reason for holding so many stocks is that you feel you cannot understand any single company well enough to assess the risks, and so you are going to hold many stocks to minimise the risk of being wrong on any single one. You stand a small chance of dramatically underperforming your benchmark if you do this, and so have a high chance of keeping your job.
Investing is not easy, but if I am paying someone $2m a year to run a portfolio, the manager had better be good enough to figure out the risk profile of a company. If they are not good enough to do that, why the hell are they getting paid so much?
Well, the manager is good enough. But the investment firm has the manager handcuffed. If you are a manager at one of the large mutual fund companies and deviate much from the index, it might be in the wrong direction. You might underperform your benchmark for a couple of years, or three, even if you are one of the best managers. And the fund marketing people will not allow that, assets will get pulled out or at least stop coming in, the Morningstar star rating goes down making it hard to advertise the fund and so it is risky for a mutual fund manager to try and outperform the market by deviating from the index.
The definition of risk is different for a mutual fund manager than it is for investors. For a manager, risk is defined as deviation from the index. For an investor, risk is defined as losing money. The root cause of the conflict is communication. The marketing people don’t tell investors that they have this conflict, and so investors naively assume their interests and those of the fund manager are aligned.
The world would be a much, much better place if the words “marketing department” and “money management” were never uttered in the same sentence. Karl Marx once wrote that capitalism would eat itself. Here we have a glaring example of that maxim.
The fact that few people understand this is why it will never change. There is a huge machine working hard to prevent people from knowing about the fact that actively managed mutual funds have different incentives than investors.
And so, after a while, even talented managers will become resigned to their lot in life. They are secure, they are making a lot of money, and they sleep well at night. After you have been doing it long enough, you forget what it means to run a stock portfolio the way it is supposed to be run. And when you get to that point, like Shawshank’s Brooks, you have been institutionalised.
The writer is a former equities strategist at Morningstar who manages a hedge fund, Sellers Capital, in Chicago. firstname.lastname@example.org
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