September 13, 2011
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In the investment business, assets under management are concentrated with the largest and most established firms. Understandably, investors tend to allocate capital to managers after they’ve established a good track record. Unfortunately, for many, the analysis stops there. By failing to separate good results from identification of what makes a great investment manager, investors are primed for disappointment.
I recently came across a Fortune Magazine article from 1989 titled Are These The New Warren Buffetts? The article attempted to identify which of the then-current cadre of young money managers might “go on to investing fame and their clients to fortunes.” Of the 12 managers highlighted in the article, 10 were in their 30s, and most only had independent track records of one to five years. Despite this, though, the article attempts to identify what makes a great money manager capable of delivering superior returns. The article provides an ex-ante assessment of what most investors only analyze ex-post.
Now that we have 22 years of history from which to judge these managers, we can evaluate the effort.
The Fortune article cites Warren Buffet, who prioritizes “high-grade ethics. The investment manager must put the client first in everything he does.” He said he wants to know that a manager handles his mother’s money as well as his clients’. Intelligence is important, but the proper temperament is essential: “Rationality is essential when others are making decisions based on short-term greed or fear,” Buffett said. “That is when the money is made.” While the article follows managers who invest across a variety of asset classes — both long and short — and utilize a variety of strategies, the common thread is a value discipline in the spirit of Buffett’s mentor Benjamin Graham. They all use fundamental analysis, among other things, to find mispriced securities that offer a margin of safety. Importantly, the all seek to minimize the true risk of investing—a permanent loss of capital.
The list of 12 managers is astounding, in that it presciently identifies many of the most prominent and successful managers of the last two decades: Michael Price, Jim Chanos, Karen and Jim Cramer, Glenn Greenberg and John Shapiro, Eddie Lampert, Richard Perry and Seth Klarman. The others on the list, including Randy Updyke and Thomas Sweeney, seem to have chosen a quieter path or retired early. The fact that so many of these managers have, in fact, “gone on to investing fame and their clients to fortunes” speaks volumes about the ability of investors to identify great managers.
Finding managers with the requisite ethics, aligned incentives, proper temperament and a disciplined value-oriented approach will go a long way toward ensuring long-term performance success.
Size matters (but not how you think it does)
In addition to the qualitative characteristics above, what other things should investors look for in choosing money managers? In Modern Portfolio Theory IS Harming Your Portfolio, I suggested that smaller firms are often in a better position to manage assets, because they are free from the rigidity of investment committees, corporate culture and the difficulty of quickly deploying assets when an opportunity arises.
The cultural constraints I was referring to were highlighted in Comfort is Rarely Rewarded; Maverick Risk and False Benchmarks, where I argued that too many in our industry have become asset gatherers instead of asset managers, favoring the business of investing at the expense of the profession of investing. When firms become successful and large, it becomes increasingly difficult for them to focus on investment results for their clients.
In a January 2009 paper entitled, “Does Size Matter in the Hedge Fund Industry?”, Melvyn Teo concluded there was a negative, convex relationship between hedge fund size and future risk-adjusted returns.
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